Under PCAOB Rule 3520, the auditor “must be independent of the firm’s audit client throughout the audit and professional engagement period,” which includes satisfying the independence criteria of the SEC and the PCAOB. But what happens when the auditor violates one of the independence rules—let’s say one of the specific prohibitions under Rule 2-01(c) of Reg S-X? Can the auditor’s violation be “cured”? Can the auditor still affirm its independence? How is that determined?

PCAOB Rule 3526 requires auditors to provide audit committees with information related to relationships of the auditor that could bear on its independence. The purpose of the rule is to provide the committee with sufficient information to understand how a relationship between the auditor and the audit client might affect the auditor’s independence and to foster a robust discussion between the auditor and the audit committee. What information does the audit committee need to evaluate the violation? At the end of last month, the PCAOB issued new Staff Guidance on Rule 3526(b) Communications with Audit Committees Concerning Independence, designed to outline the steps necessary when the auditor has affirmed its independence under the Rule even though it had violated one or more independence rules.

More specifically, Rule 3526 (b) requires that, at least annually, the auditors:

  • “(1) describe, in writing, to the audit committee of the audit client, all relationships between the registered public accounting firm or any affiliates of the firm and the audit client or persons in financial reporting oversight roles at the audit client that, as of the date of the communication, may reasonably be thought to bear on independence;
  • (2) discuss with the audit committee of the audit client the potential effects of the relationships described in subsection (b)(1) on the independence of the registered public accounting firm;
  • (3) affirm to the audit committee of the audit client, in writing, that, as of the date of the communication, the registered public accounting firm is independent in compliance with Rule 3520 [the SEC and PCAOB independence requirements]; and
  • (4) document the substance of its discussion with the audit committee of the audit client.”

As part of the inspections process, however, the PCAOB staff has observed that, under certain fact patterns, audit firms sometimes violate one or more of the independence rules, but nevertheless still affirm their independence, generally following this fact pattern:

  • Auditor addressed underlying reasons. The auditor may have addressed the circumstances underlying the violation before the audit committee communication and the signing of the auditor’s report. Then, based on its analysis, the auditor concluded that the violation would have no ongoing effects, and further “determined that (i) the violation was of such a nature that the Firm was capable of exercising objective and impartial judgment as it related to all issues encompassed within the engagement, and (ii) a reasonable investor with knowledge of all relevant facts and circumstances would conclude that the Firm was capable of exercising objective and impartial judgment on all issues encompassed within the Firm’s engagement.” Of course, as the guidance notes, in some circumstances, those conclusions would not be reasonable—for example, in the event of ongoing effects of a prohibited non-audit service, such as the design or implementation of the company’s financial information system, on the company’s financial statements or system of internal control over financial reporting. In those cases, the guidance indicates, the auditor would not be able to conclude that it is capable of exercising objective and impartial judgment.) “Alternatively, if the Firm had not yet fully addressed a violation, it had nevertheless made a determination that the Firm’s objectivity and impartiality had not been impaired and was in the process of implementing a plan to address the violation.”
  • Auditor communicated the matter to the audit committee. The communication included the nature of the violation and the auditor’s analysis, although timing may vary from right after discovery to the standard Rule 3526(b) audit committee communication.
  • The audit committee separately evaluated the auditor’s determination. Based on the information communicated, the audit committee must conduct a separate evaluation to determine whether the auditor was “capable of exercising objective and impartial judgment on all issues encompassed within the Firm’s engagement. The audit committee of the audit client has an important role in representing the interests of the audit client’s investors in this regard, particularly with respect to the ‘reasonable investor’ portion of the analysis.”
  • The audit committee and the auditor agreed to continue the audit engagement, following the audit committee’s separate evaluation.

The guidance is intended to clarify the auditor’s obligations under the fact pattern described above. Notably, however, the guidance leaves open the big question of whether the auditor’s violation of the independence rules—notwithstanding the communications to the audit committee, evaluations, determinations and other process followed—would still result in the financial statements’ being considered deficient by the SEC. Whether the SEC would accept financial statements “with a report from an auditor that has violated the independence rules, but whose objectivity and impartiality have not been impaired… is a question for the SEC, the audit client (including its audit committee), and the Firm.” Below are summaries of the FAQs in the guidance:

  • Information and process required. The guidance advises that, where the fact pattern described above has occurred, the auditor should include the following information and comply with the process below as part of its annual Rule 3526(b)(3) audit committee communication:

“a. summarizing for the audit committee each violation that existed during the year;

b. summarizing for the audit committee the Firm’s analysis of why, for each violation and notwithstanding the existence thereof, the Firm concluded that its objectivity and impartiality with respect to all issues encompassed within its engagement had not been impaired, and why the Firm believes that a reasonable investor with knowledge of all relevant facts and circumstances would have concluded that the Firm was capable of exercising objective and impartial judgment on all issues encompassed within the Firm’s engagement;

c. if more than one violation existed during the year, providing to the audit committee a separate analysis of why, notwithstanding all of the violations taken together, the Firm concludes that its objectivity and impartiality with respect to all issues encompassed within its engagement has not been impaired, and why the Firm believes that a reasonable investor with knowledge of all relevant facts and circumstances would conclude that the Firm was capable of exercising objective and impartial judgment on all issues encompassed within the Firm’s engagement;

d. engaging in dialogue with the audit committee regarding the violation(s) and the Firm’s related analyses (as described in (a)-(c) above);

e. documenting the substance of the Firm’s discussion(s) with the audit committee (as described in (d) above); and

f. affirming in writing to the audit committee that, except for the violation(s) expressly identified, the Firm would be independent in compliance with Rule 3520. For example, a Firm may choose to use the following language: ‘We have concluded that our objectivity and impartiality with respect to all issues encompassed within our engagement has not been impaired, and we believe that a reasonable investor with knowledge of all relevant facts and circumstances would conclude that we are capable of exercising objective and impartial judgment on all issues encompassed within our engagement. Except for the violation(s) expressly identified and discussed with you [and as set forth above/in separate communications dated XX/XX/XXXX], the Firm would be independent in compliance with Rule 3520.’”

  • Affirmation of independence alone inadequate. The auditor may not simply affirm to the audit committee that the auditor is independent without providing the rest of the communications identified above, even if the violation has been addressed by the time of auditor’s Rule 3526(b)(3) communication. Under Rule 3526(b)(3), the auditor must affirm that it is “independent in compliance with Rule 3520,” and, in these circumstances, an affirmation of independence with nothing more would be inaccurate.
  • Violation not cured. Compliance with the communication requirements and conclusions by the auditor and audit committee that the auditor’s objectivity and impartiality have not been impaired, including a determination to continue the engagement, do not “cure” the auditor’s violation of Rule 3520. Rather, the guidance relates solely to communications between the auditor and the audit committee and does not address whether there was a violation of the independence criteria of the PCAOB or the SEC applicable to the engagement, or whether the company needs to engage a new independent auditor, both of which are matters for the auditor and audit committee to consider and might lead them to consult with the SEC. As the guidance observes, a “decision to continue an engagement when a Firm is not in compliance with SEC or PCAOB independence rules creates a risk that an audit client’s filing that is required to contain financial statements that comply with Regulation S-X could be deemed deficient.” However, the company or the auditor can consult with the SEC staff in connection with the independence issues. The guidance notes that, depending “on the facts and circumstances, the SEC staff has in certain situations not objected to a Firm continuing to serve as its audit client’s auditor where a Firm is capable of exercising objective and impartial judgment on all issues encompassed within the engagement.”
  • Violations during prior periods. Whether the auditor must follow this same process if a violation was identified during a prior audit period—but is still within the professional engagement period—depends on a number of factors. If the violation was addressed in the prior period and covered in that period’s audit committee communication, and “no additional facts have come to light that would alter the resolution of the prior violation,” then the auditor need not describe the violation again in the current year and the auditor could still affirm its independence to the audit committee as of the date of the communication. However, if “the violation was not fully addressed or a new violation of the same type has arisen in the current year, or if the facts previously communicated to the audit committee have changed or need to be supplemented,” then the auditor would need to also include the violation in the current year’s audit committee communication, following the process described above.
  • Audit report. While the guidance provides that, in the written affirmation to the audit committee, the auditor must change the language to take into account the independence violations (as described above), the audit report does not need to be modified, so long as the above-described process has been followed and both the auditor and the audit committee have concluded that the auditor’s objectivity and impartiality have not been impaired. AS 3101, The Auditor’s Report on an Audit of Financial Statements When the Auditor Expresses an Unqualified Opinion, requires, in AS 3101.06, that the audit report be entitled “Report of Independent Registered Public Accounting Firm”; the title, however, is not considered to be a “specific assertion of compliance.” Similarly, AS 3101.09(g) requires that the report include a “statement that the auditor is a public accounting firm registered with the PCAOB (United States) and is required to be independent with respect to the company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the SEC and the PCAOB.” The guidance again concludes that the language represents a “statement of the legal requirement, not an assertion of compliance.”