Chapter 4 Applyingthe Rules Network Firms and Firm Mergers and Acquisitions

Chapter 4—Applying the rules: Network firms and firm mergers and acquisitions What is a network firm? CPA firms frequently form associations with other firms and entities and cooperate with them to enhance their capabilities to provide professional services. On occasion, such cooperation creates the appearance that firms are closely aligned or connected. Such appearance exists when one or more of the following characteristics are present: • The use of a common brand name (including common initials) as part of the firm name • Common control among the firms through ownership, management, or other means • Profits or costs sharing, excluding costs of operating the association; costs of developing audit methodologies, manuals, and training courses; and other costs that are immaterial to the firm • Common business strategy that involves ongoing collaboration among the firms whereby the firms are responsible for implementing the association’s strategy and are held accountable for performance pursuant to that strategy • The sharing of a significant part of professional resources, for example personnel, supplies, or information systems • Common quality control policies and procedures that firms are required to implement and that are monitored by the association When a firm participates in such an association, and one or more of the preceding characteristics are present, the firm is considered a network firm. Any entity the firm controls by itself or through one or more of its owners is also considered a network firm. In addition, any entity that can control the firm or that the firm is under common control with would also be considered a network firm. It is possible that not all firms in the association will meet one of the preceding characteristics. In such situations, only the subset of firms that meet one or more of the characteristics would be considered network firms. How do I apply the network firm rules? The “Networks and Network Firms” interpretation (ET sec. 1.220.010) under the "Independence Rule" (ET sec. 1.200.001) explains that when your firm is considered a network firm, your firm is required to remain independent of other network firms’ audit and review clients and vice versa. Thus, a network firm may provide audit or review services for a client only insofar as other network firms are independent of the client. For example, other network firms could not provide prohibited nonattest services (that is, services that would impair independence under the “Nonattest Services” subtopic [ET sec. 1.295] of the “Independence Rule”) for that client or have any prohibited relationships, such as investments by the firm in the client, or loans to or from that client. For all other attest clients, members of network firms should consider any threats the firm knows or has reason to believe may be created by network firm interests and relationships. If those threats are not at an acceptable level, the member should apply safeguards to eliminate the threats or reduce them to an acceptable level. 15 However, when a foreign network firm (a firm or entity that is part of the network that is located outside of the United States) departs from the "Independence Rule," the domestic network firm’s independence is not impaired provided the foreign network firm has at a minimum, complied with the independence requirements set forth in the International Ethics Standards Board for Accountants Code of Ethics for Professional Accountants. When determining if a network exists, the SEC would look at all the facts and circumstances, especially how the firms treat one another when referring audit work (that is, do they place reliance on the work received by another firm, or do they treat the work the same as if an unaffiliated firm performed the work). At the SEC-PCAOB conference on December 10, 2007, it was noted that the SEC staff continue to follow the guidance issued in the SEC’s January 2001 independence rulemaking regarding its definitions of firm and affiliate, meaning the staff will consider specific facts and circumstances, including the following: • Does the primary auditor refer to another network firm in the audit opinion? • Do the firms have common ownership, profit-sharing, or cost-sharing agreements? • Do the firms share management, have a common brand name, or use shared professional resources? • Do the firms have common quality control policies and procedures? How do I apply the rules in a merger or acquisition? The "Firm Mergers and Acquisitions" interpretation (ET sec. 1.220.040) under the "Independence Rule" (ET sec. 1.200.001) provides guidance in situations where independence with respect to an attest client may become impaired as a result of a firm merger or acquisition. The guidance would apply when either (1) a member's firm merges with or acquires another firm or entity or all or part of the business thereof or (2) a member’s firm, or all or part of the business thereof, is merged with or acquired by another firm. The interpretation focuses on two types of relationships that could impair independence: employment or association with an attest client and the provision of nonattest services that would impair independence (prohibited nonattest services). Employment or association with an attest client The interpretation requires certain safeguards to be in place in order for independence to be maintained when a partner or professional employee of one firm is employed by or associated with an attest client of the other firm. Such safeguards require that the partner or professional employee terminate the relationship prior to the closing date of the merger or acquisition and be prohibited from participating on the attest engagement team or being an individual in a position to influence the attest engagement if the engagement covers any period in which the partner or employee was employed or associated with the attest client. The partner or employee must also comply with any applicable safeguards under the provisions of the “Former Employment or Association With an Attest 16 Client” interpretation regarding disassociation from an attest client, such as the safeguard that requires any covered member to cease participation in the attest client’s employee benefit plans. The interpretation also requires that a responsible individual within the firm (for example, an individual with responsibility for the policies and procedures relating to independence) should assess the prior relationship that the partner or professional employee had with the attest client as well as the position that the individual will hold at the firm to determine if threats are at an acceptable level. If threats are determined not to be at an acceptable level, the responsible individual will need to be satisfied that safeguards are applied that will eliminate or reduce threats to an acceptable level. The interpretation further requires that in situations where the partner or professional employee will have interaction with the attest engagement team or where the attest engagement team will evaluate work performed by the partner or professional employee while he or she was employed or associated with the attest client, an individual within the firm with the appropriate stature, expertise, and objectivity must review the subsequent attest engagement, prior to issuing the attest report, to determine whether the attest engagement team maintained integrity, objectivity, and as appropriate, professional skepticism. Finally, the interpretation requires that the nature of the relationship and any safeguards that were applied be discussed with those charged with governance and that such discussion take place as soon as practicable under the circumstances but before issuing the attest report and encourages the substance of the discussions be documented. Nonattest services The interpretation also provides independence guidance in situations where one firm provided prohibited nonattest services to an attest client of the other firm. The interpretation acknowledges that the significance of the threats differ depending upon whether the prohibited nonattest services were provided by the “acquiring firm” with respect to an attest client of the acquired firm or by the “acquired firm” with respect to an attest client of the acquiring firm. In situations where the acquiring firm provided prohibited nonattest services to an attest client of the acquired firm during the period of the professional engagement or the period covered by the financial statements, threats would be so significant that they could not be reduced to an acceptable level. For example, in the situation where the acquired firm’s attest client would become an attest client of the acquiring firm (that is, the surviving firm) upon the merger or acquisition and any prohibited nonattest services performed by the acquiring firm for such an attest client would impair independence if the attest engagement were to continue. Alternatively, when the acquired firm provided the prohibited nonattest services to an attest client of the acquiring firm during the period of the professional engagement or the period covered by the financial statements, the acquiring firm’s independence will not be impaired provided certain conditions are met. The first condition is for the acquired firm to either terminate the prohibited nonattest services or modify the nonattest services such that the services will no longer be considered to impair independence. This condition should be met prior to the closing date of the acquisition. The second condition is that any individual that participated in the prohibited nonattest services engagement not be on the attest engagement or in a position to influence the attest engagement. The last condition is for the firm to perform an evaluation to determine if threats are either at an acceptable level or can be reduced to an acceptable level by the application of safeguards. The extent of the evaluation performed would be based on whether or not the prohibited nonattest services will be attributable to the acquiring firm. The nonattest services will be considered 17 attributable to the acquiring firm if the acquiring firm will assume responsibility (that is, be held liable or accountable, or both) for the results of the prohibited nonattest services performed by the acquired firm. In evaluating the significance of any threats, the interpretation provides various factors that should be considered and where threats are determined not to be at an acceptable level, the interpretation provides examples of possible safeguards to be applied. In cases where no safeguards exist that can eliminate or reduce threats to an acceptable level, independence would be impaired. The interpretation also requires a responsible individual within the firm discuss with those charged with governance the nature of any prohibited services performed that are subject to the evaluation, along with any safeguards applied, and encourages documentation of such discussion. This discussion should occur as soon as practicable under the circumstances but before issuing the attest report. 18