CA Firms / CATOs
Rule 204 - Independence Questions and Answers 1
The following questions have been received from members about the implementation of the new independence standard in their practices. Institute staff members have provided their answers based on the information provided in the question. Members who are uncertain about the application of the standard to a specific situation are invited to contact the Institute’s practice advisors at firstname.lastname@example.org. Questions have been grouped according to subject.
1. In the United States we heard about Sarbanes-Oxley and the SEC setting new rules for auditors. In Canada it seems like a backroom committee of CAs came up with a new standard for their own professional members, without any oversight or involvement of regulators or government. How can the public be confident in this new standard?
The process for developing and adopting the new rules was consistent with the CA profession’s long tradition of self-regulation. The standard was developed with input from regulators and other stakeholders. There was a period of public comment – comments received were made by the public and were taken into account in finalizing the rules. The standard is based on the standard recommended by the International Federation of Accountants and is augmented by SEC requirements for public companies
2. Isn’t this new independence standard a knee-jerk response to Enron/WorldCom? Will it prevent an Enron/WorldCom happening in Canada?
The process actually started before Enron – the Independence Forum that brought together auditors, regulators, analysts, academics and preparers took place in June 2001, from which point the Public Interest and Integrity Committee had a good sense of what direction it should take in developing a new standard. At the same time, Enron has provided impetus and momentum to the development, and a visibility it might not have had otherwise. The new standard is not a response to Enron and, on its own would not prevent an Enron in Canada but it would help. Enron also involved fraud and other forms of misconduct that would not have been prevented by an independence standard.
3. Why did it take so long to develop this standard?
The development of the standard involved significant consultation with regulators and other stakeholders. Also, after the period of public exposure, the SEC issued new regulations in response to the Sarbanes-Oxley Act – it was necessary to carefully review these changes to determine appropriate implementation in Canada to protect the public interest.
4. Can you explain how this standard will be approved in its final form? Is this approval process the same across the country? If not, why not?
The new standard will require a member vote for every province, except Quebec where the process for implementation is in government hands. Special general meetings of the provincial institutes either have been held recently or will be held very soon to seek member approval. The members of the Ontario Institute approved the new rules at the Special General Meeting held on November 27, 2003.
5. What is new in these rules; what’s changed? Was there nothing in place before?
The former rules required objectivity with respect to assurance engagements and specified auditing procedures engagements. The new rules emphasize “independence” because this term has gained general acceptance internationally. The new rules state that independence is required for a member or firm to be free of any influence, interest or relationship that, in respect of a particular engagement, impairs the professional judgment or objectivity of the member or firm. The rules provide that a member or firm, who is required to be independent in respect of a particular engagement, must identify and evaluate threats to independence and, if they are not clearly insignificant, identify and apply safeguards to reduce them to an acceptable level. Where safeguards are not available to reduce threats to an acceptable level, the member or firm must eliminate the activity, interest or relationship creating the threats, or refuse to accept or continue the engagement. The rules then require the member or firm to document the matters considered in evaluating independence and the conclusion reached. Finally, the new rules prohibit specified types of activity because they create threats that are so significant that safeguards are never adequate.
6. Some people have said that this rule is in response to concerns about the integrity of CAs – is that true?
No. This rule addresses the independence of auditors. The project to update the rules was undertaken because it was recognized that while the old rules of independence had served the public well, it was time to review and modernize the rules to reflect changing circumstances and public expectations.
7. Shouldn’t the new independence rules contain much more details about the updated standard, as opposed to the extensive council interpretations? In the event of a legal challenge to a member’s independence, wouldn’t the Courts look to the rules, as opposed to the council interpretations?
The Institute has used Council interpretations for many years to provide guidance to members on the interpretation of the rules, including those related to the former Rule 204.1 concerning the objectivity of members. The Courts have never questioned that practice, which is aimed at providing helpful assistance to members in understanding and complying with their professional responsibilities under the rules.
ALL ASSURANCE ENGAGMENTS
1. Will the updated standard apply to all types of engagement?
The new rules setting the independence standard apply to all assurance engagements and specified auditing procedures engagements and to insolvency engagements. They do not apply to compilation engagements. However, members and firms are reminded that where they are not independent, they are required to disclose the nature and extent of any activity, interest, or relationship that impairs objectivity. This requirement was contained in the former Rule 204.3 and is not changed in the updated standard.
2. Are there any exemptions for private companies?
The rules related specifically to audits of large public companies (market capitalization or total assets over $10 million) do not apply to private companies.
3. Why aren’t review engagements exempted from this updated independence standard?
Review engagements were subject to the former rules on objectivity. In addition, CICA Handbook 8100.15 requires an objective state of mind as part of the standards for a review engagement. This is necessary since practitioners are providing negative assurance to the users of the financial information.
4. What are the new rules on financial interest?
Members on the engagement team, and their immediate family, cannot have a financial interest in client. Partners in the office of the lead engagement partner cannot have financial interest in the client. Also no other member of the firm, and their immediate family, can own more than 0.1% of a client of the firm.
5. Isn’t this more “permissive” than the former rule?
Somewhat, but it is introduced to reflect the modern reality of dual income families. The SEC made this change over two years ago. The prohibition for members of the engagement team is not changed from what was set out in the former rule. Those are the individuals who actually work on the client engagement.
6. Do the new rules introduce more prohibitions that are applicable to all clients?
Many of the prohibitions that apply to all clients were previously covered by the former Rule 204.1 and the related Council interpretations. The new prohibitions are:
Providing legal services to an audit or review client.
AUDITS AND REVIEWS FOR SMALL PUBLIC COMPANIES OR PRIVATE COMPANIES
1. Why are the same rules for big firms auditing big public companies being applied to the small firms reviewing private companies or small public companies?
The rules related specifically to audits of large public companies (market capitalization or total assets over $10 million) do not apply to small public companies or to private companies. Other than prohibitions with respect to financial interests and family relationships, the only prohibitions for reviews and audits of small listed companies are:
Not making management decisions or performing management functions;
These prohibitions are reasonable and will not be unduly burdensome for small practitioners.
2. Don’t the new rules place too much of a burden on small audit firms?
We believe they do not. During the draft standard’s public comment period the Public Interest and Integrity Committee heard from a number of individuals from small firms, expressing their concerns about the length and complexity of the standard and a concern that it would prohibit them from providing assistance to their audit clients. The Public Interest and Integrity Committee listened to these concerns and believes it has developed a final standard that is sensitive to these concerns and protects the public interest. In particular, there are a large number of very small public companies that do have sufficient internal accounting resources and therefore rely on assistance from their audit firms to develop high quality financial statements. Therefore the new rules provide that the specific prohibitions for listed entities only apply to those entities with market capitalization or total assets in excess of $10 million.
3. How was the exemption for small listed entities arrived at? Why $10 million?
During the comment period, the Public Interest and Integrity Committee heard much persuasive evidence that small public companies do not have, and cannot afford, sufficient internal accounting resources to cope with all of today’s reporting requirements. Such entities, therefore, rely on their auditors to provide assistance in this area.
In the view of the PIIC, the $10 million exemption balances the concerns of smaller listed entities with the Committee’s prime objective of developing a new standard that protects the public interest.
Also, despite the exemption, auditors are still required to use the independence standard’s framework in every engagement, so that if, even in dealing with a smaller entity, they were faced with a threat, they would be forced to evaluate and take action to reduce or eliminate the threat, or remove themselves from the engagement. Also the financial interest prohibitions are the same for auditors of private and public companies.
4. Is it fair to say that the PIIC yielded to the pressure of the smaller audit firms by including this exemption, and by so doing places investors at risk?
Not at all. One size does not fit all. What the exemption does is to recognize the special circumstances of smaller entities, and to recognize that common sense should be applied in order to both protect the public interest and not place an unfair burden on small businesses in Canada. There are many small public companies in Canada.
This exemption allows those smaller entities to receive more accounting assistance from their auditors and thus relieve them of the expense of retaining others to provide this accounting assistance. These smaller entities typically cannot afford internal expertise or a second accounting firm, but under the new standard they will still have high-quality financial reporting and their auditors will still be subject to meaningful independence standards.
5. My small clients rely on me to prepare journal entries. Can I still prepare them?
Members can certainly continue to prepare journal entries for their non-listed entity clients. The prohibition in Rule 204.3(23) applies only when those journal entries are prepared without the approval of the client. This should not be problematic for practitioners since the required approval is easily obtained by thoroughly discussing the results of your work with your clients.
6. In the Council interpretations, there is a lot of discussion about safeguards within firms and within the client. But I have a small practice with very few staff and my clients are small businesspeople, how can I implement those safeguards?
The discussions about safeguards within the Council interpretations are meant to give members and firms some examples of the safeguards possible to help reduce threats. They can almost be viewed as a menu of possible choices. They may not all be available due to the size of the practice and your clients’ business. Members and firms are not being asked to implement any particular safeguard. They are being asked to identify and, where applicable, employ safeguards that fit their circumstances based on the size of thier practice and nature of their clientele. It is up to the member or firm to decide what will work for them and their clients. However, they should make sure they document the process.
7. In the Council interpretations, there is a lot of discussion about audit committees. But my clients are small private businesses, how can we discuss anything with audit committees when they don’t exist?
The discussions about meeting with the client’s audit committee is just one of many examples of possible safeguards in reducing a threat. If your client doesn’t have an audit committee, meet and discuss the issue with the board of directors or with management of the entity. Discussion with audit committees is not a mandated requirement. You can use your professional judgement to determine who should be consulted.
8. Is it true that I can’t provide accounting and bookkeeping services to my review clients?
This is not true. The prohibition on providing accounting and bookkeeping services is for listed entities. Members may provide accounting and bookkeeping services to non-listed entities if the self-review threat is reduced to an acceptable level. There is a full discussion in the Council interpretations (CI/52, 141 and 142) as to what constitutes reasonable safeguards. Basically, you need a detailed discussion about the results of your work with the client and have them approve the results, which would effectively include the journal entries. This is probably what you do already and should not be an added burden.
9. As a sole practitioner, how can I manage the self-review threat to an acceptable level when I provide accounting and bookkeeping services to my small business clients?
The Institute recognizes that practitioners with small clients have to manage the threat of providing bookkeeping services in a practical manner. CI/52 states that explaining the results and obtaining client approval is an appropriate way to reduce the threat to an acceptable level. This is simple to do since practitioners already do it now.
Furthermore, it is suggested that members consider having another professional review complex transactions when they arise (CI/143). This is a prudent practice that many members already follow since it’s in their clients’ best interest, and their own reputation, to ensure they comply with current accounting standards. What is considered complex by one practitioner is not necessarily so considered by another practitioner. It all depends on your experience, so use your professional judgement.
10. Can I provide advocacy services for my clients under the new rules?
You cannot provide advocacy services for clients for which you are providing assurance and specified auditing procedures engagements. But, the prohibition on providing advocacy services for such clients is not new. They are prohibited by existing Rule 201.4. However, the prohibition does not extend, for example, to a situation where a practitioner accompanies a client to see a banker so long as the accountant is there in a role of explaining the factual information provided to the banker by the client and not as an advocate for the client.
11. Most of us don’t audit big public companies, why aren’t there exemptions for the work we do for our smaller clients?
Other than the all-client prohibitions - most of which are not new - practitioners are not restricted in their services to their small business, private company, or small audit clients, as long as they are mindful of the threats to their independence and the safeguards to reduce those threats to an acceptable level.
AUDITS OF LISTED ENTITIES
1. What prohibitions are in place for public companies, and how do they compare with what the SEC now has in place?
The new standard contains specific rules for auditors of listed entities:
The rules for listed entities apply to those listed entities with market capitalization or total assets in excess of $10 million.
2. Why have only these particular types of services been prohibited?
There are probably an infinite number of consulting services – that is why a principles based framework is so appropriate. It is not possible to deal with every single service.
The specific services that are prohibited are not permitted because they create unacceptable threats to independence. For these services there are no safeguards that could be applied to protect independence in fact or in appearance.
3. Why aren’t firms prohibited from doing any consulting for audit clients?
Not all consulting services pose an unacceptable threat to independence. Certain consulting services – for example providing a valuation service where the results of the service will not be subject to audit procedures – do not provide an unacceptable threat to independence. Safeguards may be adequate -- but if they are not the services cannot be performed.
4. What kinds of consulting services are allowed under these rules?
Consulting services that do not create an unacceptable threat to independence – for example providing a valuation service where the results of the service will not be subject to audit procedures does not provide an unacceptable threat to independence
5. What are the new partner rotation requirements?
There are four categories of audit partner on listed entity engagements that are subject to rotation requirements:
Firstly the lead engagement partner and the quality control reviewer (often called the reviewing or second partner) cannot serve in that capacity for more than five years. After five years they will be subject to a five-year “time-out” period before they may resume either role.
Next the lead engagement partner on a significant subsidiary (which is one that represents more than 20% of the consolidated entity) cannot serve in that capacity for more than seven years after which he/she would be subject to a two-year “time-out” period.
Finally, a partner other than a specialty or technical partner who provides more than 10 hours of audit services to the listed entity must rotate after seven years and be subject to a two-year time out period.
6. How do you define a lead partner?
That’s the person with overall responsibility for the engagement – the person who signs the audit report.
7. Why does the rule not require replacement of the audit firm after a prescribed number of years?
This question was carefully considered by the PIIC. While such a requirement in theory may seem appropriate, it is felt that it would not be a practical approach, for either large or small firms that audit listed entities. Specifically, the significant additional financial costs to the client and the loss of institutional knowledge possessed by the entity’s previous audit firm would in all likelihood far outweigh any potential benefits that could be derived from retaining a new audit firm. The benefits that would be achieved by requiring the replacement of the audit firm can be achieved through partner rotation, without the significant drawbacks that would result from replacing the audit firm. The view that mandatory firm rotation may not be the most efficient way to strengthen auditor independence and enhance audit quality was supported in a report released November 24, 2003 by the General Accounting Office of the United States government, following a survey it conducted of publicly traded companies, stakeholders such as institutional investors, regulators and financial institutions. In addition, the requirements for partner rotation established in the new independence rules are consistent with the partner rotation requirements mandated in the United States under the Sarbanes-Oxley Act.
8. What is the new provision that prevents auditors from going to work for their clients?
There is a one-year cooling off period before a person who worked on the audit of a public company can go and work for that company in a senior financial position.