The profession's new independence standard for assurance engagements represents a major step toward rebuilding investor confidence
By Don Wray and Jan Munro
The Canadian CA profession has made another step to strengthen our financial reporting system with the release of a new independence standard for assurance providers in Canada.
Issued by the CICA's Public Interest and Integrity Committee, the standard reflects the updated global standard recently issued by the International Federation of Accountants, augmented by the US SEC requirements for public companies. While the development of this standard was under way before the events that led to the erosion in investor confidence in the wake of Enron and other corporate failures in the US, it should still contribute greatly toward rebuilding investor confidence. Subject to member approval, it will be effective January 1, 2004.
Independence and objectivity requirements for the CA profession are not new. The requirement for objectivity in an assurance engagement remains the same, with independence being the critical criterion. What is new is the systematic, principles-based framework for analyzing independence for each prospective assurance engagement, including new types of service that may emerge. It thus becomes a "living" standard.
The new standard provides significantly more guidance than the previous Council Interpretation. This guidance will help members and firms to apply the framework and remain independent when required. It is supplemented by many examples of the common circumstances encountered in practice, along with a list of definitions of the terms used.
The new requirements
When independence is required for a particular engagement, the member or firm must complete the following four steps:
1. Identify threats to independence, which are categorized as:
• Self-interest threat: when a firm or a person on the engagement team could benefit from a financial interest in, or another self-interest conflict with, an assurance client.
• Self-review threat: when any product or judgment from a previous engagement needs to be evaluated in reaching conclusions in the particular assurance engagement.
• Advocacy threat: when a firm, or a person on the engagement team, promotes an assurance client's position or opinion to the point that objectivity may be, or may be perceived to be, impaired.
• Familiarity threat: when, by virtue of a close relationship with an assurance client, its directors, officers or employees, a firm or a person on the engagement team becomes too sympathetic to the client's interests.
• Intimidation threat: when a person on the engagement team may be deterred from acting objectively and exercising professional scepticism by threats, actual or perceived, from the directors, officers or employees of an assurance client.
2. Evaluate the significance of any threat and for each threat identified determine if there are safeguards that can be applied to eliminate the threat or reduce it to an acceptable level. Possible safeguards include:
• professional, legislative, or regulatory safeguards
• safeguards within the entity
• safeguards within the firm
3. Determine if there are prohibitions that preclude performing the engagement. Prohibitions describe circumstances and activities that members and firms must avoid when performing an assurance engagement because there are no adequate safeguards that will, in the view of a reasonable observer, eliminate a threat or reduce it to an acceptable level.
4. For each threat that is identified as not clearly insignificant, document:
• a description of the nature of the engagement
• the threat
• a description of the safeguard applied to eliminate the threat or reduce it to an acceptable level and
• an explanation of how the safeguard eliminates the threat or reduces it to an acceptable level.
The flowchart illustrates the above steps.
REVIEW OF INDEPENDENCE STANDARD – FLOWCHART
* Consider whether compilation engagement will meet client's needs and if so, disclose nature and extent of lack of independence in the Notice to Reader.
Some prohibitions will apply to all assurance clients, while others will apply only to audits of public companies. Public companies are referred to as "listed entities." A listed entity is defined in the standard as an entity whose shares or debt are quoted or listed on a recognized stock exchange, other than an entity that has market capitalization and book value of total assets that are both less than $10 million. An entity that meets the definition will be considered to be a listed entity until:
• its securities cease to be quoted or listed, or
• its market capitalization and total assets have both fallen below the $10-million threshold for two years.
The "prohibitions" listed below are relevant only if the member or firm proposes to perform an audit or other assurance engagement for a client. Members and firms must always remember that the failure to observe a particular prohibition will mean the member or firm will not be independent of the client for an audit or assurance engagement, and will therefore be prohibited from performing the assurance engagement.
Prohibitions applicable to assurance engagements for all clients
1. Members of the engagement team (and immediate family members) may not have a financial interest, as defined, in an assurance client or a related entity. This is extended to network firms (also defined) in the case of audit clients. Non-engagement team members of the firm (and immediate family) are prohibited from owning more than 0.1% of an audit or review client.
2. The firm and members of the engagement team may not have a loan, or a loan guarantee, to or from an assurance client or a related entity. There are limited exceptions for loans made in the ordinary course of a bank client's business.
3. The firm and members of the engagement team may not have a close business relationship with an assurance client, unless the relationship is limited to an immaterial financial interest that is insignificant to the client, firm or member.
4. Members of the engagement team may not have an immediate family member in a position with the client where that person would be able to influence the subject matter of the assurance engagement.
5. Members of the engagement team must not be officers or directors of the client, or employees of the client in a position to influence the subject matter of the assurance engagement, during the period covered by the engagement. As well, other members of the firm may not be officers or directors of an assurance client.
6. Members and firms are prohibited from performing management functions (as described) for an assurance client.
7. Members and firms must obtain client management approval for the making of journal entries, accounting classifications, etc. The creation of original or source documents such as cheques, invoices, etc. is prohibited.
8. Members and firms may not provide legal services that involve dispute resolution of matters that are material to the financial statements of audit and review clients.
9. Members and firms may not provide corporate finance services such as dealing in, promoting, or buying/selling an assurance client's securities.
10. A member or firm may not provide an assurance service to a client for a fee that is significantly lower than market ("low ball") unless the member can demonstrate that all professional standards have been met in performing the service.
11. Members and students on the engagement team and the firm may not accept other than insignificant gifts or hospitality from an assurance client.
Prohibitions applicable to audits of public companies only
1. A former member of the audit team may not take a senior financial position with the client for one year.
2. Audit partners must take leave of the audit team in accordance with the prescribed rotation requirements.
3. The client audit committee must pre-approve all services provided by the firm to the client.
4. Audit partners may not be directly compensated by the firm for selling non-assurance services to their audit clients.
5. Members and firms may not provide:
• bookkeeping and accounting services,
• financial information systems design and implementation,
• actuarial services,
• valuation services,
• internal audit services,
unless it is reasonable to conclude that the results of the services will not be subject to audit procedures.
6. Members and firms may not provide the following services, even if not subject to audit:
• expert services, including litigation support;
• legal services;
• management functions;
• human resources services;
• corporate financial services.
A solid foundation
The new independence standard is a modern standard that provides a principles-based framework for analyzing independence for all assurance engagements. The principles are designed to apply to all circumstances – if a specific situation is not addressed in the standard, the principles can still be applied. The PIIC believes that the principled approach, together with the SEC requirements for public companies, should make a major contribution toward restoring investor confidence.
Donald G. Wray, LLB, FCA, is chair of the CICA's Public Interest and Integrity Committee.
Jan Munro, CA, is an independent consultant who provides support to the Public Interest and Integrity Committee on independence matters.
