The SEC Proposes to "modernize" Auditor Independence Rules

Editor's Note: The Public Interest Section of the American Accounting Association is pleased to publish the following blog post by Francine McKenna, independent journalist at The Dig, a newsletter, an educator and a researcher. Please contact lawrence.chui@stthomas.edu with questions, comments, or suggestions about our blog, or to express interest in our organization. Disclaimer: When you read the comments of our columnists, please keep in mind that they only speak for themselves. They are not expressing the positions of the AAA or of any other party.

Project Big Picture, Covid-19 and the frailty of English Football Finance

Editor's Note: The Public Interest Section of the American Accounting Association is pleased to publish the following blog post by Dr Rob Wilson & Dr Daniel Plumley from Sheffield Business School, Sheffield Hallam University, Sheffield, UK. Please contact lawrence.chui@stthomas.edu with questions, comments, or suggestions about our blog, or to express interest in our organization. Disclaimer: When you read the comments of our columnists, please keep in mind that they only speak for themselves. They are not expressing the positions of the AAA or of any other party.

 

Covid-19 has unmasked the frailty of the English football financial model. A host of professional clubs in the football pyramid on the brink of financial collapse. The UK government has persisted with its ban on allowing fans to attend live events, which cuts off the lifeblood of the ticket revenue that ensures clubs can meet their financial obligations. Yet, English club finances were bleak well before Covid.

Since the formation of the English Premier League (EPL) in 1992 and the lucrative broadcasting revenues that have followed, the financial gap between the ‘bigger’ clubs and the rest has continued to grow. In this regard, the recent discussion regarding Project Big Picture (a motion tabled by the US owners of Liverpool and Manchester United to revisit the governance structure of the EPL broadcast revenue distribution), labelled a sugar coated cyanide pill, has raised further eyebrows surrounding its financial implications for a number of clubs. Ironically, it is the power and dominance of clubs such as Liverpool and Manchester United that is in part the issue.

Revenue distribution (from the EPL TV deal) in the English football pyramid is a major problem and leads to significant financial inequality between the EPL and the English Football League (EFL). It has also contributed to a decline in competitive balance in the pyramid. On the face of it, there are some positives to Project Big Picture that can address these issues. A £250m bailout to the EFL would not only be welcome but necessary for some lower league clubs to survive. Similarly, the proposed distribution formula of 25% of future EPL broadcasting revenue to the EFL is a positive step. Reducing the EPL to 18 teams could, theoretically lead to stronger competitive balance; good news for future revenue generation if we accept that competitive balance, and uncertainty of outcome, drives revenue. Perhaps most importantly, Project Big Picture proposes to scrap parachute payments which are destructive to competition (especially in the Championship) and help fuel inequality.

However, clubs outside the wealthy elite should be troubled by changes to the voting rights proposal. This is another land grab by the clubs that feed at the top table and destabilises the foundations of the football pyramid. The ‘big 6’ clubs have already taken more share of the international television money and reducing the number of teams needed to pass a collective vote will only be to the detriment of the smaller clubs in the league system.

The devil, as always, is in the detail and all may not be what it seems linked to these proposals. Further detail regarding the 25% of future broadcast revenues for the EFL revealed cause for concern. It stated that clubs promoted from the EFL will have £25m deducted from their TV money for the first 2 seasons in the EPL and this is then returned when/if they are relegated. This system effectively retains a parachute payment and, importantly, reduces the ability of promoted clubs to compete in the EPL. Additionally, the total number of games sold to broadcasters in the future will be smaller as the proposals will also allow clubs to sell up to eight of their own games through their own broadcasting channels. The 25% of the total pot to share between the other 72 clubs continues to shrink as the finer details emerge.

Project Big Picture appears to be over before it has started, and talk has quickly moved to a European Football League (an idea that has been on/off the table for the last two decades). This time, it appears to have FIFA’s backing and is reportedly being supported by Wall Street banking giant JP Morgan to the tune of $6bn. It would see a move to a US style sports model for European football and, unsurprisingly, the American owners at Liverpool and Manchester United have been mentioned as the driving force behind the proposals. UEFA, European footballs governing body will reject the proposals, seeing it as a direct threat to their flagship Champions League competition.

Meanwhile, the lack of balance in English footballs financial equation remains. Clubs continue to make poor financial decisions, becoming emotionally involved in spending more than they earn. A trait more commonly found in regular business sectors. Were clubs run as a genuine going concern, there would be no need for a bailout in the first place. But, perhaps this is a question better addressed to the auditors of the clubs in distress? Some have argued that Project Big Picture provides financial sustainability when, in fact, the opposite is probably true. It would simply enable a continuation of the status quo, potentially fuelling a new wave of reckless spending.

If Project Big Picture has underlined one thing it is that English football is crying out for a reboot. It needs more effective financial regulation, fairer distribution of revenue and salary caps to force owners into making better choices. Clubs need to work collectively to preserve their product, casting aside self-interest in the winner takes all scenario. It’s an alien concept for business leaders that chase profit maximisation and market domination and needs external intervention from finance professionals. Without competition in football, there is no product for fans to buy.

Saving the Independent Audit

Editor's Note: The Public Interest Section of the American Accounting Association is pleased to publish the following blog post by Steve Mintz, Professor Emeritus, Cal Poly, San Luis Obispo. Please contact lawrence.chui@stthomas.edu with questions, comments, or suggestions about our blog, or to express interest in our organization. Disclaimer: When you read the comments of our columnists, please keep in mind that they only speak for themselves. They are not expressing the positions of the AAA or of any other party.

[This blog is taken from an article to be published in the October 2020 issue of The CPA Review.] 

The standards for an independent audit seem to be loosening. One area of concern is when nonaudit services are performed for an entity that becomes an affiliate of the audit client. Problems arise when otherwise permissible nonaudit services are provided to a non-audit client that becomes an affiliate of an audit client. The independence rules then apply to both clients as if they were one entity.

Some firms are now using a materiality criterion to determine whether these nonaudit services provided to an affiliate entity, that would be prohibited if the parent had provided them, violate the independence requirement in audit engagements. Applying such a materiality standard can have the effect of dismissing otherwise improper relationships. In some cases, audit firms are misrepresenting nonaudit services as part of the audit services to get around the rules that prohibit certain nonaudit services for audit clients. Purposely doing so misleads the users of financial statements about the independence of the client.

Clearly there is a problem that left untreated may fester and lead to independence violations that get worse or more intense. Too many auditors are violating ethical requirements. The possibility exists that auditors may be subconsciously regarding the independence ethical requirements as not applying to them or not worth considering because they know they are objective and have integrity. It may be that a strictly audit firm may be able to do a better job of ensuring adherence to the independence rules than a firm that has a mixed rather than an exclusively audit culture. One possible solution is to operationally split off audit services from nonaudit services to protect the independent audit.

Materiality Exceptions

KPMG was involved in a client acceptance process for an entity when it learned that the firm had been providing nonaudit services to affiliates of the entity that the firm would be prohibited from providing if it became the independent auditor of the entity. These services included bookkeeping and payroll services provided to affiliates in 11 different countries. According to Accounting and Auditing Enforcement Release No. 3530, “the KPMG audit engagement team – in consultation with the firm’s Independence Group – concluded that, based on the perceived immateriality of the locations and services provided,” KPMG’s overall independence would not be impaired if it became the auditor of the entity but also continued providing the nonaudit services to the affiliates during the transition period of February 22, 2008 and July 1, 2008. KPMG became the auditor and confirmed to the client that it was independent with respect to [the client] and its related entities under applicable SEC and PCAOB independence requirements.”[1]

Using a materiality criterion to determine whether certain nonaudit services should be allowed opens a can of worms. Logical questions are: (1) Is independence a standard left to the individual judgment of the auditors or is it based on SEC regulations and PCAOB standards? and (2) Where do you draw the line in making materiality determinations?

Mischaracterizing Nonaudit Services

In 2014, PwC performed nonaudit services for an audit client concerning Governance Risk and Compliance (GRC) software that was used to coordinate and monitor controls over financial reporting, including employee access to critical financial functions.” At the time the GRC system was being implemented, it was intended to be subject to the internal control over financial reporting audit procedures.

Communications between PwC and its audit client show that the client’s head of internal audit was concerned whether the firm could provide an implementation proposal and inquired about auditor independence. The supervising partner responded that “we are absolutely permitted to implement so there will be no issues…,” even though he was aware that the firm’s independence policies did not allow it or him to implement the GRC system.[2]

Communications with the client show the disconnect between the client’s expectations and how PwC was describing its information systems services ostensibly to skirt the requirement not to perform certain nonaudit services for audit clients. An email from the then head of internal audit of the client, who objected to the description of services contained in the draft engagement letter, informed PwC that the proposed work was an implementation project that’s been outsourced to the firm.

The final engagement letter described the work on the GRC project “as performing assessments and high-level recommendations” even though an internal PwC communication had characterized the engagement as a design and implementation project.

The firm agreed to pay over $7.9 million to settle charges with the SEC that it performed prohibited nonaudit services during an audit engagement including exercising decision-making authority in the design and implementation of software relating to an audit client’s financial reporting and engaging in management functions.

SEC Proposal to Amend Auditor Independence Rules  

On December 31, 2019, the SEC proposed amendments to Rule 2-01 of Regulation S-X that would loosen independence rules with respect to the auditing of affiliates. The proposal would limit the range of audit client affiliates from which an auditor must maintain its independence by amending the definition of “affiliate of the audit client” to carve out affiliates under common control (i.e., sister entities) that are not material to the controlling entity.

The proposed rule would give auditors more discretion in assessing conflicts of interest in affiliate relationships with audit clients of the firm. The motivation for the change seems to be an analysis by the SEC that the audit firm can maintain its objectivity and impartiality (hence its independence) in these control relationships based on a materiality exception. According to SEC Chair Jay Clayton, the rules changes would “permit audit committees and [SEC] commission staff to better focus on relationships that could impair an auditor’s objectivity and impartiality,”…and avoid “spending time on potentially time-consuming audit committee review of non-substantive matters.[3]

By introducing a significance test to determine whether an affiliate is material to the controlled entity, the SEC is opting to rely on the judgment of the auditor and audit firm to determine when independence is impaired rather than strictly applying the ethics rules as written. While a materiality test applied to financial reporting issues is commonplace (i.e., to determine whether restatements to the financial statements are warranted), it has no place in ethics determinations. Any rule violation, regardless of size tests, is unethical. There should not be a material test to determine right versus wrong. Moreover, once the door is opened to making materiality judgments on independence issues, the firms may seek to use it in interpreting other rules. For example, should a firm be able to provide “non-material” contingent fee and commission-based-services to a non-audit-affiliate once it is combined with the controlling entity for which audit services are provided? The problem with establishing a materiality criterion in one rule is it becomes an ethical slippery slope for other rule interpretations.

The U.K. Experience

There has been a great deal of controversy in the UK about how best to restrict nonaudit services for audit clients. The U.K. Competition and Markets Authority (CMA), a government department in the U.K., issued a report on April 18, 2019, that recommends an operational split of audit and nonaudit services. The large firms would be split into separate operating entities with respect to auditing and consultancy functions to reduce the influence of consulting practices upon auditing divisions. The split would help to prevent potential conflicts of interest from impairing audit independence and increasing the public trust in the quality of financial statements. However, the watchdog stopped short of recommending a full break-up based on firm services.[4]

A study group report prepared on behalf of the U.K. Parliamentary Labour Party calls for a legal split between audit and nonaudit services. The group was not convinced that an operational split would go far enough, calling instead for two legally separate organizations. In essence, it calls for a structural break-up of large firms saying that it would be more effective than other options in “tackling conflicts of interest” and providing “professional skepticism needed to deliver high-quality audits.”[5]

On July 6, 2020, the Financial Reporting Council told the Big 4 accounting firms to draw up plans for an operational split by separating their audit businesses by October 23, 2020 and for the work to be completed by mid-2024. The changes do not apply to smaller firms. The regulator stopped short of ordering a full, structural breakup that would have required audit entities to be spun off into separate legal entities.

The UK experience should be looked at by the SEC to assess whether a split-off of nonaudit services and audit services operationally could work in the U.S. The profession has talked about it for many years. It may be premature to study a legal split into two entities. Given the expanding scope of prohibited nonaudit services and how they may be mischaracterized to skirt the independence rules it seems that the time is right for such a split in the U.S. to protect the interests of the public that rely on the independent audit to make investment decisions.

 

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[1] (SEC, Accounting and Auditing Enforcement Release No. 3530, January 24, 2014, In the Matter of KPMG LLP, Respondent, (https://www.sec.gov/litigation/admin/2014/34-71389.pdf). The firm’s actions violated SECs Rule 201 (c)(5) and Rule 10A-2 .

[2] SEC, AAER Release No. 4085, In the Matter of Brandon Sprankle, CPA, Respondent, September 23, 2019.

[3] (“SEC Planning to Loosen Auditor Independence Rules, January 2, 2020, https://www.cfo.com/auditing/2020/01/sec-planning-to-loosen-auditor-independence-rules/).

[4]  (Competition and Markets Authority, “Statutory audit services market study,” Final Report, April 18, 2019, https://assets.publishing.service.gov.uk/media/5d03667d40f0b609ad3158c3/audit_final_report_02.pdf).

[5]  (“Reforming the Auditing Industry,” http://visar.csustan.edu/aaba/LabourPolicymaking-AuditingReformsDec2018.pdf).

Auditor Independence

Editor's Note: The Public Interest Section of the American Accounting Association is pleased to publish the following blog post by Francine McKenna, independent journalist at The Dig, a newsletter, an educator and a researcher. Please contact lawrence.chui@stthomas.edu with questions, comments, or suggestions about our blog, or to express interest in our organization. Disclaimer: When you read the comments of our columnists, please keep in mind that they only speak for themselves. They are not expressing the positions of the AAA or of any other party.

Auditor independence issues have been in the news in recent years in the US and in the UK. Investors wonder why they should trust auditors’ opinions when the auditors consistently miss corporate fraud, conflicts of interest and other malfeasance while also being accused or suspected of their own conflicts of interest. Which side are the Big 4 audit firms, in particular, on these days — the shareholder and capital markets or their paying clients? Public Interest and Audit Section member Francine McKenna, C.P.A. is an adjunct professor at American University's Kogod School of Business where she teaches “The Manager in the International Economy" in AU’s online MBA Program. In June 2020, she presented the paper, “SEC Proposals to ‘Modernize’ Auditor Independence Rules: Doublespeak for Capitulating to the Big 4's Dominance?” at the inaugural AAA SPARK conference for the Public Interest Section. You can find her presentation page here. The SPARK paper was based on a four-part series, published in January 2020, in her newsletter, The Dig. We’ll republish the original four-part series on the blog starting this month. 

The series updates our knowledge of new and old auditor independence violations, in particular by the Big 4 global audit firms since the adoption of updated auditor independence rules in 2001 and after additional restrictions were placed on audit firms by the Sarbanes-Oxley Act of 2002. She highlights the violations that were prosecuted by the SEC and many that weren’t. The paper also explained why the Big audit firms, in particular, have been lobbying to relax auditor independence rules, why the SEC is agreeing with those requests and the PCAOB is following the SEC’s lead.  Finally, the paper discusses the implications of this “modernization” effort for the capital markets and the auditor’s public duty.

Follow Francine @ReTheAuditors on Twitter
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re: The Auditors http://retheauditors.com

Back To The Classroom: A Professor’s Experience

Editor's Note: The Public Interest Section of the American Accounting Association is pleased to publish the following blog post by Michael Kraten, Professor of Accounting at Houston Baptist University. Please contact lawrence.chui@stthomas.edu with questions, comments, or suggestions about our blog, or to express interest in our organization. Disclaimer: When you read the comments of our columnists, please keep in mind that they only speak for themselves. They are not expressing the positions of the AAA or of any other party.

As a professor at a private regional university in one of America’s largest cities, last week’s “back to the classroom” experience was a surreal one. Speaking for 75 consecutive minutes through a face mask. Fidgeting while anchored to the podium, unable to move around the room, to remain within a camera range. Watching with trepidation while students move within six feet of friends, tug down their masks to speak, and generally struggle to respect the restrictions of social distancing standards.

How can one teach under such circumstances? How can one meet the semester’s learning objectives when students are permitted to “elect the remote learning option,” thereby eliminating the classroom entirely and opting to “attend” sessions by watching the video recordings of the live lectures?

Thus far, I only have one week of teaching under my belt. Nevertheless, I am already adapting to new realities by emphasizing certain principles:

1. EMPATHY. In unprecedented circumstances, I find that I cannot anticipate the needs of students without making a conscious effort to “stand in their shoes” and “see through their eyes” to identify their obstacles to learning. By making such an effort, I can recognize difficulties and develop solutions that may not have occurred to me otherwise.

For instance, consider an ostensibly inconsequential student presentation assignment. For students who are learning remotely, the physical classroom must be replaced by some type of electronic communication platform.

At first blush, a video platform such as Zoom or Skype may appear to offer an effective solution. But what if I view this assignment through the eyes of a disadvantaged student? Does that student possess a broadband internet connection at home? In more extreme circumstances, does the student live in a home at all? And in a “presentable” one at that?

There are various solutions to deal with this problem, though (regrettably) none is ideal. Nevertheless, by applying a sense of empathy, I may be more likely to identify the challenges that students may confront during a simple presentation activity.

2. FLIPPING THE CLASSROOM. A traditionally structured course requires students to listen to lectures and discuss cases in live classroom environments, and then to go home and apply their knowledge by completing homework assignments. For many years, though, some teachers have “flipped the classroom” by instructing students to watch video lectures at home. Then students are expected to complete their application activities in the classroom, guided by teachers who serve as coaches and mentors instead of serving as lecturers.

To be sure, this is not a new pedagogical strategy. However, when many students must “attend” lectures through videos because personal circumstances prevent them from traveling to their classrooms, “flipping the classroom” may evolve from an optional strategy to a mandatory imperative. Under such circumstances, teachers can embrace the “flipping” model and communicate with these remote students electronically, in an empathetic manner, while serving as coaches and mentors.

3. PULL COMMUNICATION. Under normal circumstances, teachers communicate with students by making verbal announcements in classrooms and posting text messages on email messages, blogs, video chat rooms, and electronic announcement boards. Students then reply by verbal conversations and email transmissions.

Under pandemic conditions, teachers can continue to communicate by utilizing these traditional methods. But imagine the discomfort that students may experience while telling teachers “I have Covid” in open Zoom chat rooms, or while reporting on students who attend off-campus “no masks allowed” parties via email messages.

New communication methods may be needed to “pull” such information from students by removing the behavioral obstacles that impede such conversations. Anonymous message systems and private reporting mechanisms may conflict with recent trends towards open and transparent group communication methods, but they may enable more effective interactions during the pandemic era.

Technology clearly plays a key role in each of these three circumstances. However, the solution in each circumstance is not technology itself. Rather, the “Path Forward” may involve the establishment of a more durable and reliable human connection between the professors and the students whom they serve.