SEC Proposes Rules to Strengthen Auditor Independence

December 18, 2002
8 minutes
David A. Fine
Jane D. Goldstein ,
Robert F. Hayes
Christopher A. Klem , Julie H. Jones

The SEC recently proposed rules under Section 208(a) of the Sarbanes-Oxley Act of 2002 (the “Act”) to (1) enhance existing rules on auditor independence, (2) clarify the audit committee’s responsibility for administering the audit engagement, and (3) require disclosure of accountant fees and audit committee policies and procedures.

Auditor Independence
The proposed rules add to and amend existing auditor independence requirements to enhance the independence of accountants that audit and review financial statements.

  • Conflicts of Interest Resulting from Employment Relationships. The proposed rules add a one-year “cooling-off’ period before an auditor can take a position at an audit client. An accounting firm would not be independent with respect to an issuer if the issuer employs a former partner, principal, shareholder, or professional employee of the accounting firm in a financial reporting oversight role within one year before it commences procedures for the current audit engagement. Under the proposed rules, a financial reporting oversight role is one in which the individual has direct responsibility for oversight over those who prepare the financial statements and related information (such as MD&A) included in the issuer’s SEC filings.
  • Services Outside the Scope of the Practice of Auditors. The proposed rules clarify the non-audit services that Section 201(a) of the Act prohibits auditors from providing to their audit clients. The nine prohibited non-audit services are:
    • Bookkeeping or other services related to the audit client’s accounting records or financial statements of the audit client;
    • Financial information systems design and implementation;
    • Appraisal or valuation services, fairness opinions, or contribution-in-kind reports;
    • Actuarial services;
    • Internal audit outsourcing;
    • Management functions or human resources services;
    • Broker-Dealer, investment adviser, or investment banking services;
    • Legal services or expert services not related to the audit; and
    • Any other non-audit services determined by the Public Accounting Auditing Oversight Board (the “PCAOB”) to be impermissible.

Many of the non-audit services prohibited by the Act are currently prohibited by existing SEC rules regarding auditor independence. The proposed rules clarify and expand these rules and eliminate the categorical exceptions and exemptions provided in the current rules. For example, the proposed rules eliminate the exception for limited situations where bookkeeping services may be provided under the current rules. Similarly, the proposed rules eliminate certain exemptions that are contained in the current rules regarding otherwise prohibited appraisal or valuation services, fairness opinions or contribution-in-kind reports to audit clients.

In place of the categorical exceptions and exemptions contained in the current rules regarding auditor independence, the proposed rules, consistent with the Act, permit auditors to provide non-audit services, including tax services, that are not expressly prohibited so long as they are pre-approved by the issuer’s audit committee, as discussed further below. The release cautions, however, that a permissible non-audit service, such as a tax service, may nonetheless result in the impairment of an auditor’s independence if the proposed non-audit service constitutes a prohibited legal or expert service or would violate the basic principles of auditor independence: that an auditor’s independence is impaired if he or she audits his or her own work, functions as a part of management or as an employee of the audit client, or acts as an advocate for the audit client. For example, an independent auditor would be prohibited from providing tax services relating to formulation of tax strategies designed to minimize a company’s tax obligations because the auditor may be required to audit his or her own work, to become an advocate for the client’s position on novel tax issues, or to assume a management function. The effect of this provision is that it eliminates the ability of accounting firms to offer many of the tax shelters that they previously provided to their audit clients.

  • Rotation of Audit Partners. Section 203 of the Act provides that the lead audit partner and reviewing partner of an audit engagement team should serve on the engagement in that capacity for no more than five consecutive years. The proposed rules would expand this five-year rotation requirement, prohibiting a partner from providing audit services to the client for a period of five consecutive years following rotation off of the audit team. The proposed rules go further than the Act and would require rotation not only of the lead and reviewing partner, but also of partners who perform audit services for the issuer. Partners who provide only tax services for the company and partners assigned to the accounting firm’s national office who may be consulted on specific accounting issues related to a client are not considered members of the audit engagement team and would not be subject to the rotation requirement. Under the proposed rules, however, partners on the engagement team that conducts the attest engagement on management’s report on the company’s internal controls (required by proposed rules implementing Section 404 of the Act) would be subject to the rotation requirement.
  • Compensation of Auditors. The proposed rules provide that an accountant is not independent if, at any point during the audit and professional engagement period, any partner, principal, or shareholder of the accounting firm who is a member of the audit engagement team earns or receives compensation based on any service provided or sold to the client other than audit, review, or attest services.

Audit Committee Administration of Audit Engagement
The proposed rules attempt to ensure that audit committees assist in assuring auditor independence by requiring audit committees to directly administer the engagement of independent auditors.

  • Audit Committee Approval of Audit Engagement. As required by the Act, the proposed rules would require audit committees to pre-approve all audit, review, or attest engagements required under the securities laws. Audit services requiring pre-approval by the audit committee are broadly defined, including services related to the issuance of comfort letters. The proposed rules attempt to ensure that audit committees assist in assuring auditor independence by requiring audit committees to directly administer the engagement of independent auditors.
  • Audit Committee Approval of Non-Audit Services. The proposed rules would also require that audit committees have sole authority to pre-approve the engagement of independent accountants to perform non-prohibited, non-audit services, which may be done either by approving a particular engagement before an accountant is engaged to provide the non-audit services or by establishing detailed pre-approval policies and procedures pursuant to which any such engagement would be entered into, which must include that the audit committee be informed on a timely basis of each service. The Act permits audit committees to delegate this pre-approval authority to a single member of the committee.
  • Auditor Reports to Audit Committees. The proposed rules would require each public accounting firm registered with the PCAOB that audits an issuer’s financial statements to report, prior to the filing of the audit report with the SEC, the following to the issuer’s 1 audit committee:
    • All critical accounting policies and practices used by the issuer,
    • All alternative accounting treatments of financial information within GAAP that have been discussed with management, including the ramifications of the use of such alternative treatments and disclosures and the treatment preferred by the accounting firm, and
    • Other material written communications between the accounting firm and management of the issuer.

Proposed Disclosure Requirements
In addition to implementing the rules required by the Act, the proposed rules introduce new disclosure requirements regarding fees paid to a company’s principal accountants and certain policies and procedures of audit committees.

  • Principal Accountants’ Fees. The proposed rules would amend Schedule 14A to modify disclosure about fees paid to principal accountants. Companies will no longer be required to disclose financial information technology consulting fees, because financial information technology consulting is a prohibited non-audit service. Companies now will be required to disclose separately all:
    • audit fees,
    • audit-related fees (such as employee benefit plan audits, due diligence related to mergers and acquisitions, internal control reviews, and consultation concerning financial accounting and reporting standards),
    • tax fees, and
    • all other fees

      paid to their principal independent auditors. Furthermore, companies will be required to disclose each year the amount of such fees paid for the two most recent fiscal years.
  • Audit Committee Actions. The proposed rules would require companies to disclose any policies and procedures developed by the audit committee concerning pre-approval of the independent accountant to perform both audit and non-audit services, as well as the percentage of fees that were pre-approved.

The proposed rules would require companies to include the additional disclosure in proxy statements or information statements, and incorporate the disclosure by reference into their annual reports, because the SEC believes this information is relevant to shareholders in deciding whether to vote for a particular director or to approve the choice of an independent public accountant. Companies that are not subject to proxy disclosure requirements would include the new disclosure in their annual reports.

Application to Foreign Private Issuers and Registered Investment Companies
The proposed disclosure requirements would apply to all issuers, including foreign private issuers; however, foreign private issuers generally are not subject to proxy disclosure requirements. Accordingly, foreign private issuers would be required to present the required disclosure on Form 20-F. Registered investment companies will be required to include the additional disclosure in annual reports on Form N-CSR, regardless of whether the disclosure is also included in proxy statements or information statements relating to election of directors or approval of independent public accountants.

The SEC has proposed permitting asset backed issuers and unit investment trusts to be exempt from the disclosure requirements.

Comment Period and Effective Date
Section 208(a) of the Act requires that the SEC adopt final rules relating to Title II of the Act no later than January 26, 2003. The release acknowledges, however, that the proposed rules expand the provisions of the Act. Accordingly, although the SEC is proposing that the new regulatory requirements become effective upon adoption of final rules, it is considering whether transition periods or delayed effective dates for some or all of the new regulatory requirements should be implemented.

Contact Information
If you have any questions or would like to learn more about the proposed rules, please contact the lawyer who normally represents you.

1 The release specifies that these reporting requirements apply to audits of financial statements of registered investment companies.