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On November 21, 2002, the Securities and Exchange Commission ("SEC"), pursuant to Section 802 of the Sarbanes-Oxley Act of 2002 ("Sarbanes-Oxley"), issued proposed Rule 2-06 under Regulation S-X ("Proposed Rule 2-06") that would require accounting firms to retain for five years certain records relevant to their audits and reviews of issuers' financial statements. [1] The SEC is requesting comments on Proposed Rule 2-06 by December 27, 2002. As mandated by Sarbanes-Oxley, the SEC must issue final rules under Section 802 by January 26, 2003.

Documents Covered

Proposed Rule 2-06 would require that the auditor retain workpapers and other documents that form the basis of the audit or review of an issuer's financial statements, and memoranda, correspondence, communications, other documents, and records (including electronic records) that meet two criteria. The two criteria are that the materials (1) are created, sent or received in connection with the audit or review, and (2) contain conclusions, opinions, analyses, or financial data related to the audit or review. The Proposed Rule, therefore, would require an auditor to retain any materials satisfying both criteria. Non-substantive materials that are not part of the workpapers, however, such as administrative records, and other documents that do not contain relevant financial data or the auditor's conclusions, opinions or analyses would not meet the second criteria and would not have to be retained.

Workpapers Defined; Differences of Opinion

Proposed Rule 2-06 would require auditors to retain "workpapers and other documents." Both Section 802 and Proposed Rule 2-06 are intended to require the retention of more than what traditionally has been thought of as an auditor's "workpapers." Since generally accepted auditing standards ("GAAS") do not use the specific term "workpapers," Proposed Rule 2-06 would rely on the language of Statement on Auditing Standards ("SAS") No. 96, "Audit Documentation" that provides: "Audit documentation is the principal record of the auditing procedures applied, evidence obtained, and conclusions reached by the auditor." Proposed Rule 2-06 would not mandate the specific workpapers to be retained and would explicitly recognize that the new Public Company Accounting Oversight Board (the "PCAOB"), subject to SEC oversight, has the ability to review and change the nature and scope of the required documentation of procedures, evidence, and conclusions related to audits and reviews of financial statements.

SAS 96 states that workpapers generally serve to provide the principal support for an auditor's report and to aid the auditor in the conduct and supervision of the audit. However, in order to ensure that the purposes of Sarbanes-Oxley are fulfilled, Proposed Rule 2-06 would specifically require that the retained materials include not only those that support an auditor's conclusions about the financial statements but also those materials that may "cast doubt" on those conclusions. This is intended to ensure the preservation of those records that reflect differing professional judgments and views (both within the accounting firm and between the firm and the issuer) and how those differences were resolved. The SEC has asked for comment on whether the "cast doubt" standard adequately reflects the concerns of Section 802 or whether another standard, such as "significant differences in professional judgment" would be more appropriate.

The SEC proposing release discusses the professional obligation of each person involved in an audit engagement to bring his or her concerns to the attention of others in the firm and as appropriate, to document those concerns, citing SAS No. 22, "Planning and Supervision," and interpretations of that Statement as well as additional statements in SAS 96. The SEC proposing release gives the example that a memorandum prepared by a member of a large accounting firm's national office that is critical of the accounting used by an audit client, or of a position taken by the partner in charge of the audit of those financial statements, should be retained. [2] The other SEC example indicates that an auditor's written communications with an issuer's audit committee about alternative disclosures and accounting methods used by the issuer that are not the disclosures or accounting preferred by the auditor should also be retained.

Which Issuers?

As mandated by Sarbanes-Oxley, Proposed Rule 2-06 requires retention by auditors of the applicable documents of "issuers," as defined under Section 10A(f) of the Securities Exchange Act of 1934 (the "Exchange Act"), which was added by Section 205(d) of Sarbanes-Oxley. A Section 10A(f) "issuer" is an issuer [3] whose securities are registered under Section 12 of the Exchange Act, or that is required to file reports pursuant to Section 15(d) of the Exchange Act, or that files or has filed a registration statement that has not yet become effective under the Securities Act of 1933 and has not been withdrawn.

In addition, the SEC would extend Proposed Rule 2-06 to apply to audits and reviews of registered investment companies, which was not required by Sarbanes-Oxley.

Neither Section 802 of Sarbanes-Oxley nor Proposed Rule 2-06 exempt auditors of foreign issuers' financial statements. Therefore, the retention requirements would apply to domestic and foreign accounting firms conducting audits or reviews of foreign issuers' financial statements.

The SEC has asked for comment on whether the application of Proposed Rule 2-06 should be extended to audits or reviews of registered investment advisers and broker-dealers that are not necessarily issuers or possibly to all issuers, whether or not they meet the requirements of Section 10A(f). The SEC has also asked whether similar document retention obligations should be extended to the issuers themselves and not just their auditors.

Retention Period

The retention period in Proposed Rule 2-06 is five years and is not based on the fiscal period covered by the financial statements being audited or reviewed but the year in which the audit or review is concluded.

Interaction With Section 103

Section 103 of Sarbanes-Oxley directs the PCAOB to adopt an auditing standard that requires each registered public accounting firm to retain for a period of not less than seven years audit workpapers and other information that support the conclusions in the auditor's report. While the seven year retention period is longer than that contained in Section 802 and Proposed Rule 2-06, the scope of documents that must be retained under Section 103 appears to be narrower. The SEC has asked for comment on whether the retention period in the Proposed Rules should be extended to seven years to coincide with the retention period in Section 103.