SEC Proposes Rules Regarding Auditor Independence Pursuant to the Sarbanes-Oxley Act
 
December 5, 2002
 

The Securities and Exchange Commission (the SEC) issued proposed rules on December 2, 2002, in accordance with Title II of the Sarbanes-Oxley Act (the Act).  The proposed rules are intended to enhance the SEC's requirements regarding auditor independence by:

• Imposing additional restrictions on employment relationships with former accounting firm employees;
• Prohibiting various non-audit services
• Defining pre-approval requirements for allowable non-audit services
• Imposing a mandatory audit partner rotation schedule
• Requiring auditors to report certain matters to the audit committee; and
• Increasing disclosure obligations regarding accounting firm relationships.

The proposed rules would apply to companies that file quarterly and annual reports under Section 13(a) or 15(d) of the Exchange Act. 

Restrictions on Employment Relationships

The proposed rules expand the restrictions on employment by audit clients of former accounting firm employees.

Currently, an accounting firm is not deemed independent if a former member of the audit engagement team is employed by an audit client while such member has a financial interest in or a position of influence over the accounting firm.  The audit engagement team includes: all partners, principals, shareholders, and professional employees participating in an audit, review or attestation engagement of an audit client.

Under the proposed rules an accounting firm would not be deemed independent if a former member of the audit engagement team is employed by an audit client in a "financial reporting oversight role" within one year from the commencement of the current audit.  A "financial reporting oversight role" refers to direct responsibility for oversight over those who prepare a company's financial statements and related information that are included in filings to the SEC.

Prohibited Non-Audit Services

Section 201(a) of the Act prohibits an accounting firm that audits a company's financial statements from performing, contemporaneously with the audit, any non-audit services, including:

1. Bookkeeping or other services;

2. Financial information systems design and implementation;

3. Appraisal or valuation services, fairness opinions, or contribution-in-kind reports;

4. Actuarial services;

5. Internal audit outsourcing services;

6. Management functions or human resources;

7. Broker or dealer, investment adviser, or investment banking services;

8. Legal services and expert services unrelated to the audit; and

9. Any other service that the Accounting Standards Board determines, by regulation, is impermissible.

An accounting firm may, however, engage in any non-audit services, including tax services, that are not listed above, if the audit committee of the company pre-approves those non-audit services in accordance with Section 202 of the Act.

The proposed rules would incorporate the list of non-audit services prohibited under the Act and amend the SEC's existing rules by eliminating the exceptions and exemptions under which such non-audit services would have been permitted.

The proposed rules are not intended as an all-inclusive list.  The SEC identified three "simple principles" which, if violated, would impair an auditor's independence.  First, an auditor cannot audit his or her own work.  Second, an auditor cannot perform management functions.  Third, an auditor cannot act as an advocate for a client.

Audit Committee Administration of the Engagement

Section 202 of the Act requires audit committees to pre-approve all audit and non-audit services provided to a company, but also provides an exception to the pre-approval requirement for certain non-audit services.

The proposed rules require that audit committees pre-approve all engagements for accounting firms to complete audit, review, and attest report work.  For all other kinds of accounting firm engagements (non-audit services), audit committees must pre-approve each engagement or the engagement may be entered into pursuant to pre-approval policies and procedures established by the audit committee, except that the pre-approval requirement may be waived where the aggregate amount of all such services provided constitutes no more than five percent of the total revenues paid to the accounting firm during the fiscal year in which the services are being provided or such services are promptly brought to the attention of the audit committee and approved prior to the completion of the audit by the audit committee or a designated member.

Partner Rotation

Section 301 of the Act requires the rotation of the lead audit partner and the reviewing partner every five years.  Under the proposed rules, all partners who perform audit services for a company would be required to rotate.  This includes the lead partner, the concurring review partner, the client service partner, and other "line" partners directly involved in the audit.  Partners who serve on the engagement team that conducts the review of a company's interim financial information, as well as the engagement team that conducts the attest engagement on management's report on a company's internal controls, would be required to rotate.  Partners assigned to "national office" duties who may be consulted on the audit however, are not subject to the rotation requirement.  The proposed rules also require that, following rotation, a partner may not provide audit services to the audit client for a period of five consecutive years.

Compensation of Auditors

The proposed rules will prevent accounting firms from compensating a partner, principal or shareholder of an accounting firm who is a member of the audit engagement team, during the audit or the engagement period, for the performance of any non-audit services or the procuring of engagements with an audit client to provide any non-audit services.  Compensation would include any form of income or monetary benefit distributed to the person.

Auditor Communication with the Audit Committee

Section 204 of the Act requires auditors to timely report specific information to audit committees.  The proposed rules would require each registered public accounting firm that audits a company's financial statements to report, before the filing of such report with the SEC, to a company's audit committee regarding: (i) all critical accounting policies and practices; (ii) all alternative accounting treatments; and (iii) other material written communications.  Communications about critical accounting policies and procedures and alternative accounting treatments may be written or oral.

i. Critical Accounting Policies and Practices

The SEC expects discussions regarding critical accounting policies and procedures to include reasons that certain estimates or policies are or are not considered critical and how current and anticipated future events may impact those determinations.  They should also include an assessment of management's disclosures along with any significant proposed modifications by the auditors that were not included.

ii. Alternative Accounting Treatments

Discussions of alternative accounting treatments should include the alternative accounting treatments of financial information within GAAP that have been discussed with management, including ramifications of the use of such alternative treatments and disclosures and the treatment preferred by the accounting firm.  The proposed rule is intended to cover recognition, measurement, and disclosure considerations related to accounting for specific transactions, as well as general accounting policies.

iii. Other Material Written Communications

When determining what are  "other material written communications" auditors should use a subjective standard.  The Act specifically refers to the management letter and schedules of unadjusted differences as examples of material written communications to be provided to the audit committee.

Increased Disclosure

The proxy disclosure rules currently require a company to disclose the professional fees it paid to its principal independent accountant in the most recent fiscal year.  The proposed rules would require companies to disclose these fees for the two most recent fiscal years and provide more detailed disclosure of the categories of fees paid.  Categories of fees would include (i) audit fees, (ii) audit-related fees, (iii) tax fees, and (iv) all other fees.

The proposed rules also would require a company to disclose the audit committee's pre-approval policies and procedures in its proxy statements and their annual reports as well as the percentage of fees that were pre-approved by the audit committee pursuant to such policies and procedures.

The proposed rules, along with the SEC's introduction and comments, are available at the SEC Web site (www.sec.gov). Interested persons are invited to submit comments on the proposed rules, which must be received at the SEC no later than 30 days after the proposed rules are published in the Federal Register.  The SEC is expected to adopt final rules by late January 2003.

Holland & Knight will be tracking this and other developments in the implementation of the Act. For further information, please contact Michael Jamieson or Steve Sonberg at 1-888-688-8500.