Auditor Independence Rules Impact Business Valuation and Litigation Services

Rules issued by the SEC early this year, along with a revision of Interpretation 101-3, “Performance of Other Services,” of ET section 101, Independence (AICPA, Professional Standards, vol. 2, ET sec. 101.01,) may affect CPA firms providing litigation and business valuation services.

By Michael A. Crain, CPA/ABV, ASA, CFE, and Michael G. Ueltzen, CPA, CFE

Recent events such as the Enron and WorldCom corporate scandals and the resulting Sarbanes-Oxley Act have put a spotlight on CPAs’ roles as auditors of financial statements. Many of the events have focused attention on the importance of auditor independence.

The independence issues related to attest services may very well affect CPAs who provide other types of services as well. Many practitioners affiliated with full-service CPA firms provide business valuation and litigation services and may be affected to some degree by the independence requirement for the audit, attestation, and review practices within their firms.

Recent events

In response to the recent business and audit failures of publicly held companies, Congress enacted the Sarbanes-Oxley Act, resulting in formal rules on auditor independence for auditors of publicly held companies. The Securities Exchange Commission (SEC) issued the rules on January 28, 2003 (http://www.sec.gov/rules/final.shtml). As quoted in the 148th Congressional Record (S7351, S7364), Senator Sarbanes's intent was to “draw a bright line around a limited list of nonaudit services that accounting firms may not provide the public company audit clients because their doing so creates a fundamental conflict of interest to the accounting firms.” In order to be independent, accounting firms must comply with a simple set of principles that preclude them from:

Auditing their own work.
Functioning as a part of management or as an employee of the audit client.
Acting as an advocate for the audit client.
Serving as a promoter of the company stock or other financial interests.

Included among the prohibited services to public company audit clients are (1) appraisal or valuation services, fairness opinions, or contribution of in-kind reports, and (2) legal services and expert services unrelated to the audit.

On March 19, 2003, the AICPA Professional Ethics Executive Committee (PEEC) issued an exposure draft that proposed a revision of Interpretation 101-3 dealing with auditor independence under Rule 101, Independence (AICPA, Professional Standards, vol. 2, ET sec. 101.01), of the Code of Professional Conduct. The revision to this Interpretation (AICPA Exposure Draft, Omnibus Proposal of Professional Ethics Division Interpretations and Rulings) was proposed by the Committee to ensure the standard’s continued effectiveness in promoting independence when a CPA renders non-attest services to an attest client. In addition, the proposal included revisions to the standards on business valuations, which are primarily in response to similar independence changes made by the International Federation of Accountants (IFAC). As a member of IFAC, the AICPA is obligated to have standards that are not less restrictive than those of IFAC. Among the elements of the AICPA’s proposed revision would be a modification to recognize that engagements may be subject to independence rules of other regulatory bodies (that is, the SEC, Government Accounting Office [GAO], or others) and to further clarify the general requirements for performing nonattest services for attest clients. The requirements include:

The CPA shall not perform management functions or make management decisions for the attest client.
The client must agree to perform significant functions in connection with the nonattest engagement including making all management decisions, performing all management functions, designating a competent employee to oversee the services, evaluating the adequacy and results of services performed, accepting responsibility for the results of the services, and establishing and maintaining internal controls including monitoring activities of the engagement.
The CPA shall establish and document in writing the understanding with the client regarding the engagement and respective responsibilities.

The requirements established in paragraph 2 place a burden on the CPA to document that the client accepts responsibility for the non-attest service. Even more important, the client must assume a significant role in the engagement and the related conclusions. CPAs who provide litigation and dispute resolution services or valuation services to attest clients should be familiar with these general requirements. The revised Interpretation clearly requires that the client agree to accept responsibility and evaluate the results of the application (the use) of the non-attest work. Although the client does not need to participate in the litigation and dispute resolution or valuation process, the general requirements do require that the client evaluate and accept responsibility for the non-attest work.

The final revised Interpretation is expected to have a transition period. In this event, the revised interpretation would not be effective immediately for existing nonattest engagements.Specifically addressed in the revised Interpretation is a discussion of valuation services provided to attest clients; however, unlike the SEC Rule, no discussion was included for expert services. At the time of the writing of this article, the proposed change to the Interpretation was undergoing final review by the Professional Ethics Executive Committee. The final Interpretation is expected to be issued in the fall of this year.

Impact on litigation services

In the past, practitioners justifiably looked to the issues of Rule 102, Integrity and Objectivity (AICPA, Professional Standards, vol. 2, ET sec. 102.01), Integrity and Objectivity (AICPA ET § 102) as the primary guidance as to whether an expert service could be rendered for an attest client. With the publication of the SEC Rule on Auditor Independence and the probable implementation of the proposed Interpretation 101-3, the CPA who intends to provide a litigation or dispute resolution service to an attest client should tread carefully. If the attest client is a publicly held company, the CPA should look to the SEC Rule on Auditor Independence. If the attest client is not a publicly held company, the CPA should determine how the client would comply with paragraph 2 of the general requirements established by Interpretation 101-3 (see above). Given the requirements of paragraph 2 of the proposed Interpretation 101-3, the CPA may think that retention by legal counsel for the attest client (in lieu of the attest client) may suffice. The SEC concluded, however, that such a relationship does not comply with the Rule on Auditor Independence.

For guidance concerning providing litigation or dispute resolution services to an attest client, see the “Q&A” sidebar below. These sidebar discussions encompass various issues in addition to independence.

Providing Litigation and Dispute Resolution Services to an Attest Client: Q&A

The following examples are intended to provide some guidance to the CPA who is considering providing litigation or dispute resolution services to an attest client:

Can the CPA conduct an internal investigation or fact-finding?
— Yes, provided there is no influence from outside legal counsel. This specific situation is discussed in the SEC Final Rule and the CPA may find additional guidance contained in the Final Rule.
Can the CPA firm conduct an investigation as to any accounting improprieties?
— Yes, that would be considered to be part of the
normal scope of an audit assignment. Should the investigation result in a situation in which the CPA may have to defend the attest work or should the evidence suggest SEC violations, the CPA should consult legal counsel and may find additional guidance in the SEC Final Rule on Auditor Independence.
Can the CPA firm be retained by either a corporation or partnership in a corporation or partnership dispute or by one of the shareholders or partners?
— Probably not as the CPA would have a conflict of
interest, thus impairing the member's integrity and objectivity. The CPA would also encounter difficulty in complying with the general requirements of paragraph 2 of the proposed Interpretation 101-3 for performing non-attest services.
Could the CPA firm be retained in a litigated matter by counsel representing an attest client?

—Probably not. Even if the CPA complies with the
general requirements of paragraph 2 of the proposed Interpretation 101-3, the CPA’s creditability, integrity, and objectivity may be impaired in the eyes of the trier of fact.
Can the CPA provide insurance appraisal (business interruption) services for an attest client?

—Probably not. Even if the CPA complies with the
general requirements of paragraph 2 of the proposed Interpretation 101-3, the CPA’s creditability, integrity, and objectivity may be impaired in the eyes of the trier of fact.

Unlike many other services provided by CPAs, the courts may also actively participate in evaluating the integrity, objectivity, and independence of CPAs providing litigation or dispute resolution services. The impact of the courts’ role on this scope of services is currently unknown. CPA firms who provide litigation or dispute resolution services for audit, attest, and review clients should carefully evaluate whether those litigation or dispute resolution services impair auditor independence and decide carefully and deliberately whether to proceed with a litigation or dispute resolution service for an attest client.

Impact on business valuation services

Business valuations are required for a variety of reasons, including tax, merger and acquisition, litigation, and financial reporting. If a CPA firm performs audit, attest, or review services for a public or nonpublic client and valuation issues affecting the financial statements arise, what are the limitations for employees of the CPA firm on performing valuation services?

Several areas of GAAP may require valuation services to properly reflect the balances of assets on a company’s financial statements. They include:

Financial Accounting Standards Board (FASB) Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation, which addresses the fair value of employee stock options.
FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities, which addresses the fair value of derivatives.
FASB Statement No. 141, Business Combinations, which addresses the allocation of the purchase price in a business combination (including intangible assets and goodwill).
FASB Statement No. 142, Goodwill and Other Intangible Investments, which addresses the fair value of goodwill (impairment).

In addition, certain transactions, such as corporate stock redemptions and employee stock ownership plan (ESOP) share valuations, may affect the attest client’s financial statements and involve valuation issues.

In general, independence standards prohibit auditors from testing their own valuation work if the work has a material effect on the financial statements. The proposed revision to Interpretation 101-3 specifically mentions valuation services provided to attest clients. Accordingly, full service accounting firms that provide attest services and have client financial statements with valuation issues such as those mentioned above need to consider carefully what valuation work they may perform while maintaining auditor independence.

A guiding principle for the auditor of a nonpublic company is whether he or she is testing the valuation work performed by others within the firm if that work has a material effect on the attest client’s financial statements. Auditors of public companies must follow the more restrictive SEC rule, which has no materiality limitation. The SEC rule prohibits all valuation services to a public audit client unless it is reasonable to conclude that the results of the valuation services will not be subject to audit procedures during the audit of the financial statements. As previously discussed, CPA firms must also follow paragraph 2 of the general requirements of proposed Interpretation 101-3 in providing any non-attest services to attest clients. For some privately held companies, it may not be possible to obtain the client’s acceptance of the required responsibilities specified therein.

The revision to Interpretation 101-3 is expected to state “Independence would be impaired if a member performs an appraisal, valuation, or actuarial service for an attest client where the results of the service, individually or in the aggregate, would be material to the financial statements and the appraisal, valuation, or actuarial service involves a significant degree of subjectivity.” Since business valuations generally require a significant amount of subjectivity, most valuations of business interests or financial assets and liabilities can be expected to fall under this provision.

Some guidance for CPA firms that provide valuation services to attest clients is offered in the “Q&A” sidebar below. These sidebar discussions encompass various issues in addition to independence.

Providing Business Valuation Services to an Attest Client: Q&A

The following illustrations provide some guidance to the CPA firm that is considering providing valuation services to an attest client. The examples assume the issues have a material effect on a nonpublic attest client’s financial statements.

Can the CPA firm make the allocation of the purchase price in a business combination under FASB Statement No. 141?
— No. The client or an outside valuator will need to make the allocation while the auditor tests that work.
Can the CPA firm do the goodwill impairment calculations under FASB Statement No. 142?
—The auditor may be able to perform the Step 1 test under FASB Statement No. 142 for impairment as part of the attest function, but may not do the Step 2 test for the amount of the impairment. The client or an outside valuator will need to perform the Step 2 work and the auditor will test it.
Can the CPA firm value the shares of an attest client held in an ESOP?
— No, when the value of the shares has a material effect on the company’s financial statements.
Can the CPA firm value the attest client's shares in a corporate stock redemption?
–No, when the value of the shares has a material effect on the company’s financial statements.
Can the CPA firm value the attest client's shares in a sale between two individuals?
— Yes, since the valuation has no material impact on the company’s financial statements and as long as integrity and objectivity are maintained.
Can the CPA firm determine the value of a covenant-not-to-compete for an attest client?
— No, not when the value of the covenant is material to the financial statements.
Can the CPA firm perform a tax-only valuation for the attest client or the client’s employee?
— Yes, valuations performed for nonfinancial statement purposes are permitted provided the second general requirement of the proposed interpretation is met, as long as integrity and objectivity are maintained, and the results of the tax valuation have no material effect on the financial statements.
Can the CPA firm value the shares of an attest client for the client's employee-shareholder in a divorce proceeding?
— Probably not. Even though independence is not impaired under the revised Interpretation 101-3, the CPA firm’s objectivity may be impaired in some situations especially when the employee owns a significant amount of the company’s stock. Objectivity could be impaired while performing the valuation services because of the client’s potential dissatisfaction with the valuation results and possible threat of dismissal of the firm as auditor. In addition, the trier of fact in the divorce matter may determine the appraiser is not independent and objective because of the relationship. Also, appraiser independence under business valuation standards of some valuation organizations may be impaired if the CPA is obligated to follow them.

Note that the focus of this discussion is on auditor independence, which arises in this context at the time the auditor tests the valuation work of members of the same firm (called self-review risk). Auditor independence is different from appraiser independence as the former arises from testing one’s own work. The AICPA’s proposed revision to Interpretation 101-3 relates to how valuation services affect auditor independence and does not address appraiser independence.

Concluding caveats

Although the professional requirement for auditor independence has been established for a very long time, recent events have caused a shift to more stringent interpretations of what constitutes independence. CPA firms need to evaluate carefully whether non-attest services they provide to attest clients impair their independence under the stricter interpretations.

AICPA standards do not require independence when providing litigation or dispute resolution services and business valuation services to non-attest clients (objectivity and integrity are required according to the Statement on Standards for Consulting Services No. 1). However, litigation and appraisal services practitioners need to be aware of external expectations for independence in these areas from the public, courts, and government agencies when providing opinions in testimony and reports to third parties.

Michael A. Crain, CPA/ABV, ASA, CFE is managing director of The Financial Valuation Group's office in Fort Lauderdale, Florida. He is a current member of the AICPA's Business Valuation Subcommittee and a past member of the Litigation and Dispute Resolution Services Subcommittee. He can be reached at mcrain@fvginternational.com.

Michael G. Ueltzen, CPA, CFE is the managing partner of Ueltzen & Company, LLP, Sacramento, California. He is a current member of the AICPA's Litigation and Dispute Resolution Subcommittee. He can be reached at mueltzen@ueltzen.com.