6.2 Independence Considerations

Because the SEC’s and PCAOB’s independence rules are generally more restrictive than the AICPA’s, both the auditor and management, with oversight from the audit committee, need to determine (1) whether there is possible noncompliance with the SEC’s and PCAOB’s independence rules, (2) whether there are conflicts of interest before the entity undertakes an IPO or a transaction involving a SPAC, or (3) both.

For first-time filers and when a target entity is included in a SPAC’s filing, PCAOB and SEC independence requirements apply to the most recent full fiscal year’s financial statements included in the initial filing and any other subsequent unaudited interim periods. Any earlier periods included in the filing are subject to the AICPA’s independence rules and the SEC’s general standard of independence (Regulation S-X, Rule 2-01). Accordingly, all periods of the filing need to be considered and evaluated under the SEC’s and PCAOB’s independence rules. Under the SEC’s general standard of independence, issuers must consider whether any service provided or relationship:

“Creates a mutual or conflicting interest between the [auditor] and the audit client.”
“[P]laces the [auditor] in the position of auditing [its] own work.”
“[R]esults in the [auditor] acting as management or an employee of the audit client.”
“[P]laces the [auditor] in a position of being an advocate for the audit client.”

Because certain nonattest services that the auditor is permitted to provide under the AICPA’s rules may be prohibited under the SEC’s independence rules, the auditor and management need to evaluate whether the nonattest services provided during the financial statement periods included in the registration statement (or services approved by the audit committee but not yet provided), are permitted under the SEC’s and PCAOB’s independence rules. In addition, the auditor may need to be independent of other entities, individuals, or both, that meet the definition of an affiliate of the entity under audit2 in accordance with the SEC’s independence rules but would not be considered an affiliate under the AICPA’s independence rules. For instance, while controlling entities are within the scope of both the SEC’s and AICPA’s definitions of an affiliate, the SEC’s definition does not allow for materiality considerations related to the determination of whether an upstream controlling entity is an affiliate while the AICPA’s definition does. Therefore, an entity not previously considered an affiliate under the AICPA’s independence rules may meet the definition of an affiliate under the SEC’s independence rules. Moreover, The SEC’s general standard of independence requires the auditor to consider relationships with, or services provided to, a nonaffiliate entity that is under common control with the entity under audit (i.e., one or both entities are not material to the controlling entity). See Table 6-1 for a list of potentially independence-impairing services.

Independence concerns may also arise as a result of business relationships (both indirect and direct) between the auditor, including covered persons at the auditor, and the entity commencing the IPO or SPAC transaction process, its affiliates, or persons (including entities) in a decision-making capacity at the entity under audit, such as officers, directors, or beneficial owners with significant influence. Therefore, these relationships should be reviewed for compliance with the SEC’s independence rules. Audit committee preapproval is not required for business relationships; however, such relationships may reasonably be thought to bear on the auditor’s independence and generally should be communicated by the auditor in the initial PCAOB Rule 3526 communication. See Table 6-2 for a list of potentially independence-impairing business relationships.

Services, fee arrangements, or relationships may need to be modified or terminated before the auditor is engaged or begins audit procedures in accordance with PCAOB standards. If prohibited relationships or nonattest services, including prohibited fee arrangements, were provided during the financial periods to be included in the registration statement, the auditor may not be independent and thus may not be able to issue (or reissue) auditor reports covering those periods. Therefore, the conflict and independence review should begin as early as possible (i.e., as soon as the IPO or SPAC transaction is initially considered) so that there is sufficient time to gather, understand, and appropriately address any services or relationships (e.g., financial, employment, business) for which there are potential conflicts of interest or independence implications before the IPO or SPAC transaction.

6.2.1 Conflict and Independence Review Procedures

The auditor typically will evaluate whether previous or present services and relationships (e.g., financial, employment, business) with any of the following could potentially impair its independence or otherwise pose professional, legal, or business conflicts:

The entity itself.
Any of the entity’s affiliates under SEC affiliate rules.
Individuals serving in an accounting role or financial reporting oversight role (e.g., officers or directors).
Persons (including entities) in a decision-making capacity at the entity under audit, such as officers, directors, or beneficial owners with significant influence.
Any entities that are under common control with the entity under audit but are not affiliates under SEC affiliate rules (i.e., one entity or both entities are not material to the controlling entity).

Further, the auditor, with the client’s assistance, should determine whether any individuals or entities with significant influence over the entity under audit (e.g., officers, directors, or beneficial owners, including individuals and entities that are not otherwise affiliates) have a lending relationship with the auditor, any covered person at the auditor, or an immediate family member of any covered person.

Connecting the Dots

A complete corporate entity tree is critical to performing a thorough review of independence and potential conflicts. This tree should include a detailed organizational structure consisting of all legal corporate entities considered to be (1) affiliates, including entities, individuals of the entity (as defined by the SEC), or both, and (2) entities that are under common control with the entity under audit but are not affiliates of the entity as defined by the SEC (i.e., one entity or both entities are not material to the controlling entity). At a minimum, the corporate entity tree should also include individuals or entities with significant influence over the entity under audit that are not otherwise affiliates (i.e., officers, directors, or beneficial owners with significant influence). However, for monitoring purposes, inclusion of additional beneficial owners that do not meet the significant influence criteria is preferred.

Both the auditor and management should compile a list of all the auditor’s relationships and services as well as the corresponding fee arrangements that (1) are currently being provided to the entity and its affiliates (as defined by the SEC’s rules), (2) were previously provided during the financial statement periods to be included in the registration statement, and (3) have been approved but not yet provided. In addition, any independence or conflict-related considerations should be evaluated. It is advisable for management to work closely with the entity’s auditor to ensure that the requisite information is available to complete this process in a timely fashion.

Below are examples of services (Table 6-1) and business relationships (Table 6-2) to consider in the evaluation of the auditor’s independence. As previously mentioned, there are certain differences between the SEC’s or PCAOB’s independence rules and the AICPA’s independence rules. Such differences may be particularly relevant to business relationships, as well as nonattest services currently being performed at the entity or its affiliates since an entity deemed an affiliate under the SEC’s rules may not have previously been deemed an affiliate under the AICPA’s rules. This may also be the case for certain individuals under the PCAOB’s rules (i.e., financial reporting oversight roles).

Table 6-1

Examples of Prohibited and Potentially Independence-Impairing Services for the Audit Client and Its Affiliates
Bookkeeping services or other services related to the accounting records or financial statements of the entity (including preparation of prospective financial information [e.g., forecasts and projections]). Financial information systems (both design and implementation). Valuation and appraisal services, or fairness opinions. Actuarial services. Managed services, including those that might not affect financial systems or financial reporting. Client project management (project management office consulting services). Loaned staff or secondment arrangements. Cash handling. Client agent or representative responsibilities. Internal audit or other outsourcing services (in whole or in part). Internal control services. Ongoing monitoring. Control assessment or support. Legal services, including dispute consulting. Immigration services. Forensic accounting services (including expert services and other litigation services unrelated to an audit). Broker-dealer, investment adviser, corporate finance, or investment banking services. Human resources, executive, or employee search. Psychological testing services. Background or reference checks. Corporate secretarial services. Other client advocacy, lobbying, and legislative advisory services. Language translation services — SEC filings. eXtensible Business Reporting Language (XBRL) services. Generic client training and instruction. Tax planning services that are not, at inception, at least more likely than not to be allowable under applicable laws. Tax compliance services for which the auditor may be (1) appointed the agent or (2) handling cash or making payments on behalf of the entity. Tax services for an individual serving in a financial reporting oversight role. Contingent or value-added fee arrangements.

Examples of Prohibited and Potentially Independence-Impairing Services for the Audit Client and Its Affiliates

Bookkeeping services or other services related to the accounting records or financial statements of the entity (including preparation of prospective financial information [e.g., forecasts and projections]).
Financial information systems (both design and implementation).
Valuation and appraisal services, or fairness opinions.
Actuarial services.
Managed services, including those that might not affect financial systems or financial reporting.
Client project management (project management office consulting services).
Loaned staff or secondment arrangements.
Cash handling.
Client agent or representative responsibilities.
Internal audit or other outsourcing services (in whole or in part).
Internal control services.
Ongoing monitoring.
Control assessment or support.
Legal services, including dispute consulting.
Immigration services.
Forensic accounting services (including expert services and other litigation services unrelated to an audit).
Broker-dealer, investment adviser, corporate finance, or investment banking services.
Human resources, executive, or employee search.
Psychological testing services.
Background or reference checks.
Corporate secretarial services.
Other client advocacy, lobbying, and legislative advisory services.
Language translation services — SEC filings.
eXtensible Business Reporting Language (XBRL) services.
Generic client training and instruction.
Tax planning services that are not, at inception, at least more likely than not to be allowable under applicable laws.
Tax compliance services for which the auditor may be (1) appointed the agent or (2) handling cash or making payments on behalf of the entity.
Tax services for an individual serving in a financial reporting oversight role.
Contingent or value-added fee arrangements.

Table 6-2

Examples of Prohibited and Potentially Independence-Impairing Business Relationships With the Audit Client and Its Affiliates and With Persons (Including Entities) in a Decision-Making Capacity at the Entity Under Audit, Such as Officers, Directors, or Beneficial Owners With Significant Influence (Including Entities Controlled by These Individuals or Entities)
Alliance relationships. Teaming relationships. Prime/subcontractor relationships. Reseller relationships. Commission or referral fee relationships. Certain vendor relationships. Other marketplace business relationships (including certain indirect marketplace business relationships).

6.2.2 Audit Committee Preapproval Requirements and Other Communications

Before auditors are engaged to perform audit services and before they commence work, audit committee preapproval is required for all services to be provided to the entity and its subsidiaries. For existing permissible nonaudit services that will continue to be provided after the auditor is engaged to perform a PCAOB audit, audit committee approval is required before the service can be continued. This approval is required under Regulation S-X, Rule 2-01, and must be obtained before the audit client (including an audit client that is the target entity in a SPAC transaction) files a registration statement with the SEC. In connection with seeking such audit committee approval, the requirements of PCAOB Rules 3524 and 3525 also apply to permissible tax services and permissible nonaudit services related to ICFR, as applicable, including required written communications and discussions with the audit committee. Audit committee approval is not required for services that are completed before the auditor is engaged to perform a PCAOB audit. Audit committee preapproval is not required for business relationships; however, such relationships may reasonably be thought to bear on the auditor’s independence and generally should be communicated by the auditor in the initial PCAOB Rule 3526 communication.

Section 600 of the code of the International Ethics Standards Board for Accountants (IESBA) requires the entity’s audit committee to concur that any nonaudit services provided to upstream controlling entities or downstream controlled, nonconsolidated entities do not affect the auditor’s independence from the entity under audit before the engagement begins or work commences. This requirement is an expansion of the aforementioned approval requirement under Regulation S-X, Rule 2-01. Section 410 of the IESBA code requires that additional information regarding fees paid or owed to the auditor be communicated to the entity’s audit committee as well. Both of these IESBA requirements should be addressed through the initial PCAOB Rule 3526 communication if not addressed in an earlier audit committee communication.

In accordance with PCAOB Rule 3526, before accepting an initial engagement to audit an entity under PCAOB standards, the auditor must (1) communicate, in writing, to the audit committee all relationships between the auditor and the audit client and its affiliates (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 the auditor’s independence; (2) discuss, with those charged with governance (i.e., the audit committee), the potential effects of such relationships on the auditor’s independence; and (3) document the substance of the discussion with the audit committee regarding the potential effects of the relationships described in the initial written communication on the auditor’s independence. The matters covered during the initial written communication may include relationships beyond the audit period or professional engagement period. Acceptance of the audit engagement occurs after the auditor completes its engagement acceptance activities and before it obtains the executed engagement letter establishing the terms of the new engagement to perform PCAOB audits in connection with the IPO (referred to as the “IPO engagement letter”). Rule 3526 also includes the auditor’s responsibilities with respect to annual communications to the audit committee.

Footnotes

Entity whose financial statements or other information is being audited.