The issue of auditor independence has been existence since the dawn of the public accountant. The guidance governing independence of auditors is not new either. However, auditors still struggle to play by the rules.

In fact, just last week, just last week, the PCAOB released a Staff Inspection Brief, Preview of Observations from 2016 Inspections of Auditors of Brokers and Dealers. It its Brief, the PCAOB highlighted that they continue to see instances in which independence appeared to be impaired because auditors were involved in the preparation of the financial statements or performed bookkeeping or other prohibited services for their broker and dealer clients.

And this isn’t the only time auditors of brokers and dealers have struggled with independence in recent years. Don’t believe me? Check out this post from over a year ago, which even includes an example of an auditor’s involvement in financial statement preparation! In light of these continued struggles, we could not think of a better day than Independence Day to (re)focus on auditor independence!

What is Independence?

When trying to answer independence questions (e.g. what is independence?) one of our go-to resources in the AICPA’s Plain English Guide to Independence. According to that document, independence is defined as follows:

• Independence of Mind – State of mind that permits a member to perform an attest service without being affected by influences that compromise professional judgment, thereby allowing an individual to act with integrity and exercise objectivity and professional skepticism.
• Independence in Appearance – Avoidance of circumstances that would cause a reasonable and informed third party, who has knowledge of all relevant information, including safeguards applied, to reasonably conclude that the integrity, objectivity, or professional skepticism of a firm or member of the attest engagement team is compromised.

Need more of a reminder on the rules of independence? Check out our blog post here. Think you’re on board with the requirements? Let’s test your knowledge!

Scenario 1: Just Friends

Amber Clark is the auditor of Back in Black Inc., an upscale Goth clothing manufacturer. Over the past several years, she has developed a close working relationship with the controller, Dianne Clark (not related). They are Facebook friends and Amber is invited to Dianne’s annual blowout Goth party. They are even planning to go on a Goth cruise together next spring, but will have to share a cabin due to the expense.

Is independence impaired?

Answer: Probably. The Conceptual Framework for AICPA Independence Standards defines independence in appearance as “the avoidance of circumstances that would cause a reasonable and informed third party, having knowledge of all relevant information, including safeguards applied, to reasonably conclude that the integrity, objectivity, or professional skepticism of a firm or a member of the attest engagement team has been compromised.”

Problems with independence in appearance occur when practitioners become too close to their clients. When you are too close to a client, there is a heightened risk that perhaps the auditor is unduly influenced by the client, which, in turn, raises questions regarding the auditor’s integrity, objectivity, and ability to exercise professional skepticism.

Let’s look at another example…

Scenario 2: Outstanding Loans

Freddy Mercury is the engagement manager on the Champions Bank. Freddy has an outstanding home loan with Champions, but that is only because his loan was acquired by Champions last year. He also has a car loan with Champions for the purchase of his new Mercury Sable.

Is independence impaired?

Answer: No. The mortgage on his home is grandfathered and car loans fully securitized by the vehicle are permitted.

If you are a covered member, which Freddy would be considered to be, with respect to an attest client, you and your immediate family may not have a loan to or from:

• The attest client
• An officer of director of the attest client
• An individual holding 10 percent or more of the attest client’s outstanding equity securities

Certain exceptions affect this rule. First, specific loans exist that covered members are permitted to have from lending institution attestation clients, including:

• Car loans and leases collateralized by the vehicle.
• Credit card and overdraft reserve account balances that are kept current and do not exceed $10,000 (by payment due date, including any grace period).
• Passbook loans fully collateralized by cash deposits at the same financial institution.
• Loans fully collateralized by an insurance policy.

In addition, if you have a loan from a lending institution that is an attest client that meets certain criteria, you loan may be grandfathered (that is, you may be allowed to keep it). For your loan to be grandfathered, you must have obtained it under normal lending procedures, terms, and requirements. The following loans may be grandfathered:

• Home mortgages
• Other secured loans
• Unsecured loans that are immaterial to your net worth

Okay, how about one last example?

Scenario 3: Travel Expenses and Meals

Clarice Starling is the audit partner on Lamb Inc. Clarice is always “wining and dining” the CFO, Hannibal Lecter to further their business relationship. One afternoon, Dr. Lecter invited Clarice to fly on the corporate plane to Ireland to hear the lambs crying at slaughter, a sound he feels she must hear once in her life. At first, she refuses, but Dr. Lecter insists saying, “Quid pro quo, Clarice!” She eventually accepts. That evening on the plane, they dine on fava beans and a nice glass of Chianti.

Is independence impaired?

Answer: Yes. The “wining and dining” is probably fine, but once she accepts the trip to Ireland, Clarice’s independence is impaired as she is no longer independent in appearance. According to the AICPA’s Plain English Guide to Independence, Independence is impaired if the firm (or a member of the firm) accepts a gift that is not clearly insignificant. We have a feeling that a trip to Ireland classifies as significant.

In terms of the wining and dining, the guide states that a covered member may give a gift to persons associated with the attest client and not impair independence if the gift is reasonable in the circumstances. In addition, covered members may give or receive entertainment, provided it too is reasonable in the circumstances. When determining the reasonableness of the gift, Clarice should evaluate the event giving rise to the gift, the cost or value, the frequency with which gifts are given, whether business was conducted, and who participated in the gift or event.

We hope these extreme, but factually-based, examples have helped you to see the finer points and distinctions when evaluating auditor independence. This is not an area that is black and white, but often involves judgment when asserting that the audit team is independent in fact AND appearance.

Finally, we would like to take this time to wish all of our readers in the United States of America a very happy Independence Day this 4^th of July. We hope your day is filled with plenty of sunshine, friends & family, fireworks, and all things red, white, and blue!

Disclaimer
This post is published to spread the love of GAAP and provided for informational purposes only. Although we are CPAs and have made every effort to ensure the factual accuracy of the post as of the date it was published, we are not responsible for your ultimate compliance with accounting or auditing standards and you agree not to hold us responsible for such. In addition, we take no responsibility for updating old posts, but may do so from time to time.