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Audit firm and independence
November, 16th 2006
The more one attempts to shackle audit firms, the more vague and complex the legislation becomes.

The auditing profession has had a pretty tumultuous time over the past five years or so.

All accounting regulators are talking about independence and ethical practices and are passing rules to govern audit firms.

The Public Company Accounting Oversight Board (PCAOB) in the US the body that started off the regulation raj recently acted and obtained the approval of the Securities and Exchange Commission (SEC) for " Ethics and Independence Rules Concerning Independence, Tax Services and Contingent Fees".

The rules state that an audit firm would not be considered to be independent of its client if:

It enters into a contingent fee arrangement with the audit client;

Provides certain services related to the tax treatment of a confidential or "aggressive" transaction; and

Provides tax services to certain members of the management who serve in financial oversight roles for the client.

The PCAOB helpfully clarifies that the firm can provide all other tax services to the audit client if these services are pre-approved by the Audit Committee.

The clause regarding the contingent fee was already prevalent in the SEC Rules, which however provided an exception for fees for tax services based on the results of judicial proceedings or the finding of governmental agencies.

The PCAOB amended this to provide exception to fees fixed by courts and other agencies not linked to a finding or result a bankruptcy court, for instance. Confidential transaction, the PCAOB explains, involves marketing, planning or opining in favour of the tax treatment of such transaction.

An aggressive transaction is one where:

The transaction was initially recommended, directly or indirectly, by the audit firm.

A significant purpose of the transaction is tax avoidance.

The tax treatment of the transaction is most likely to be disallowed under applicable tax laws.

Futile laws?

The clause regarding providing tax services to certain members of the management proves the futility of passing governance laws ever so often. While it is clear that the service cannot be provided to the person who is directly responsible for financial oversight a pretty complicated way of referring to the Chief Financial Officer a person who is promoted to this role can utilise such services provided the engagement was commenced before the promotion and completed within six months of the promotion.

Despite such detailed legislation, what happens in case independence is marred in the period between the promotion and the completion of the assignment is left unsaid.

After so much of policing laws, audit firms get some philosophical advice: The audit firm and its associated individuals should remain independent of the audit client throughout the professional engagement period and the associated individuals would not cause the firm to violate relevant laws, rules or professional standards. It would not be too radical to state that the Sarbanes-Oxley Act (SOX) whose offshoot all these regulations are has served its purpose in a limited way at a high cost.

The more one attempts to shackle audit firms, the more one would have to think of ways to prevent them from getting chained in the first place. The end-result is vague legislation.

Indian Independence

SOX has had limited impact in India. Fortunately, SEBI the Indian equivalent of SEC is not thinking of implementing such legislation, save the restrictive clauses in Clause 49 of the Listing Agreement, as tax and audit services are typically a combo offer to many clients in India.

This only proves that one can be perceived to be cosy with a client and provide him audit and tax services without allowing either of them to be a compromise. Independence is most certainly a state of mind.

Mohan R. Lavi
(The author is a Delhi-based chartered accountant.)

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