New Ethics Rule on Leases Proposed

The AICPA Professional Ethics Executive Committee (PEEC) has proposed revisions to the code of ethics around how leases between an auditor and their client impacts independence.  The changes were precipitated by the new FASB standard on leases because the current ethics interpretation on leases focuses on whether the lease is an operating lease or a capital lease.  Currently, if the leases is an operating lease with comparable terms to similar leases, then independence is not considered to be impaired.  On the other hand, if the lease is a capital lease, then independence would be considered impaired because a capital lease is like debt and, generally speaking, an auditor cannot borrow from a client.

As you are aware, the new leasing standard has changed the importance of the operating versus capital lease distinction now that either type of lease will show up on the balance sheet and either type of lease results in a liability (akin to debt) for the lessee.   The PEEC therefore decided to take a ‘threats and safeguards’ approach that focuses on the terms and significance of the lease.  If the terms are not market terms for similar leases, then independence is threatened, and the auditor is in violation of the code of ethics.  Similarly, if the lease is material to the firm, an individual on the engagement team or someone who can influence the engagement, then independence is threatened, and the auditor would find themselves in violation of the code of ethics.

Like the new lease standard, the new ethics rules are no longer cut and dry based on the predefined criteria of an operating versus a capital lease.  This means auditors are going to have to take more time to understand the leasing arrangements that exist and then use judgment to determine if those leases impair independence.

While the change does not directly impact CPAs in business and industry because independence is not an ethical issue we focus on since we aren’t independent to begin with; that doesn’t mean we should just ignore this interpretation.  If you are in the business of leasing then these rules could make finding an auditor who is independent more difficult.  The new accounting rules also increase the likelihood that service business might also be in the leasing business if it uses PP&E in providing service, so service companies might also have a similar issue in finding an auditor.  Even if you have plenty of auditors to choose from, the new rules will likely add some additional administration to the auditor independence process and that might require the client (you) to provide more information about potential arrangements with individuals that work for the audit firm on an ongoing basis.

If you are interested in learning more about the proposed revision to the ethics code the exposure draft can be found here, and if you wish to comment, comments are due by December 20, 2017.

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