Dan Guy and Stephen Zeff
Retired audit firm partners represent an attractive pool of potential members for public company boards of directors and their audit committees. Given the new listing requirements of the US stock exchanges, retired partners are being actively pursued for appointment to corporate boards in the US. But before considering or making such appointments, the audit firm and the company must resolve a number of independence issues.Listing requirements
In December 1999, the New York Stock Exchange (NYSE), the National Association of Securities Dealers (NASD), and the American Stock Exchange (AMEX) adopted new listing requirements that all members of a company's audit committee, with the exception of a small business filer, had to be or had to become financially literate. In addition, at least one member of the committee must possess accounting or financial expertise.
Although the meaning of financial literacy is vague and varies among the exchanges, we believe that all audit committee members should have a general understanding of financial statements, including generally accepted accounting principles, and a general knowledge of what auditors do. Because of the financial literacy requirements and other attributes that partners of audit firms have, retired partners of such firms are prime candidates for appointment to corporate boards and their audit committees.Independence issues
The financial collapse of HIH Insurance was widely reported in the Australian press in 2001 (see Accountancy, July 2001, p11). Among the many issues raised by the extensive press coverage in the wake of the collapse was that two of the company's non-executive (ie, outside) board members were retired senior partners of HIH's external audit firm, one of the Big Five partnerships. It also came to light that both of these retired partners were members of the board's audit committee, and one was chairman of the committee.
Appointing retired partners of a company's external audit firm to its board of directors brings up a number of questions pertaining to the audit firm's independence and objectivity. When, in addition, a retired partner of the company's external audit firm also sits on, let alone chairs, the board's audit committee, serious questions about the independence and objectivity of the committee may be raised.
It is worth mentioning that the practice of appointing retired partners of a company's external audit firm to the company's board, and even to the board's audit committee, is not precluded by any rules and regulations in such countries as the US, Canada, the UK, Australia and New Zealand. In the US, the practice would be allowed so long as there was no financial dependence or influence on the old firm, or any appearance of the retired partners' continued association with it.SEC rule and safeguard requirements
If a retired partner of an audit firm becomes a member of the board of directors of one of the firm's audit clients, he or she is thrust into an accounting or financial reporting oversight role. Therefore, the Securities and Exchange Commission's rule 2-01(c)(2)(iii), Employment at Audit Client of Former Employee of Accounting Firm, applies. The rule covers all retired partners from the audit firm without regard to their line of service (audit, tax, or consulting). To maintain its independence the audit firm must:
- Eliminate any capital balance related to the retired partner.
- Eliminate any other financial arrangement with the retired partner except for a fully funded fixed-payment retirement account or rabbi trust (ie, an irrevocable trust whose assets are not accessible to the audit firm until all benefit obligations are paid) that is not dependent on the audit firm's financial results.
- Ensure that the retired partner has no influence over the audit firm's operations or financial policies.
In addition, the SEC and the American Institute of Certified Public Accountants require the audit firm to have and administer the following safeguards in order to reduce the risk of impairing independence. The required safeguards specify actions that are necessary prior to (pre-employment) and after ( postemployment) the partner's retirement. The preemployment safeguards apply when the retired partner was in some way associated with the audit engagement prior to retirement. In those situations, the audit firm is required to have policies that oblige the partner to:
- Report promptly to the audit firm that a possible-appointment to the client's board of directorsis being considered.
- Be immediately removed from the audit engagement and any other association related to that engagement.
In addition, the audit firm is obliged to review the partner's work to assess whether the retiring partner exercised appropriate professional scepticism on the audit engagement.
Without regard to whether the retired partner was associated with the audit engagement, the audit firm must also implement certain postemployment safeguards. These are:
- The on-going engagement team must determine whether the audit plan needs to be modified to control for the risk of circumvention (ie, the retired partner's ability to influence the conduct of the audit).
- If, as a member of the client's board of directors, the retired partner will have significant interaction with the audit team, the audit firm should ensure that the team has the stature to deal effectively with the retired partner.
- If the retired partner had significant interaction with the audit team and joins the audit client's board within one year of retiring from the audit firm, the firm must assign one of its professionals, who was not involved in the audit, to undertake a separate review of the following year's audit.
An interpretation of the AICPA's Code of Professional Conduct adds to the SEC's rule and safeguards by prohibiting certain practices that would cause a reasonable investor to conclude that the audit firm's independence was impaired.
These practices include, for example, listing the retired partner's name as a member of the audit firm and providing office amenities to the retired partner. The essence of the requirement is that the retired partner should not appear to participate in the activities of, or be associated with, the audit firm.Required discussion concerning a board member's independence
Under NYSE, NASD, AMEX, and SEC requirements, the external auditor is required, at least annually, to disclose to the company's audit committee, in writing, all relationships between the auditor and the company that may reasonably bear on independence. In addition, the SEC requires the audit committee to state in its annual report to shareholders whether the committee received the external auditor's disclosures about independence and whether the committee discussed independence issues with the external auditor.
When a retired partner joins a client's board of directors, this matter will certainly require the external auditor to disclose and discuss the issue with the audit committee. During this discussion, the audit committee should, of course, address the pre- and post-employment safeguards with the external auditor. In addition, the audit committee should inquire about any practice or relationship between the retired partner and the company that would cause an impairment of independence, including any concerns about the appearance of independence.Issues relating to the audit committee's independence
If a retired partner were to become a member of the audit committee of a client of the partner's former audit firm, independence issues relating to the audit committee should be considered. If the audit firm and the retired partner were to follow all of the foregoing SEC and AICPA requirements, the audit firm may be deemed to be independent, but the retired partner may not be suitable for service on the audit committee.
The audit committee, among other things, is responsible for overseeing all aspects of the external auditor's independence, including his performance of non-audit services, and whether those services were compatible with maintaining independence. In turn, the board of directors is the guardian of the audit committee's independence. Independence is the hallmark of the audit committee. Otherwise, how can the audit committee oversee the quality of the audit, evaluate the external auditor's performance, and, if needed, replace the external auditor?
As noted above, in 1999 the NYSE, NASD, and AMEX adopted new independence requirements. They identify directors who should not ordinarily be appointed to an audit committee, because they are not considered to be independent. In general, the requirements address independence from the company's perspective. That is, current employees, certain former employees, the immediate family members of current and former employees, and consultants and others having business relationships with the company are not considered to be independent.
When they established their new independence requirements for audit committee members, the stock exchanges explicitly treated the case of an existing partner in an audit firm who has a business relationship with the company. However, the requirements do not deal with retired partners from audit firms who might serve on the committee. In fact, we are unaware of any published writings that address the appointment of retired audit firm partners to an audit committee. Although a retired audit firm partner who joins the audit committee of a current client of the partner's former audit firm would not usually fall foul of the explicit NYSE, NASD, or AMEX independence rules, the analysis and discussion should go beyond those requirements.
The essence of an audit committee member's independence is his or her mental objectivity. But a further dimension of independence involves the appearance of objectivity. Before appointing a director to its audit committee, the board of directors should consider whether a reasonable investor, having knowledge of all of the relationships that the director has, or had, to the company, would consider the individual to be objective and independent.
A board should be exceedingly reluctant to appoint a retired partner of its external audit firm to its audit committee. Such a potential appointee must assure the board that he or she convincingly possesses the attributes of independence, and would, as well, be seen by a reasonable investor as independent, in order to justify appointment to the audit committee. We recommend that, at the least, a cooling-off period be used for purposes of such an appointment. According to current US requirements for service on a company's audit committee, a former employee of the company or its affiliate during the last three years is not considered to be independent. Thus, a useful rule-of-thumb to follow as a minimum would be to apply a threeyear cooling off period to retired partners from the firm that is the company's external auditor. In our view, an even longer cooling-off period in such circumstances would be warranted.Conclusion
In view of the NYSE, NASD, and AMEX requirements that audit committee members possess financial literacy, retired partners are excellent candidates for appointment to corporate boards and their audit committees. When the retired partner is from a firm other than the company's external audit firm, there are no unique independence issues that call for resolution. However, when a retired partner from the company's external audit firm is appointed to the board, there are a host of independence issues that must be considered to avoid impairing the audit firm's independence.
If the retired partner were also to be appointed to the board's audit committee, even if the audit firm were to satisfy all of the attributes of independence, there could be significant objectivity and independence issues that could weaken the committee's performance. We believe that it will be very difficult to persuade analysts, stakeholders, the press, juries and jurists, and the public that a retired partner of an audit firm could perform effectively as a member of the audit committee of a client of the partner's former firm. There is an ample pool of retired partners from other audit firms to consider without having to entertain an appointment that might taint the committee's independence.
Dan M Guy CPA has a litigation consulting practice in Santa Fe, New Mexico. Stephen A Zeff is professor of accounting at Rice University. Their article is edited from a longer version, which appeared in the US publication Director's Monthly.