Auditor Independence and Ethical Responsibilities: Critical Points to Consider When Contemplating an Audit Firm Restructuring
Acting Chief Accountant
Aug. 29, 2022
Introduction – Complex Business Relationships and Audit Firm Restructurings
Auditor independence and a culture of professional ethical behavior are critical to an audit firm’s ability to fulfill its gatekeeper responsibilities. Accounting firms must keep these responsibilities in mind in all contexts, including when exploring complex business relationships and firm restructurings. In this regard, we have observed audit firms exploring the sale of a portion of their business to an external party while retaining an equity interest or other form of continuing involvement in that business, or divesting all or portions of the accounting firm’s consulting practice to a third-party entity. While such contemplated sale and divestiture deals are not new, in the view of OCA staff, complex transactions with investors that are not traditional accounting firms, and have not previously been subject to the same independence and ethical responsibilities, elevate the risk to an auditor’s independence with respect to its audit clients. In these complex practice structures and divestitures, it is paramount that the accounting firm fully understands its responsibility for maintaining auditor independence and it discloses such requirements to the non-accounting firm investors involved in the transaction so that the accounting firm can obtain the information necessary to fulfill its responsibilities.
For example, when contemplating such transactions, it is critical that accounting firms and their advisors consider the applicability of the definition of “accounting firm” in Rule 2-01 of Regulation S-X (“Rule 2-01” or “the Commission’s auditor independence rule”) to all entities involved in the transaction in order to avoid potential violations of the Commission’s auditor independence requirements. Per the Commission’s definition, an accounting firm includes “the organization’s departments, divisions, parents, subsidiaries and associated entities [emphasis added], including those outside of the United States” and the organization’s pension, retirement, investment, or similar plans. The definition of accounting firm is critically important as it determines which entities are subject to the Commission’s auditor independence rule.
In consultations, we have observed that recent contemplated transactions by accounting firms may involve private equity or other investment structures purchasing ownership interests in the accounting firm (as defined above).
Private equity structures can be complex, and can include entities that have varying levels of influence over other entities—either within their investment portfolio or within the contemplated structure. When an accounting firm is considering obtaining an investment from a private equity or other investment structure, each entity within such structure would need to be carefully evaluated to determine if the entity is an “associated entity” and is therefore part of the accounting firm for purposes of assessing potential impacts on, among other things, compliance with the Commission’s auditor independence requirements.
While the Commission has not defined “associated entity,” it is the staff’s view that the following are pertinent considerations, among others, when making this determination for each entity within the private equity or investment structure: (i) the financial interest the entity has in the accounting firm; and (ii) the ability the entity may have to influence the operating or financial decisions of the accounting firm.
Consider the following hypothetical example. A fund holds an investment in an accounting firm. A general partner has a financial interest in the fund and is responsible for the fund’s investment decisions, and an investment adviser controls the general partner. In this hypothetical example, absent additional facts and circumstances, the OCA staff view is that a reasonable investor with knowledge of all relevant facts and circumstances would conclude that all three entities—the fund, the general partner and the investment adviser—have a financial interest in the accounting firm. In our view, a reasonable investor would also view those three parties as having influence over the accounting firm, either by being a holder of record of the ownership interest (e.g., the fund) or through the ability to control or influence the holder of record.
Relatedly, there may also be individuals, other than audit firm partners, who directly invest in the accounting firm. Such investors’ interests must be evaluated to determine whether they are a shareholder in the accounting firm and, if so, they should be assessed under the “covered person” definition of Rule 2-01. For example, such investor could be a covered person due to having characteristics of being in the chain of command of the accounting firm.
Determining which entities meet the legal definition of accounting firm based on all relevant facts and circumstances is a critical step. However, this determination is just the starting point for the analysis and does not represent the only bounds by which independence considerations should be assessed. Beyond the determination of which entities meet the definition of accounting firm, it is the view of OCA staff that it would be a high hurdle for the accounting firm to be in compliance with Rule 2-01(b) of Regulation S-X (the general standard of auditor independence) if it provides any audit, review, or attestation services with a nexus to the Commission’s independence requirements for any entities within the private equity structure. This is because the relationship would raise potential mutual or conflict of interest concerns in fact or appearance with respect to the nature of the financial relationship between the private equity structure as a whole and the accounting firm.
Accordingly, for any such transaction to avoid potential auditor independence violations, all parties to the transaction should understand the need for both the accounting firm and any covered persons who are investors to implement monitoring processes and controls in order to comply with, among other requirements, the Commission’s auditor independence rule.
Additional Challenges from Private Equity Investment
A membership organization representing the private investment industry describes private equity firms as having a “continuously evolving universe of entities.” This ever-changing environment can create even greater challenges for maintaining auditor independence by the accounting firm after an investment by a third-party or sale of an accounting firm’s business. Maintaining auditor independence would require a suitably-designed and implemented system of vigilant ongoing monitoring of: (i) compliance with applicable regulatory requirements, including—critically—the Commission’s auditor independence requirements; (ii) audit quality; (iii) the accounting firm’s ethical culture; and more broadly, (iv) gatekeeping responsibilities in the interests of investor protection. Importantly, monitoring processes that are effective under the original private equity investment structure may no longer be effective upon the initial investor’s exit and the resulting new equity structure of the accounting firm.
In addition, we observe that private equity investments are often not held on a long-term basis and generally focus on maximizing return on investment. This investment strategy could create incentives that conflict with the auditor independence rules. Accounting firms that enter into transactions with private equity firms should therefore proactively guard against any potential issues, including appearance issues, regarding the accounting firm’s priorities and motives that could compromise its ethical responsibilities and compliance with independence requirements. This may require, among other things, that accounting firms be willing to forego potential revenue so that they can comply with their professional responsibilities and independence requirements. Doing otherwise risks the accounting firm’s reputation and status as a gatekeeper for investor protection.
We remind accounting firms that a failure to comply with auditor independence requirements at any time during an audit and professional engagement period is impermissible. If, post-transaction, accounting firms are unable to comply with these requirements, enforcement investigations and proceedings by the Commission, the PCAOB, or both may result.
Divestiture of a Portion of the Business
In some cases, an accounting firm may contemplate the divestiture of a portion of its business or other form of restructuring where its intent is that the divested entity no longer is part of the accounting firm post-transaction. In such cases, OCA staff expects that, post-transaction, the accounting firm and the divested entity should, at a minimum: (1) adopt separate corporate governance, management and financial structures; (2) terminate all interests between the accounting firm and the divested entity; (3) not have any revenue or profit sharing between the accounting firm and the divested entity; (4) not have any co- or joint-marketing agreements or advertising arrangements (or equivalent) between the accounting firm and the divested entity; (5) prohibit the divested entity and its affiliates from profiting from the accounting firm’s name or logo prospectively; and (6) complete promptly any transition-related shared services between the accounting firm and the divested entity.
We remind accountants that they are required to be independent in both fact and appearance, and when auditor independence is a close-to-the-line call, accounting firms need to have a strong culture and tone at the top that prioritizes its independence and ethical responsibilities above all else. In the current environment, as some accounting firms may be considering changes to their capital and firm structures, we expect accounting firms to keep as their top priority a focus on their vital gatekeeper function. In particular, the fundamental importance of auditor independence, ethical behavior, and a focus on audit quality to maintain the trust of investors. Any business decisions made by an accounting firm should be made with these foundational principles at the forefront.
 This Statement represents the views of the staff of the Office of the Chief Accountant (“OCA”). It is not a rule, regulation, or statement of the Securities and Exchange Commission (“SEC” or the “Commission”). The Commission has neither approved nor disapproved its content. This Statement, like all staff statements, has no legal force or effect: it does not alter or amend applicable law, and it creates no new or additional obligations for any person. “Our” and “we” are used throughout this Statement to refer to OCA staff.
 See, e.g., Paul Munter, Acting Chief Accountant, The Critical Importance of the General Standard of Auditor Independence and an Ethical Culture for the Accounting Profession (June 8, 2022).
 See, e.g., Journal of Accountancy, Private Equity’s Push into Accounting (Oct. 6, 2021), available at https://www.journalofaccountancy.com/news/2021/oct/private-equity-push-into-accounting.html; Cherry Bekaert, Cherry Bekaert Announces Strategic Investment from Parthenon Capital (June 30, 2022), available at https://www.cbh.com/firm-news/cherry-bekaert-announces-strategic-investment-from-parthenon-capital/.
 Wall Street Journal, Deloitte Explores Splitting Auditing, Consulting Arms, Following Ernst & Young (June 8, 2022), available at https://www.wsj.com/articles/deloitte-exploring-splitting-auditing-consulting-arms-following-ernst-young-11654709024?mod=Searchresults_pos1&page=1; Financial Review, The Three Ways E&Y Could Split Its Consulting Arm (June 2022), available at https://www.afr.com/companies/professional-services/the-three-ways-ey-could-split-its-consulting-arm-20220607-p5arsw.
 The Commission has acknowledged the existence of alternative practice structures saying, “[i]n recent years, accounting firms have explored ‘alternative practice structures’ and increasingly entered into new business arrangements with entities not engaged in public accounting.” See Final Rule: Revision of the Commission’s Auditor Independence Requirements, Release No. 33-7919 (Nov. 20, 2000) (the “2000 Adopting Release”), available at https://www.sec.gov/rules/final/33-7919.htm.
 17 CFR 210.2-01(f)(2).
 See supra note 2.
 See 2000 Adopting Release, supra note 5, in which the Commission stated “[w]e intend this phrase [associated entities] to reflect our staff's current practice of addressing these questions in light of all relevant facts and circumstances, looking to the factors identified in our staff's previous guidance on this subject.”
 There may be other parties within a private equity or investment structure such as the limited partners in a fund holding an equity interest in an accounting firm that would need to be evaluated as well. These parties would likely be deemed to have a financial interest in the accounting firm. However, given the variability that exists in limited partnership agreements, a reasonable investor’s conclusions regarding whether or not the limited partner(s) have influence over the accounting firm either directly or indirectly through an ability to influence the fund would be based on the specific facts and circumstances. OCA staff are available for consultation on specific fact patterns.
 17 CFR 210.2-01(f)(11).
 17 CFR 210.2-01(f)(8).
 See Rule 2-01(b). See also supra note 2.
 See Qualification of Accountants, Release No. 33-10876 (Oct. 16, 2020) (the “2020 Adopting Release”), available at https://www.sec.gov/rules/final/2020/33-10876.pdf. See also letter commenting on the proposing release preceding the 2020 Adopting Release from American Investment Council (Mar. 16, 2019), available at https://www.sec.gov/comments/s7-26-19/s72619-6960376-212774.pdf.
 See 2020 Adopting Release, supra note 14, at 43-44.
 See PCAOB QC Section 20, System of Quality Control for a CPA Firm’s Accounting and Auditing Practice, paragraph .20 (requiring the accounting firm to establish monitoring policies and procedures to evaluate the independence, integrity, and objectivity, personnel management, acceptance and continuance of clients and engagements, and engagement performance elements of the accounting firm’s system of quality control).
 See supra note 2, which states, “To preserve the critical role that accountants play in serving the public interest and fulfilling an investor protection mandate, audit firms should lead by example. They should, for example, prioritize auditor independence and a culture of ethical behavior in all professional activities, and where independence on an audit engagement is a close-to-the-line call, the firms must be willing to forego audit and review fees or potentially lucrative restructuring proposals to comply with their independence responsibilities.”