PCAOB: 5 Good Practices For Auditor Independence

The bar graph below shows the total number of independence comment forms issued by audit firm category—global network firms (GNFs), non-affiliate firms (NAFs), and broker-dealer firms—for 2021, 2022, and 2023:

In a separate staff report on observations from the PCAOB’s 2023 audit firm inspection cycle, the audit regulator said instances of auditor independence noncompliance “increased significantly” from the previous year.

“We continued to identify potential violations of the Securities and Exchange Commission’s independence requirements, including financial relationship requirements. These potential violations, mainly with triennially inspected audit firms (which includes non-U.S. GNF), include financial relationships, employment relationships, business relationships, non-audit services, contingent fees, and audit committee administration of the engagement,” the PCAOB said in the 2023 inspection cycle staff report, which was released last month. “Some of the annually inspected firms continue to report a high rate of noncompliance by audit firm personnel reporting their financial relationships in accordance with firm policies that could be more restrictive than the SEC or PCAOB independence requirements, in the applicable audit firm’s monitoring system. We also observed deficiencies related to PCAOB Rule 3524, Audit Committee Pre-approval of Certain Tax Services.”

The following pie chart summarizes all independence comment forms for the period 2021 to 2023:

“Auditor independence is a critically important topic not only for the PCAOB and audit firms but for anyone who invests in a public company or uses the services of a broker-dealer,” the PCAOB said. “Investors expect (and SEC and PCAOB rules require) that audits are being performed by skilled professionals capable of exercising objective and impartial judgment and maintaining their independence from the public companies or broker-dealers they audit. Therefore, compliance by all personnel and partners with SEC and PCAOB standards and rules and an audit firm’s internal process to preserve independence from their audit clients, in fact and in appearance, is fundamental to investor confidence and to building a strong audit firm culture of integrity and audit quality.”

Given the number of audit deficiencies related to auditor independence that inspectors have noted over the past three years, the PCAOB in this latest staff report provided audit firms with a handful of good practices to help them and their auditors comply with PCAOB and SEC rules and standards.

“A good practice could be a procedure, technique, or methodology that is appropriately comprehensive and suitably designed in relation to the size, nature, and complexity of the audit firm and thus may contribute to the quality of audit services,” the PCAOB said.

The following five good practices related to independence have been observed by PCAOB inspectors:

1. Increasing the use of technology-based tools

Some audit firms increasingly use technology-based tools to promote early detection of potential personal independence violations. For example:

• Audit firms have implemented tools to frequently compare time charged by audit firm personnel to financial holdings reported by the personnel for early identification of potential violations.
• Audit firms have also automated the process, including using direct feeds from broker systems, to compare financial holdings reported by personnel to the firms’ restricted entity listings to identify potential violations prior to audit engagement assignment.
• Some audit firms have developed automated tools that audit firm personnel use to report financial holdings that include prompts to remind them of reporting requirements for various types of financial holdings and features that allow professionals to pre-clear acquisitions of financial holdings.
• Certain audit firms use tools to analyze areas of repeated independence violations to send targeted communication to other audit firm personnel with similar reported financial holdings, to prompt them to consider if they have a similar inaccurate or non-reported financial holding and, if so, to take action to update their financial holding disclosures as may be appropriate.
• Certain audit firms monitor their independence reporting system for individual metrics and send targeted compliance reminder emails to personnel who (a) had no spousal entries, (b) had not accessed the monitoring system within the last three months, and/or (c) had empty monitoring system accounts with nothing to declare.

2. Enhancing the frequency of personal independence representations

Certain audit firms have increased the frequency for personnel to provide independence compliance representations to a quarterly or semi-annual basis. Also, to enhance the process, certain audit firms have tailored the representations based on personnel’s financial interests and/or services provided to audit clients.

3. Enhanced processes

Certain audit firms employed an enhanced process that includes mandatory meetings with firm personnel skilled in independence matters to guide them through their financial holding disclosures, and those of close family members, to ensure proper considerations are given to reporting all financial holdings. During this process, disclosed financial holdings may be compared to supporting documentation, such as current account statements or tax filings, to verify the accuracy and completeness of reported financial holdings.

4. Establishing disciplinary actions

Audit firms have put in place specific policies and procedures providing sanctions for personal independence policy violations including, but not limited to, failure to timely complete semi-annual or quarterly personal independence representations. The procedures include audit firms assessing the severity, frequency, and nature of personal independence policy violations and determining disciplinary actions commensurate with the violations. Disciplinary actions may include financial sanctions, promotion deferrals, mandatory independence training, removal from issuer audit engagements, or required independence reviews in subsequent years.

5. Use of templates

Using a global template with standardized language for all audit engagement letters for clients subject to SEC and PCAOB independence standards and rules. This template has helped prevent the inclusion of indemnification clauses, contingent fees, and other prohibited fees or services in the engagement letters of “other auditors.”