The tenth anniversary of the enactment of the Sarbanes-Oxley Act of 2002 (Sarbanes-Oxley) reminds us of the many changes that have occurred during the last 10 years in the accounting industry.
The scandals of Enron, WorldCom, and others helped lead to Sarbanes-Oxley, and also helped the American Institute of Certified Public Accountants (AICPA) and the Securities and Exchange Commission (SEC) create stricter professional ethics requirements in working with audit clients. The AICPA provides the framework for professional ethics in the “Code of Professional Conduct.”
Independence Requirements
Specifically, ET 100-1.06 in the Code of Professional Conduct defines independence as:
- Independence of mind – The state of mind that permits the performance of 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 – 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 had been compromised.
Further in ET 100-1.13, independence concerns related to self-review are identified.
- Self-review threat – Members reviewing as part of an attest engagement evidence that results from their own, or their firm’s, non-attest work, such as preparing source documents used to generate the client’s financial statements.
It should be noted that the safeguards related to self-review are strictly applied for audits of public companies based on the SEC requirements. However, for private companies, the requirements are accounted for under the AICPA standards, which appear to have more subjectivity. For non-public companies, if management approves all account classifications, provides source documentation for journal entries, and takes responsibility for the resulting financial statements, the auditor may be able to assist in providing journal entries during the course of the audit. As significant judgment may be applied in this evaluation, there are widespread differences in the application of these rules.
Tax Independence
Typically, the concern related to self-review for tax professionals focuses on the preparation and audit of the accounting for income taxes. The accounting standard for this area is ASC 740 (formerly FAS 109). For many companies, the provision for income taxes may represent the single largest expense on their income statement and the deferred or current tax accounts may be a significant component on the balance sheet. Evaluating the considerations for recording a valuation allowance or liabilities for uncertain tax positions often requires a significant amount of judgment. As a result of the above concerns, this area has received more scrutiny during the last 10 years.
Who Should Care About Tax Independence?
Clearly, public companies have focused on the SEC requirements and typically have sufficient internal resources to prepare the accounting for income taxes. However, many smaller private companies may not have internal resources and will look to outside service providers to prepare the income tax provision.
Since the prior three years of financial data and audit certifications may be included in certain public filings (i.e., IPO offerings), companies that are intending to go public or be acquired by a public company in the next three years should evaluate independence now. Certain industries, such as high tech, that are more likely to meet the above criteria should be focused on tax independence.
For many private equity funds, the public market is a significant exit strategy for their portfolio companies. Private equity firms may work with a significant number of different audit firms either directly or through their portfolio companies, therefore, identifying independent firms can be difficult.
In addition to the possibility of being a public company, the second AICPA definition, “independence in appearance,” should cause non-public companies to pause. Have companies considered if the readers of their financial statements (i.e., lenders, stockholders or others) could “believe” that the independence of the audit was impaired because the auditor was auditing their own work?
Summary
Following the numerous scandals and increased focus on audit transparency and independence, it is apparent that the SEC has determined that tax independence is essential for public companies. For private companies, careful consideration should be given by management and shareholders to evaluate the importance of tax independence.
Published December 18, 2012.
