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Auditor Independence and SEC Enforcement Actions

Auditor Independence and SEC Enforcement Actions

Auditor independence is super important when it comes to public company auditing in the U.S. Auditors need to remain objective and impartial when conducting audits so that investors can trust the financial statements. The Securities and Exchange Commission (SEC) is in charge of enforcing the auditor independence rules and will bring enforcement actions when auditors don’t follow the requirements. Over the years, the SEC has charged a bunch of auditors and audit firms with not being independent from their clients. These enforcement actions highlight some of the key threats to auditor independence and provide lessons for audit firms on how to stay objective.

What is Auditor Independence?

Auditor independence means an auditor can maintain an unbiased mindset when conducting an audit. Auditors should be free from any influence, interest, or relationship that could mess with their professional judgement. Like the SEC says, “When an auditor acts as an advocate for its audit client, that independence is compromised.”SEC rules prohibit auditors from having certain financial, employment, business, and personal relationships with audit clients that could make people doubt their objectivity. For instance, auditors can’t own stock in their audit clients, get bonuses based on the results of an audit, or provide certain non-audit services to audit clients. Audit firms also have to have quality controls and partner rotation policies that help protect independence. Additionally, public companies need to have independent audit committees that are responsible for hiring, paying, and overseeing the external auditors.

Why Auditor Independence Matters

Auditor independence is crucial for protecting the integrity of financial reporting. Investors rely on auditors to closely examine companies’ financial statements and confirm they don’t have any major misstatements. If auditors lack independence, they might be more likely to accept a company’s questionable accounting without asking enough questions or might not exercise enough professional skepticism. This could allow misstatements or fraud to go unnoticed, undermining the reliability of the financial statements. Even just the appearance of impaired independence can shake investor confidence and raise doubts about the audit process. Like the SEC says, auditor independence rules aim to protect “investor protection and investor confidence.”

Common SEC Enforcement Actions

The SEC often brings enforcement actions against auditors related to independence violations. Some common situations that have led to charges include:

• Auditors providing prohibited non-audit services to audit clients
• Auditors having improper business or financial relationships with audit clients
• Auditors lobbying on behalf of audit clients
• Auditors having overly close personal ties with client employees
• Failures by audit firms to properly monitor and disclose independence impairments

Often these enforcement actions involve charges against both the audit firms and individual auditors. The firms and auditors typically agree to settle the charges without admitting or denying the SEC’s findings.

Non-Audit Services

One issue that keeps coming up is auditors providing non-audit services, like consulting or tax work, to their audit clients. SEC rules prohibit auditors from providing certain non-audit services that could compromise their independence. For example, in 2019 the SEC charged PwC with improperly providing various non-audit services, like accounting and HR help, to companies they audited. PwC agreed to pay $7.9 million to settle the charges. The SEC said PwC broke independence rules and didn’t give audit committees the information they needed to assess if the non-audit services hurt PwC’s objectivity.

Business Relationships

The SEC also often brings cases involving auditors having improper business relationships with clients. This could include situations like:

• Owning stock in an audit client
• Having joint business ventures or investments with an audit client
• Providing services to an audit client on a bonus fee basis

In 2016, the SEC charged Ernst & Young and two of its former partners with lacking independence because of close personal relationships between the auditors and client employees. The sketchy relationships included romantic relationships and vacationing together.

Lobbying Activities

Auditors can’t lobby on behalf of their audit clients, since that puts them in the position of being an advocate. But the SEC has found cases of audit firms engaging in improper lobbying activities. In 2014, the SEC charged Ernst & Young with breaking independence rules when one of its subsidiaries lobbied congressional staff on behalf of two audit clients. Ernst & Young paid $4 million to settle the charges.

Failure to Disclose

The SEC has also targeted auditors for failing to properly disclose independence impairments to audit committees. Audit firms have to report all independence issues so that audit committees can evaluate the impact. In 2019, the SEC fined MNP LLP $1.5 million for violating rules related to disclosing non-audit services to issuer audit committees. The SEC said proper disclosure allows audit committees to closely examine auditor independence.

Impact on Audit Firms

SEC enforcement actions can have major consequences for audit firms. The penalties, disgorgement, and interest can total millions of dollars. The firms often have to overhaul compliance procedures and submit to additional reviews by the SEC. Enforcement actions also damage audit firms’ reputations. They can raise doubts among investors and audit committees about the firms’ commitment to independence. As a result, audit firms make big efforts to comply with independence requirements and avoid violations. This includes implementing robust internal compliance programs, training auditors on independence rules, and imposing restrictions around non-audit services and business relationships.

Recent Changes to SEC Independence Rules

While longstanding auditor independence rules remain in place, the SEC recently updated certain requirements to align with developments in practice. In October 2020, the SEC adopted amendments focusing on three key areas:

• Certain Lending Relationships: Eases restrictions on auditors getting consumer loans, like mortgages and credit cards, from audit client employees.
• Business Relationships: Narrows restrictions on non-audit services to affiliates of audit clients that aren’t under common control.
• Audit Committee Communications: Reduces requirements around communicating certain independence matters annually to audit committees.

According to SEC Chairman Jay Clayton, the updates “will increase investor protection by focusing audit clients, audit committees, and auditors on areas that may threaten an auditor’s objectivity and impartiality.”

Looking Ahead

Maintaining auditor independence remains one of the pillars of financial reporting. The SEC will likely keep closely watching auditors and bringing enforcement cases when independence violations happen. At the same time, the SEC may consider additional updates to independence rules to keep up with the evolving audit landscape. But any changes will aim to protect investors and uphold audit quality.Audit firms also need to stay vigilant in complying with independence requirements. Robust internal compliance programs, proper disclosures to audit committees, and a tone at the top emphasizing independence help safeguard objectivity. Ongoing investments in compliance, training, and monitoring systems can help auditors avoid the severe consequences of an SEC enforcement action.