SEC Modernizes Auditor Independence Rules– October 28, 2020 by Syed Farooq

This blog was updated 2/17/21

Earlier this month, the Securities and Exchange Commission (SEC) continued its modernization plan and updated rules related to auditor independence requirements. Auditors must be independent of audit clients both “in fact and in appearance.” Over the past two decades since Rule 2-01 of Regulation S-X was adopted, SEC staff have experienced areas where the independence rule has triggered non-substantive breaches resulting in precious time, cost and resource allocation of audit clients, auditors and audit committees alike. Given current market conditions and an industry shift towards globalization and specialization, the SEC has now tailored its independence rules and emphasized matters that are more likely to impede an auditor’s objectivity.
SEC Chairman Jay Clayton describes the new rules: “These modernized auditor independence requirements will increase investor protection by focusing audit clients, audit committees, and auditors on areas that may threaten an auditor’s objectivity and impartiality. They also will improve competition and audit quality by increasing the number of qualified audit firms from which an issuer can choose.”
Below is a summary of Rule 2-01’s amendments, and how we think these changes could ultimately benefit audit clients and their investors.

Definition Amendments

As the world evolved and business relationships increased in complexity, various definitions within Rule 2-01 became passé and required clarification. As such, the revised SEC rule:

  • Amends the definition of an affiliate of the audit client:

    • Includes a materiality qualifier with respect to operating companies, including portfolio companies, under common control

    • Clarifies the application of the definition to operating companies and direct auditors of an investment company or investment advisor or sponsor

    • Introduces the concept of a “dual materiality threshold” where a sister entity, which is an entity under common control with an entity under audit, would now be deemed an affiliate of an audit client only if it and the entity under audit were each material to the controlling entity

  • Amends the definition of an investment industry company complex:

    • Incorporates the term “entity under audit” to focus analysis from the perspective of the entity under audit and explicitly define the term “investment company” to include unregistered funds, e.g., hedge funds, private equity and venture capital funds, etc.

  • Amends the definition of audit and professional engagement period:

    • Addresses what is often an issue among many in an auditor’s independence: how long ago the relationship or service ended

    • Applies the one year look-back period for all first time filers, including domestic issuers and foreign private issuers, resulting in treating all first time filers similarly. Under the current rule they are defined differently. This parity would also benefit capital formation.

Loan or Debtor-Creditor Relationship Amendments

Most auditors have student loans, consumer loans and mortgages. The ongoing compliance with these relationships at firms can be overwhelming and quite complex depending on the individual and the extent of their relationships. The revised SEC rule:

  • Amends “except student loans”:

    • An auditor is not independent if they have any loan to or from an audit client and certain other persons related to the audit client — with four original exceptions (loans collateralized by automobiles, insurance policies, cash deposits and primary residences).

    • The new exception applies to student loans obtained from a financial institution under normal lending procedures, terms, etc. provided the loan was obtained by an individual or immediate family member for their educational expenses prior to becoming a covered person in the firm.

  • Clarifies the reference to “a mortgage loan”:

    • Revises “a mortgage loan” to “mortgage loans” - Note: The rule was not intended to exclude just one outstanding mortgage on a borrower’s primary residence. The SEC also does not intend to expand the mortgage loans exclusion to non-primary residences, such as secondary or vacation homes.

  • Revises the credit card rule to refer to consumer loans:

    • Replaces the reference to “credit cards” with “consumer loans” to encompass other types of consumer financing, such as retail installment loans, cell phone installment plans, home improvement loans, etc.

    • Continues to mandate an outstanding consumer loan balance of $10,000 or less, emphasizing that a limited amount of debt routinely incurred by a covered person or any of their family members for personal consumption, even if the entity is an audit client, would typically not impair independence.

Other Amendments

Among the other amendments, the revised SEC rule also:

  • Amends the reference to “substantial stockholder”

    • Replaces the term “substantial stockholders” in the Business Relationships Rule with the phrase “beneficial owners (known through reasonable inquiry) of the audit client’s equity securities where such beneficial owner has significant influence”

    • Helps foster compliance and consistency in application with the Loan Provision Rule

  • Introduces a transition framework to address inadvertent violations as a result of corporate mergers and acquisitions

    • Requires an auditor to comply with applicable independence standards throughout the period, correct the independence violation resulting from the merger or acquisition as promptly as possible, and have a quality control system in place as described in the rules.

According to Thomson Reuters’ Security Data Company, there were 6,057 mergers and acquisitions conducted by publicly listed U.S. firms between the three year period ended December 31, 2019.

Our Take on What the Amendments to the Auditor Independence Rule Mean

As the world continues to evolve and globalize, we welcome the SEC’s changes to continue to modernize and adapt its decades-old independence rule with the current times. An objective and impartial audit is crucial to investor confidence and protection.
By clarifying and tailoring its independence rules to better focus on what’s important, the SEC has improved clarity in application, which could result in potential quantitative compliance cost savings that benefit both audit firms, audit clients and investors alike. The amendments may also have qualitative implications such as improving the overall audit process by expanding the pool of eligible auditors that may have been restricted by the previous rules. Further, clients may now be able to better align the expertise of a firm with their needs, potentially improving audit and financial statement quality along the way.
The new rule is effective on June 9, 2021. Voluntary early compliance is permitted; however, auditors are not permitted to retroactively apply the final amendments to relationships and services in existence prior to the effective date or early compliance date if selected by an audit firm.

>> See the complete final rule here along with various SEC illustrative examples:  “Qualifications of Accountants”
Contact Syed Farooq at or a member of your service team to discuss this topic further.

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Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law.