Which of the following individuals are considered covered persons with respect to an audit client?

Article Published: Oct 11, 2021 // Updated: Mar 02, 2022

In June 2021, the Securities and Exchange Commission (SEC) made amendments effective for certain rules regarding auditor independence requirements (known as Rule 2-01 of Regulation S-X).[1] The intention behind these amendments was to modernize the SEC's rules governing auditor independence and more effectively focus the analysis of independence on relationships or services that may threaten an auditor's objectivity and impartiality as well as reduce the effect that the independence rules can have on a company's ability to select an auditor.

Although several substantive amendments were made to the auditor independence requirements, what is known as the "general standard" (i.e., Rule 2-01(b)) did not change as a result of these amendments. For instance, the introductory text to Rule 2-01 indicates, in evaluating the general standard, the SEC will consider whether a relationship or service:

• Creates a mutual or conflicting interest with the audit client;
• Places the auditor in the position of auditing their own work;
• Results in the auditor acting as management or an employee of the audit client; or,
• Places the auditor in a position of being an advocate for the audit client.

When applying these amended standards, companies must still keep in mind the general standard, which further indicates that "an accountant is not considered to be independent with respect to an audit client, if the accountant is not, or a reasonable investor with knowledge of all relevant facts and circumstances would conclude that the accountant is not capable of exercising objective and impartial judgment on all issues encompassed within the accountant's engagement."[2] Therefore, even in circumstances when a service or relationship is not explicitly prohibited by the independence rules under Rule 2-01, the general standard requires auditors, audit committee members and management to evaluate a service or relationship from the perspective of a reasonable investor and determine whether there is a real or perceived impact on the auditor's objectivity and impartiality.

The following provides an overview of key changes to the related SEC rules as a result of the amendments:

• Numerous amendments were made by the SEC that impacted the consideration of an affiliate of an audit client, including, amongst other things, defining an "entity under audit," revising the definition of an "audit client" and introducing a dual materiality threshold to determine whether entities under common control (sister entities) are affiliates under SEC rules and regulations. For instance, if the entity under audit or the sister entity are not material to the controlling entity (the Parent), the sister entity would not be considered an affiliate of the audit client.
• Prior to the SEC's amendments, an "affiliate" included entities under common control with the entity under audit (sister entities), including sister entities that are part of an investment company complex (ICC).

"For instance, if the entity under audit or the sister entity are not material to the controlling entity (the Parent), the sister entity would not be considered an affiliate of the audit client."

• Revisions were also made to the definition of "Investment Company Complex" (ICC) to incorporate a significant influence provision that includes:
  • Any entity over which an audit client that is an investment company or investment advisor/ sponsor has significant influence, unless the entity is not material to the audit client; and,
  • Any entity that has significant influence over an audit client that is an investment company or investment advisor/sponsor, unless the audit client is not material to the entity that has significant influence over it.
• The revised definition could result in the exclusion of certain investment companies, advisers and sponsors that are not material to the controlling entity and should be applied to each entity under audit that is an investment company or an investment adviser or sponsor.

• The definition of "audit and professional engagement period" was revised to shorten the look-back period to one year for first-time domestic filers (e.g., IPOs, SPACs, reverse mergers, etc.) when evaluating potential SEC independence compliance for both existing and new audit relationships.
• Under the original definition an auditor of a first-time domestic filer had to be independent of the company for all periods covered by the financial statements included in the registration statement. However, under the amended definition, an auditor now only must be independent under SEC rules and regulations of the company for the last fiscal year subject to audit prior to the initial filing. For prior years covered by the filing, the auditor must comply with applicable independence standards (e.g., AICPA independence standards).
• Nevertheless, it should be noted that despite the amendments to the look-back period, the SEC general standard of independence did not change.
• Consideration of independence is a shared responsibility between management, the audit committee, and the audit firm, and the look back period rules must be carefully evaluated in conjunction with the general standard to ensure compliance with all periods included in the filing.

• The amendments revised the definition of "other financial interests in an audit client" to allow for additional certain loan types to be exempt from the independence requirements including:
  • Revised "mortgage loan" to "mortgage loans" to allows for multiple different loan types, including primary and secondary mortgages as well as home equity loans on primary residences.
  • A covered person[4] can have their student loans exempted from SEC independence considerations if the loans were not obtained while the covered person in the accounting firm (or their immediate family member) was a covered person.

• Replaced reference to "substantial stockholders" with the concept of beneficial owners with significant influence over the entity under audit. This may result in a reduction of business relationships with entities and individuals that violate the SEC independence rules by focusing on business relationships with entities and individuals that have decision-making capabilities or may have the ability to impact an audit firm's objectivity.

• The amended guidance provides a new transition framework to allow audit firms a period of time to exit services that become impermissible as a result of a merger or acquisition activity. For example, if the auditor performs audit services for Company A and performs an advisory management function for Company B, and Company A acquires Company B, an evaluation would need to be performed by Company A to determine if the relationship is permitted to continue to exist. The accounting firm is expected to promptly address any conflicting services or relationships resulting from the merger preferably prior to the effective date of the transaction. This amendment however does not preclude the requirement for all relationships to be in compliance with the general standard.

Overall, the adoption of these amendments is intended to have many benefits including, but not limited to:

• Reducing compliance costs for both audit firms and clients;
• Focusing the independence analysis on relationships or services that are most likely to impact an auditor's objectivity and impartiality; and,
• In IPO situations potentially preventing the need to change auditors or delay an IPO in order to comply with independence requirements.

While many may generally think that changes coming from the SEC only impact public companies, private companies and private equity companies in particular should also evaluate the impact of these changes if their auditors are required to follow SEC independence standards. The new rules may allow greater use of the same audit and accounting firm to provide services to sister companies that don't meet the materiality threshold under the new rules. Further, private companies looking to enter an IPO may run into less roadblocks as it relates to auditor independence due to the shorter lookback period.

"...private companies looking to enter an IPO may run into less roadblocks as it relates to auditor independence due to the shorter lookback period."

Finally, when applying these amendments, it is important to exercise extreme caution and not consider the amendment in isolation, but instead ensure you are considering the amendments through the lens of the general standard. The situations for which these amendments apply can be extremely limited and facts and circumstances based. To understand how these changes may impact your company, we encourage management to reach out to your auditors to discuss the services provided and whether these amendments may impact current or future service offerings. DHG is ready to answer any questions you may have – contact us today.

[1] SEC Final Rule release 33-10876 Qualification of Accountants.

[2] Rule 2-01(b).

[3] Rule 2-01(f)(4).

[4] The SEC's definition of a "covered person" in the firm, with respect to an audit client (or its affiliates) includes (1) individuals on the "audit engagement team," (2) personnel in the "chain of command" over members of the audit engagement team or concerning the conduct of the audit, (3) any professionals who provide any professional service to an audit client (or its affiliates), and (4) any other partner, principal, or shareholder from an "office" of the accounting firm that participates in a significant portion of the audit.