Issues with corporate finance services to audited entities.
What corporate finance services can you provide to entities that you also audit? The auditor independence rules are discussed in this article.
The Auditing Practices Board’s (APB) Ethical Standards 1 and 5 address, between them, the requirement for auditors to be independent of the entities they audit, and, in particular, the threats to independence that can arise from providing non-audit services (NAS) to or in respect of those entities. There are, broadly, three types of NAS:
First, a list of services where ES5 suggests that it can generally be presumed that threats to independence will not arise. These are known as ‘audit-related services’.
Second, a list of services which feature prohibitions in all or some circumstances, particularly when auditing listed entities.
The third category covers all other potential NAS including those on the margins of the other categories. This requires a case-by-case analysis having regard to actual threats, perceived threats given the look and feel of the matter and also any particular requirements in the ES.
The Auditing Practices Board’s (APB) Ethical Standard 5 (Revised December 2010) includes a discussion on corporate finance at paragraphs 126 to 136. This includes prohibitions on certain activities and a discussion on some of the other issues to consider when applying a threats and safeguards approach to other areas.
A number of issues have arisen in interpreting the discussion. We do not believe that this is an area in which we can produce ‘frequently asked questions’ as corporate finance engagements tend to be too complex and too variable to make generalisations. However, we have set out, in the rest of this article, some general observations on the matters to consider when assessing whether a particular corporate finance NAS can or should be provided. However it must be stressed that the circumstances of each situation must be taken into account on a case by case basis; each firm has its own policies and procedures with which to make and document the appropriate assessments.
The article is set out in number of relatively self-contained parts which focus on:
The discussion in each part presupposes that the client has informed management, a concept considered further in part 5.
APB Ethical Standard 5 (Revised December 2010) paragraph 131 (a) states that an audit firm should not undertake an engagement which “would involve the audit firm taking responsibility for dealing in, underwriting or promoting shares” as this would give rise to an unacceptable advocacy threat that could not be reduced by the application of safeguards.
The concepts of dealing in, or underwriting shares, are relatively straightforward. However, “promoting shares” can mean different things in different circumstances and for that reason, the term is not defined. Working out what potential engagements would be covered by the prohibition will be helped by considering what threats to objectivity and independence it is trying to address. These principally relate to situations where an auditor is put in the position of advocating the desirability or particular attributes of shares in the audited entity which could be affected by the financial information subject to audit. An example of this would be where an audit firm proposes to act as agent in the sale of shares in an audit client directly to the public. This would put the auditors in a very awkward position if audit work suggested that the company was not in as good a state as it had been purported or even implied to be.
The APB (and the International Ethics Standards Board for Accountants, which has a similar prohibition in its code of ethics) has determined this type of promotional activity results in significant threats to objectivity and independence which cannot be reduced to an acceptable level by the implementation of safeguards.
The general dictionary definition of advocacy involves a party actively supporting an idea or proposition. Whilst private advice to a client may meet this definition, the risk is generally mitigated to a satisfactory level where the client has informed management. However, where support for a proposition (such as an opportunity to invest, either through equity or debt) is expressed to third parties, this gives the appearance of acting for or on behalf of the client. That is not consistent with the concept of independence from the entity being audited.
The prohibition might not necessarily cover support services that do not involve advocacy. For example, acting as an audited entity’s lead advisor can involve a variety of advice to the client that would not constitute advocacy However, in the case of a start-up or early stage fund-raising, for instance, there is an increased risk that the lead advisor’s role might be sufficiently broad (or might expand) so as to become advocacy. For an existing company, there will be factual information that can be referred to, but for a start-up or early stage fundraising, the lead advisor may be trying to present a concept to investors. The existence of a strong management team with an established track record will make it less likely that the audit firm will be perceived as leading any promotional activity with potential investors or providers of funding.
The lead advisor role is considered further in part 2 in the context of a potential sale, and other support work is considered in part 3 in the context of capital raising. However in all circumstances, the key point is that each potential engagement needs to be assessed on a case by case basis to assess whether the promotion prohibition should be applied or, if not, whether other types of threat (for example management, or self-review) could be generated, and if so whether they can be safeguarded against
APB Ethical Standard 5 (Revised December 2010) paragraph 127 states that "The potential for the auditor’s objectivity and independence to be impaired through the provision of corporate finance services varies considerably depending on the precise nature of the service provided. The main threats to auditor’s objectivity and independence arising from the provision of corporate finance services are the self-review, management and advocacy threats."
As lead adviser, the audit firm would be responsible for advising on, organising and presenting an offer for sale of an audit client or the response to an offer on behalf of an audit client. The work will vary but typically the lead adviser will also, amongst other things:
It may be possible to carry out such activities without endangering the objectivity or independence of the audit firm. The key threats to consider are whether these activities will result in the audit firm taking decisions that are the responsibility of management of the audit entity, that the firm is not implicitly promoting the entity’s shares (especially in item 3 above) and that any other threats, in particular self-review and advocacy, are appropriately managed. An example of a safeguard that might be put in place to manage a self-review threat could include complete separation of the audit and lead advisory teams, possibly even operating out of separate locations.
If these types of activities would involve prohibited activities, such as taking decisions on behalf of management, or threats that cannot be or reasonably seen to be, safeguarded against, then the audit firm should either not accept the lead adviser engagement or resign from the audit appointment.
Acting as lead adviser is usually performed under a contingent fee arrangement. This article is not primarily about fee arrangements but it is worth noting that in addition to the factors discussed above, the audit firm will need to consider the prohibitions in respect of contingent fees for non-audit services contained in APB Ethical Standard 4, paragraph 15: “The audit firm shall not undertake an engagement to provide non-audit services in respect of an audited entity on a contingent fee basis where:
(a) the contingent fee is material to the audit firm, or that part of the firm by reference to which the audit engagement partner’s profit share is calculated; or
(b) the outcome of those non-audit services (and, therefore, the amount of the fee) is dependent on a future or contemporary audit judgment relating to a material matter in the financial statements of an audited entity.”
An example of a circumstance in which consideration under b) would be required is if an audit of an entity and an engagement to dispose of its shares on behalf of the members by the audit firm were taking place at the same time, and the price that would be realised by the sale of the shares (and the amount of the contingent fee) could be influenced by the audited accounts.
It may be possible to undertake at least some of these services without resulting in actual or perceived threats to audit independence that cannot be properly safeguarded against. APB Ethical Standard 5 (Revised December 2010) paragraph 127 states that "The potential for the auditor’s objectivity and independence to be impaired through the provision of corporate finance services varies considerably depending on the precise nature of the service provided. The main threats to auditor’s objectivity and independence arising from the provision of corporate finance services are the self-review, management and advocacy threats. Self-interest threats may also arise, especially in situations where the audit firm is paid on a contingent fee basis."
There is not a blanket prohibition on the provision of corporate finance services to audit clients, other than certain activities related to shares (see above). Each situation should be looked at on a case by case basis together with the associated threats. Some of the detailed considerations that may be relevant are set out below.
Considerations on types of services that may be providedES5 paragraph 131 prohibits services which would result in either of the following:
Paragraph 135 clarifies that the prohibition does not include provision of advice to an audited entity on funding issues and banking arrangements.
Consideration therefore needs to be given to whether the proposed engagement would be covered by the paragraph 131 prohibition.
Such a consideration could arise, for example, in assisting with the building of a financial model where the support for a transaction depends on the adoption of accounting policies that relate to material items that are at variance from those adopted in the past by the entity in preparing its financial statements; or, where the entity does not have an existing policy, a policy that is not well established and appropriate.
In the examples of the corporate finance services listed at the beginning of this part, the threats to an auditor’s objectivity and independence will be more significant the more the auditor is seen to be involved (for instance accompanying the management to meetings with potential investors and advising on terms) and is perceived as being aligned with the interests of the client. Importantly, it would be preferable for the audit firm to be advising the audit client on its interaction with other parties, rather than interacting with them on its behalf, as there is a risk such contact could develop into "taking decisions or making judgements which are the proper responsibility of management".
A general threats and safeguards analysis of the objectivity and independence of the audit firm also needs to be applied. For example, a threat would arise if assistance was provided with a financial model that will be used by management in assessing the going concern status of the entity at the time of the next audit.
In each case, one should evaluate the threats to objectivity and independence and consider whether they are capable of being reduced to an acceptable level by the application of effective safeguards which must be appropriately documented.
ES5 paragraph 129 suggests safeguards that may be appropriate, such as having an audit partner who is not involved with the audit client to review the audit work undertaken. Paragraph 129 sets out other examples of safeguards. For example it is not usually the audit partner who will provide the corporate finance services listed in the question, but "partners and staff who have no involvement in the audit of the financial statements" and may be an "independent corporate finance partner".
If it has been determined that, with appropriate safeguards in place, the services can be undertaken for an audited entity, the audit partner is required to confirm and document that the provision of the non-audit service to the audit client is acceptable to him or her.
Finally, it should be noted that when the corporate finance engagement relates to the sale or purchase of a material part of the audit entity’s business, the audit engagement partner should disclose the engagement to the audit committee (if there is one) or those charged with governance. Therefore it is not only the auditor who needs to be satisfied that independence considerations do not preclude the audit firm from acting for the audit client in this situation.
Particular considerations in relation to contingent fees
It is probable that the different services may be delivered under different fee arrangements. For example, building a financial model is often done on a fixed fee basis, whereas the provision of introductions to private equity funds and then advising on negotiations with potential investors is commonly performed under a contingent fee arrangement. Therefore in considering whether or not each of the services listed above can be performed, the impact of the related fee arrangement must also be considered.
Performing work for an audited entity under a contingent fee arrangement may give rise to a self-interest threat. - "self-interest threats may also arise, especially in situations where the audit firm is paid on a contingent fee basis" (ES5 paragraph 127).
APB Ethical Standard 4 (revised December 2010), paragraph 15 prohibits contingent fee arrangements for non-audit services to audited entities in certain circumstances – see part 2 above. Paragraph 18 points out that even if the prohibition does not apply, there are a number of factors that still need to be taken into account to determine whether there are actual or perceived threats to independence and if so whether there are sufficient safeguards to enable a contingent fee arrangement to be acceptable. It is difficult to provide a generic solution to all situations and each one must be considered on a case by case basis.
It is not unknown for the Articles of Association of a company to specify that, in the event of a possible sale of shares, the auditor should prepare a valuation of the shares to be sold. Can the auditors actually carry out such a valuation?
APB ES5 (revised December 2010), paragraphs 76-83 deal with the provision of valuation services to audit clients. The independence issues are most likely to result from potential self-review and management threats. Therefore there are a number of restrictions set out in ES 5. These depend on whether the client is listed or not, as follows:
Whether the valuation has a direct effect on the financial statements will depend upon the particular circumstances:
ES5, paragraph 81 contains a provision that if the audit firm is designated by legislation or regulation as being required to carry out a valuation, the restrictions in paragraph 77 do not apply. Nevertheless, effective safeguards of independence must still be applied. The Articles of Association would clearly not qualify as ‘regulation’ for this purpose.
A self-review threat might still arise indirectly where accounting consequences flow from a valuation performed by the auditor and where that impact needs to be re-evaluated for the purposes of the audit. Examples include the following situations:
The audit firm might be requested to perform a valuation of the shares of an audit client for another party, for example a potential acquirer of the shares. That party might be an independent third party or a connected party, for example members of management of the audit client considering a management buy-out of the company. For the purposes of the prohibitions on valuation services in paragraph 77 of ES5, what is relevant is whether the valuation will in fact have a material effect on the financial statements which will in due course be subject to audit by the audit firm, such that the self-review threat arises.
Where the valuation is not being made available to the audited entity which is the subject matter of the valuation, it should be evident that the valuation could not have an effect on the financial statements.
ES5, paragraph 78 also recognises that a management threat can arise from the provision of valuation services. A significant threat would arise, for example, if management is required to use the share valuation to support a business decision, for example as the basis for determining the strike price for a share buy-back. However, if management will merely take the valuation into account as part of the information to support their negotiation of a business transaction involving the shares of the company with a third party, then the management threat is reduced.
If an audit firm does perform a valuation for an audit client in permitted circumstances, it would be best practice for a partner, other than the audit client service partner, to be appointed to perform the work. This is to avoid any suggestion of the auditor preparing a valuation that is biased or perceived to be biased towards one shareholder rather than another.
Whatever the circumstances and whoever the engaging party is, the audit firm must assess the threats to objectivity and independence of any engagement to provide a valuation and, if permitted, apply relevant safeguards in order to reduce the threat to an acceptable level. If the threats cannot be reduced to an acceptable level, the auditor is not permitted to undertake the valuation engagement.
The ethical standards refer to a need for informed management whenever non audit services are to be provided to an audited entity. This can be achieved by the audit firm presenting to management the output of its work in the form of a discussion of ranges of possible values or options, together with the criteria on which they are based. The audit firm should provide sufficient information and explanation to enable management of the audit client to evaluate the results of the non-audit service rationally, make the judgments and decisions that are the proper responsibility of management and accept responsibility accordingly.