Regulators Require Accounting Firms to Comply With New Quality Control Systems as a Safe Harbor
A few months ago, in October 2020, the U.S. Securities and Exchange Commission (“SEC”) adopted amendments to auditor independence standards and rules outlined in SEC Rule 2-01 of Regulation S-X (17 C.F.R. §210.2-01). In November 2020, the Public Company Accounting Oversight Board (“PCAOB”) followed suit by approving revisions to its independence standards and rules so that they would align with the recent SEC revisions. See PCAOB Release No. 2020-003. The Texas Rules of Professional Conduct adopted by the Texas State Board of Public Accountancy (“Texas Board”) provide that public accountants, “shall conform in fact and in appearance” to the independence standards established by the American Institute of Certified Public Accountants, the SEC and the PCAOB. See 22 Tex. Admin. Code Rule §501.70; see also §501.73. Although the recent revisions to the independence rules do not take effect until June 2021, the PCAOB encourages registered firms to comply immediately. See PCAOB Release No. 2020-003, p. 4.
In making these revisions, it was reiterated that the amendments are intended to more effectively focus the independence analysis and help, “maintain the bedrock principle that auditors must be independent in fact and in appearance.” See 85 FR 80508-01, “Qualification and Accountants” (Dec. 11, 2020). To that end, the amendments offer the following:
- Updated definitions for “Audit Client” and “Investment Company Complex” to clarify acceptable relationships with an audit client and its affiliated entities;
- Clarification concerning acceptable debtor-creditor relationships between the individual auditors and the audit client arising from student, mortgage and consumer loans;
- Revisions to the “Business Relationships Rule” concerning individuals with potential control or influence over the audit client; and
- A safe harbor for inadvertent independence violations by an auditor arising from client mergers and acquisitions.
Each of these topics is worthy of close study prior to their June 2021 effective date. But the safe harbor for inadvertent independence violations deserves immediate attention and implementation because there are compliance costs associated with it, including the requirement that the firm establishes a quality control system.
More specifically, the safe harbor amendments adopted by the SEC and PCAOB provide a transition framework to address inadvertent independence violations arising from an audit client corporate event, such as a merger or acquisition. For instance, an acquisition transaction could result in an auditor independence violation if the auditing firm provides non-audit services to the target company and audit services to the acquiring company. To avoid liability for such an inadvertent violation, the amendments to the independence rules require that the auditor:
- Comply with the applicable independence standards when the services began, as well as throughout the relationship prior to the event;
- Correct any independence violations arising from the merger or acquisition as promptly as possible;
- Have in place a quality control system with procedures and controls that:
- monitor the audit client’s merger and acquisition activity to provide timely notice of a merger or acquisition, and
- allow for the prompt identification of potential violations after initial notification of a potential merger or acquisition that may trigger independence violations, but before the transaction has occurred.
See 17 C.F.R. §210.2-01(e) (effective Jun. 9, 2021). If the audit firm fails to establish such a control system immediately, it could result in clients having to delay mergers and acquisitions, terminating audit services mid-stream, and other potentially costly disruptions. See 85 FR 80537.
Importantly, a violation of the independence rules is also a violation of the Texas Board Rules of Professional Conduct and could subject both the individuals and the firm to disciplinary action. See Tex. Public Accountancy Act, §901.502(6). If the Texas Board finds there are grounds for discipline, it may revoke, suspend, or refuse to renew a firm or individual’s license. Id. §901.501(a). It may also impose administrative penalties; the upper range for lack of independence is $100,000 per violation. See 22 Tex. Admin. Code §519.9(a). Therefore, firm management and compliance team members should carefully consider the independence rule requirements and implement a quality control system for possible inadvertent violations as soon as possible.
Hedrick Kring Bailey, PLLC has extensive experience consulting and advising both regional and national accounting firms concerning complex issues before the Texas Board, including licensing, independence, and the practice of public accountancy. David McAtee has been representing major accounting firms and their partners for over three decades. David’s experience includes litigation, arbitration, and governmental investigations, primarily involving allegations of audit failures. David is well-known for his defense of over 100 investigations launched by the Texas State Board of Public Accountancy. Jeff Price has worked directly with David on State Board investigations and general licensing issues for nearly 10 years.