Chapter 6 Financial Relationships

Chapter 6 — Financial relationships When do my (or my family’s) financial interests impair independence? This chapter discusses various types of financial relationships and how they affect independence. Although this chapter focuses on how these rules apply to you and your family, keep in mind that your firm also is subject to the financial relationship rules (because the AICPA Code of Professional Conduct [the code] includes firms in its definition of covered member). As a covered member, you (and your spouse or spousal equivalent and dependents) are not permitted to have a • direct financial interest in an attest client, regardless of how immaterial it would be to your net worth. • material indirect financial interest in the attest client. Note: The code does not define or otherwise provide guidance on determining materiality. In determining materiality, you should apply professional judgment to all relevant facts and circumstances and refer to applicable guidance in the professional literature. Both qualitative and quantitative factors should be considered. In addition, if you commit to acquire a direct or material indirect financial interest in an attest client, your independence would be impaired. For example, if you sign a stock subscription agreement with the attest client, your independence would be considered impaired as soon as you sign the agreement. Examples of financial interests include shares of stock; mutual fund shares; debt security issued by an entity; partnership units; stock rights; options or warrants to acquire an interest in an attest client; or rights of participation, such as puts, calls, or straddles. The following types of financial interests are direct financial interests: • Owned by you directly • Under your control • Beneficially owned1 by you through an investment vehicle, an estate, a trust, or another intermediary if you can either o control the intermediary or o have the authority to supervise or participate in the intermediary’s investment decisions For example, if you invest in a participant-directed 401(k) plan whereby you are able to select the investments held in your account or are able to select from investment alternatives offered by the plan, you would be considered to have a direct financial interest in the investments held in your account. 1 A financial interest is beneficially owned if an individual or entity is not the record owner of the interest but has a right to some or all of the underlying benefits of ownership. These benefits include the authority to direct the voting or disposition of the interest or to receive the economic benefits of the ownership of the interest. 22 You also have a direct financial interest in an attest client if you have a financial interest in an attest client through one of the following: • A partnership, if you are a general partner • A Section 529 savings plan, if you are the account owner • An estate, if you serve as an executor and meet certain other criteria • A trust, if you serve as the trustee and meet certain other criteria For example, suppose you are a covered member with respect to ABC Co., and you are also a general partner of XYZ Partnership. XYZ Partnership owns shares in ABC Co. Under the independence rules, you would be deemed to have a direct financial interest in ABC Co. that would impair your independence, regardless of materiality. An indirect financial interest arises if you have a financial interest that is beneficially owned through an investment vehicle, an estate, a trust, or another intermediary when you can neither control the intermediary nor have the authority to supervise or participate in the intermediary’s investment decisions. For example, if you invest in a defined contribution plan that is not participant directed, and you have no authority to supervise or participate in the plan’s investment decisions, you would be considered to have an indirect financial interest in the underlying plan investments, in addition to a direct financial interest in the plan. Note: The “Financial Interests” subtopic (ET sec. 1.240), the “Trusts and Estates” subtopic (ET sec. 1.245), and the “Insurance Products” subtopic (ET sec. 1.257) of the “Independence Rule” (ET sec. 1.200.001) provide extensive examples of various types of financial interests and whether they should be considered to be direct or indirect financial interests, including investments in mutual funds, retirement and savings plans, Section 529 plans, trusts, partnerships, and insurance products. The SEC classifies your investment in an SEC audit client held through another entity (the intermediary) as direct if either of the following is true: • You participate in the intermediary’s investment decisions or have control over them. • The investment in the client by the intermediary (which is not a diversified mutual fund) represents 20 percent or more of the value of its total investments. If neither of the preceding applies, your investment in an SEC audit client through another entity would normally be considered to be an indirect financial interest in that client. 23 What if my immediate family or I receive a financial interest as a result of an inheritance or a gift? If, due to an unexpected event, you or members of your immediate family receive a financial interest in an attest client that would impair your independence, you may qualify under an exemption in the rules if you meet the following criteria: • The financial interest was unsolicited. • You dispose of the interest as soon as practicable but no later than 30 days after you become aware of it and have the right to dispose. • If the interest is material, but you do not have the right to dispose of the interest (for example, as in the case of stock options or restricted stock), you do not participate in the attest engagement. What are the rules that apply to my mutual fund investments (and those of my family) if my firm audits those mutual funds? If you are a covered member with respect to a mutual fund attest client of your firm, and you or your immediate family own shares in the fund, you have a direct financial interest in the fund client. The SEC rules also prohibit the firm and covered persons and their immediate family members from having any financial interest in an entity (even one that is not a client) that is part of an investment company complex that includes an SEC audit client. Which rules pertain to my mutual fund investments (and those of my family) if my firm audits companies held in those mutual funds? Financial interests that you and your immediate family have in attest clients through a mutual fund are considered to be indirect financial interests in those attest clients unless the fund is a diversified mutual fund. If a mutual fund is diversified, and you or your immediate family, or both, own 5 percent or less of its outstanding shares, the fund’s holdings in attest clients for which you are a covered member will not be considered material indirect financial interests in those attest clients. Thus, you would be relieved of the burden of having to monitor whether, and to what degree, the fund invests in attest clients for which you are a covered member. If the fund is not diversified or if you or your family, or both, own more than 5 percent of the fund’s equity, you should treat the fund’s holdings as indirect financial interests. For example, suppose ABC Mutual Fund, a diversified mutual fund, owns shares in attest client XYZ, and • ABC Mutual Fund’s net assets are $10 million. • your shares in ABC Mutual Fund are worth $50,000. • ABC Mutual Fund has 10 percent of its assets invested in XYZ. • your indirect financial interest in XYZ is $5,000 ($50,000 × 0.10). 24 If $5,000 is material to your net worth, independence would be considered to be impaired. May I have a joint closely held investment with an attest client? As a covered member, if you or the attest client, individually or collectively, controls an investment, that investment is considered to be a joint closely held investment. If this joint closely held investment is material to your net worth, independence would be considered to be impaired. In this rule, the term attest client includes certain persons associated with the attest client, such as officers, directors, or owners, who are able to exercise significant influence over the attest client. The SEC rules prohibit you and your immediate family from having a joint business venture with an SEC audit client or persons associated with the client in a decisionmaking capacity (meaning officers, directors, or substantial shareholders), regardless of whether the venture is material to your net worth. The SEC believes that these joint ventures, regardless of whether they are material, cause the client and audit firm to have mutuality of interests, which impairs independence. May my family or I borrow money from, or lend money to, an attest client? If you are a covered member with respect to an attest client, you and your immediate family may not have a loan to or from • the attest client. • an officer or a director of the attest client. • an individual holding 10 percent or more of the attest client’s outstanding equity securities (or other ownership interests). Certain exceptions affect this rule. First, specific loans exist that covered members are permitted to have from lending institution attest clients, including • car loans and leases collateralized by the vehicle. • credit card and overdraft reserve account balances that are kept current and do not exceed $10,000 (by payment due date, including any grace period). • passbook loans fully collateralized by cash deposits at the same financial institution. • loans fully collateralized by an insurance policy. In addition, if you have a loan from a lending institution that is an attest client (for example, a bank) that meets certain criteria, your loan may be elegible for a transistion provision (that is, you may be allowed to keep it). For your loan to be elegible for a transistion provision, you must have obtained it under normal lending procedures, terms, and requirements. The following loans may be elegible for a transistion provision: • Home mortgages • Other secured loans • Unsecured loans that are immaterial to your net worth 25 Generally speaking, a loan may be elegible for a transistion provision if you obtained it before • you became a covered member with respect to the attest client. • the lending institution became an attest client. • the attest client acquired the loan. To maintain your loan’s elegibility for a transistion provision status, you must keep the loan current (that is, make timely payments according to the loan agreement). In addition, you cannot renew or renegotiate the terms of the loan (for example, the interest rate or formula) unless the change was part of the original agreement (for example, an adjustable rate mortgage). There are no transition provisions. The SEC rules only provide exceptions for the following loans obtained from a lending institution under its normal lending procedure, terms, and requirements: • automobile loans and leases collateralized by the automobile • loans fully collateralized by the cash surrender value of an insurance policy • loans fully collateralized by cash deposits at the same financial institution • mortgage loan collateralized by the borrower’s primary residence provided the loan was not obtained while the covered person in the firm was a covered person The prior test for loans to or from record or beneficial owners of an audit client’s equity securities (1) has been replaced with a test for beneficial owners known through reasonable inquiry, of an audit client’s equity securities, and (2) no longer references a more than 10 percent ownership test, but rather is based on significant influence over the audit client. Reasonable inquiry is an inquiry by the auditor and the audit client in conjunction with the consideration of the audit client’s governance structure, governing documents, Commission filings, or other information prepared by the audit client which may relate to the identification of a beneficial owner. An accountant would not be independent when the accounting firm, any covered person in the firm, or any of his or her immediate family members has any loan (including any margin loan) to or from an audit client, or an audit client’s officers, directors, or beneficial owners (known through reasonable inquiry) of the audit client’s equity securities where such beneficial owner has significant influence over the audit client. Significant influence refers to the principles in ASC 323. May I have a brokerage account with an attest client? The AICPA rules indicate that for independence to be maintained, a covered member whose assets are held by a broker-dealer attest client must not receive any preferential treatment or terms, and 26 any assets that are subject to risk of loss must be immaterial to the covered member’s net worth. In addition, margin accounts may be subject to the preceding loan rules.2 Under the SEC rules, you may have a brokerage account with an SEC audit client if your account only holds cash or securities and is fully insured by the Securities Investor Protection Corporation. May I have a bank account with an attest client? As a covered member, you may have a bank account with a client bank or similar depository institution (for example, checking, savings, money market accounts, and certificates of deposit) if your deposits are fully insured by state or federal deposit insurance agencies or if uninsured amounts are not material to your net worth.3 The SEC prohibits covered persons and their immediate families from having bank account balances with an SEC audit client in excess of FDIC insurance limits. That is, deposits in excess of FDIC limits are considered to impair independence, even if the amounts are immaterial to you and your family.4 May I have an insurance policy with an attest client? The AICPA rules5 indicate that to maintain independence, a covered member must not receive any preferential treatment or terms when purchasing an insurance policy from an attest client. If the policy has an investment option, the financial interest rules must be applied. The SEC prohibits covered persons and their immediate family members from owning an individual insurance policy issued by an SEC audit client unless both of the following criteria are met: 2 • The individual obtained the policy before the professional became a covered person. • The likelihood of the insurer becoming insolvent is remote. See the following section, “May My Family or I Borrow Money From, or Lend Money to, an Attest Client?” 3 Both AICPA and SEC rules permit a practical exception for firms that maintain deposits exceeding insured limits when the likelihood of the financial institution experiencing financial difficulties is considered remote. 4 The SEC treats money market funds (as opposed to money market accounts) as mutual funds for purposes of its rules. Also see Rule 2-01(c)(1)(ii)(B). 5 The guidance is found in the “Insurance Products” subtopic (ET sec. 1.257) of the “Independence Rule” (ET sec. 1.200.001). 27 May I give gifts or entertainment to, or accept gifts or entertainment from, an attest client? The “Offering or Accepting Gifts or Entertainment” interpretation (ET sec. 1.285.010) under the “Independence Rule” addresses the exchange of gifts and entertainment among covered members, the attest client, and certain persons associated with the attest client (for example, persons in key positions and persons owning 10 percent or more of the attest client’s outstanding equity securities or other ownership interests). Independence is impaired if the firm, a member of the attest engagement team, or a person able to influence the engagement accepts a gift that is not clearly insignificant. A covered member may give a gift to persons associated with the attest client and not impair independence if the gift is reasonable in the circumstances. In addition, covered members may give or receive entertainment, provided it too is reasonable in the circumstances. The “Offering or Accepting Gifts or Entertainment” interpretation (ET sec. 1.120.010) under the “Integrity and Objectivity Rule” (ET sec. 1.100.001) covers a broader issue when partners, professionals, or their firms exchange gifts or entertainment with clients (not just attest clients) or persons associated with clients. Generally, gifts are differentiated from entertainment by whether the client participates in the activity with the firm member. (For example, giving tickets to a sporting event for the client to use would be considered a gift versus attending the event with the client, which would be considered entertainment.)7 Relevant factors in determining reasonableness include the event or occasion (if any) giving rise to the gift or entertainment, cost or value, frequency, whether business was conducted, and who participated. 28