On December 2, 2002, the Securities and Exchange Commission ("SEC"), as required under Section 208(a) of the Sarbanes-Oxley
Act of 2002 (the "Act"), issued proposed rules
[fn1] to enhance its existing requirements regarding auditor independence. Under existing Rule 2-01 of Regulation S-X, there are
four general principles in determining an auditor's independence with respect to its audit client, including whether the relationship
(a) creates a mutual or conflicting interest between the auditor and client, (b) places the accountant in a position of auditing
its own work, (c) results in the accountant performing management functions, or (d) places the accountant in a position of
acting as an advocate for the audit client. The proposed rules do not affect the provision of non-audit services by audit
firms to companies that they do not audit.
Proposed Rules
Prohibited Employment Relationships
Section 206 of the Act prohibits an accounting firm from auditing a public company's financial statements if the chief executive
officer, chief financial officer, controller, or chief accounting officer, or any person serving in an equivalent position
at the company, had been employed by the accounting firm and had participated in an audit of the company during the preceding
one-year period. The prohibited period commences one year prior to the earlier of (a) when the auditor began the current fiscal
year's audit or (b) when the auditor began review procedures necessary to conduct a timely review of the company's quarterly
financial information associated with the current fiscal year.
The proposed rules extend the prohibition to include any employee who serves in a "financial reporting oversight role." Any
individual who has direct responsibility for oversight over those who prepare the company's financial statements and related
information (including the management's discussion and analysis) that is included in SEC filings would be deemed to be in
a "financial reporting oversight role."
Prohibited Non-audit Services
Under Section 201(a) of the Act, it is unlawful for a registered public accounting firm that performs an audit of a public
company's financial statements (and any person associated with such a firm) to provide to that public company, contemporaneously
with the audit, any of the following nine prohibited non-audit services: bookkeeping services; financial information systems
design and implementation; appraisal or valuation services; actuarial services; internal audit outsourcing services; management
or human resources functions; broker-dealer, investment adviser or investment banking services; legal services and other expert
services unrelated to the audit; and any other service that the Public Accounting Oversight Board determines, by regulation,
is impermissible.
Many of these services are already covered under existing Rule 2-01 of Regulation S-X. The proposed rules provide further
guidance regarding several of these prohibited non-audit services, certain of which are described below.
Internal Audit Outsourcing
The current rules allow a company to outsource its internal audit function to the company's independent auditors so long as
certain criteria are met. The proposed rules would prohibit such outsourcing function and eliminate the exceptions contained
in the current rules, including those for certain small businesses. However, the proposed rules would allow outsourcing of
certain nonrecurring evaluations of discrete items or programs that are not, in substance, the outsourcing of the internal
audit function and would allow the outsourcing of operational internal audits unrelated to internal accounting controls, financial
systems or financial statements.
Legal Services
The proposed rules expand the coverage of the current rules by prohibiting an auditor from providing any service to a public
company that, under circumstances in which the service is provided, could be provided only by someone licensed, admitted,
or otherwise qualified to practice law in the jurisdiction in which the service is provided.
Expert Services
The current rules do not prohibit an auditor from providing expert services to an audit client. The proposed rules state that
an auditor will not be independent if the auditor provides expert opinions for a public company in connection with legal,
administrative, or regulatory proceedings or acts as an advocate for a public company in such proceedings. This prohibition
would include providing consultation and other services to legal counsel in connection with litigation (for example, forensic
accounting services in connection with SEC enforcement investigations).
Tax Services
The current rules do not prohibit an auditor from providing tax services to an audit client. Under the proposed rules, in
general, an auditor is allowed to provide tax services to public companies as long as those services have been pre-approved
by the audit committee. However, the company must be wary of tax services that fall within the category of prohibited legal
or expert services, or which result in the impairment of independence under the four general principles governing auditor
independence under existing Rule 2-01. For example, representation before a tax court would be prohibited, since, in that
case, the auditor would be serving as an advocate. Similarly, the formulation of tax strategies designed to minimize tax obligations
(e.g. tax shelters) would be prohibited, since they would require an auditor to audit its own work, to become an advocate
for the client, or to assume a management function. The SEC has requested comment on whether there are other tax services
that should be prohibited by the SEC's independence rules, and comments are anticipated focusing on tax services involving
material contingent liabilities, including tax audit representation and tax planning services.
Audit Committee Pre-Approval of Audit and Non-Audit Services
The proposed rules would require that the audit committee pre-approve all audit, review or attest engagements. Furthermore,
with respect to all permissible non-audit services, either (a) the audit committee must expressly pre-approve any such service
before the audit firm is engaged, or (b) the engagement must be entered into pursuant to detailed pre-approval policies and
procedures established by the audit committee and the audit committee must be informed after engagement on a timely basis
of each service so engaged. The Act allows the audit committee to delegate pre-approvals to a single audit committee member.
The proposed rules provide that pre-approval requirement is waived for non-audit services if (a) they do not constitute, in
the aggregate, more than 5% of the total revenues paid by the public company to the auditor during any fiscal year; (b) at
the time of the engagement, such services were not recognized by the public company as non-audit services and (c) when the
public company recognizes them as non-audit services, they are promptly brought to the attention of, and approved by, the
audit committee.
Audit Partner Rotation
Section 203 of the Act provides that an auditor must rotate the lead audit partner every five years. This was a change from
the current requirements under the AICPA's SEC Practice Section, which requires the engagement partner who is responsible
for the audit of a public company to rotate off the engagement after seven years and remain off the engagement for two years
thereafter.
The proposed rules implement the Act's five-year on/five year "cooling off" rotation requirement, and extends it to all partners
who perform audit services for the public company (or any significant subsidiary), including partners who conduct review or
attest engagements and any tax partner who performs significant services that are a necessary part of the auditor's ability
to complete the audit. Partners assigned to "national office" duties who are typically consulted on specific accounting issues
related to public company clients are not subject to the rotation requirement. However, the proposed rules provide that an
audit firm may stagger the rotation of partners to ensure that the engagement team has appropriate expertise to conduct a
satisfactory audit.
Audit Partner Compensation
The proposed rules provide that an auditor would not be considered independent if, at any point during the audit and professional
engagement period, any partner, principal or shareholder of the audit firm who is a member of the audit engagement team earns
or receives compensation based on the performance of, or procuring of, engagements with that public company, to provide any
non-audit services. Compensation would include any form of monetary benefit distributed to the partner, principal or shareholder,
including allocation of partnership "units" to a partner.
Auditor Communication with Audit Committees
Section 204 of the Act directed the SEC to issue rules regarding the timely reporting of specific information by auditors
to the audit committee. The proposed rules are intended to cover recognition, measurement, and disclosure considerations related
to the accounting of specific transactions; the initial selection of and changes in significant account policies; and the
impact of management's judgments and accounting estimates. They would require that, prior to the filing of any audit report
with the SEC, the auditor report to the audit committee, either orally or in writing:
- all critical accounting policies and practices to be used by the public company;
- all alternative accounting treatments of financial information under generally accepted accounting principles that have been
discussed with management of the public company, including the ramifications of using alternative disclosures and treatments
and the auditor's preferred treatment; and
- other material written communications between the auditor and the management of the public company or registered investment
company, such as a management representation letter, schedule of material adjustments and reclassifications and a listing
of unrecorded adjustments and reclassifications.
Expanded Disclosure
The proposed rules expand the disclosure required in proxy statements concerning audit and non-audit services provided by
a public company's outside auditors. Public companies would be required to report, for each of the two most recent fiscal
years, four categories of fees: audit fees; audit-related fees (new category); tax fees (new category); and all other fees,
as well as sub-categorize the audit-related fees and all other fees based on the nature of the services provided. They would
also be required to disclose the percentage of fees in each category that were approved by the audit committee.
Companies would also be required to disclose any policies and procedures developed by the audit committee concerning pre-approval
of the auditors to perform both audit and non-audit services. The proposed disclosure would set out in detail the audit committee's
policies and procedures for engaging the auditors to perform non-audit services, either by description or by attaching a copy
of the policies and procedures to the proxy statement. For companies that do not file proxy statements, such disclosures are
required in the annual filing on Form 10-K, 20-F or 40-F, as the case may be. In addition, the proposed rules require parallel
disclosure regarding audit committee pre-approval policies and procedures and the amount of professional fees paid to auditors
for registered management investment companies in annual reports on proposed Form N-CSR.
Application to Foreign Private Issuers and Foreign Audit Firms
Generally, the provisions of the Act that relate to auditor independence and the proposed rules would apply to foreign private
issuers and to foreign audit firms. Accordingly, there are a number of areas in which the proposed rules could cause conflicts
with requirements of other countries:
- The proposed ban on auditors providing legal services for their clients could be problematic in certain foreign jurisdictions
where auditors, directly or through affiliates, commonly provide legal services, including tax services (which are considered
legal services in certain foreign jurisdictions) to audit clients.
- The rotation requirement could impose a substantial hardship on foreign private issuers and result in a lower quality of audited
financial statements particularly in jurisdictions where there are fewer numbers of qualified auditors.
- There may be legal or regulatory impediments which would make it difficult for foreign private issuers to comply with the
requirement for pre-approval of non-audit services.
Anticipated Time Frame for Adoption
The deadline for public comment on the proposed rules is January 13, 2003. The Act mandates that final rules be adopted no
later than January 26, 2003. The SEC proposes that the provisions would be effective upon adoption of final rules; however
it is considering whether there should be a transition period for some of the provisions, including relating to audit partner
rotation, audit committee communications, disclosures of fees paid to auditors and partner compensation.
Footnotes
1: See SEC Release 34-46934.
