SEC Issues Final Rules Regarding Auditor Independence, Lawyer Conduct, Off-Balance Sheet Activity Disclosure, and Record Retention Pursuant to the Sarbanes-Oxley Act
 
February 20, 2003
 

Auditor Independence

The SEC issued final rules on January 28, 2003 relating to auditor independence.  These rules will become effective on May 6, 2003.

Prohibited Non-Audit Services. Under the final rules, accounting firms may jeopardize their independence if they provide certain non-audit services to companies during the audit or professional engagement period.  The prohibited services include:  

• bookkeeping
• appraisal services
• actuarial services
• management functions or human resource work
• broker-dealer, investment adviser or investment banking services
• legal services and other expert services unrelated to auditing
• internal audit outsourcing
• financial information systems design and implementation; and
• any other expert services unrelated to the audit as defined by the SEC

The accounting firms can provide tax services, such as tax compliance and planning and tax advice, if such services are pre-approved by the company's audit committee and such services would not impair auditor independence.   

The provisions referring to "prohibited services" will not go into effect until after May 6, 2004.  Certain transition rules apply to contracts for prohibited services entered into prior to May 6, 2003.

Audit Committee Pre-Approval. A company's audit committee must pre-approve all permissible non-audit services under the rules.  Further, all audit, review or attest engagements must be approved by the audit committee or entered into pursuant to detailed pre-approval policies and procedures promulgated by the audit committee. 

There is an exception to the pre-approval requirements for non-audit services if all such services:

• do not aggregate to more than five percent of total revenues paid by the company to its accountants during the fiscal year when the non-audit services are performed
• were not recognized as non-audit services at the time of the engagement; and
• are promptly brought to the attention of audit committee and approved by the audit committee

The rules regarding pre-approval apply to all audit, review and attest services, and non-audit services entered into after May 6, 2003. Contracts for permissible non-audit services entered into prior to May 6, 2003, must be completed by May 6, 2004. 

Cooling Off Period. The final rules prohibit former members of an audit engagement team from assuming a "financial reporting oversight role" with a former audit client for a period of one year.  A "financial reporting oversight role" is a role in which one has direct responsibility for or oversight over the preparation of a company’s financial statements and related information, such as MD&A disclosure, that must be filed with the SEC.  These rules will apply to employment relationships that begin after May 6, 2003.

Partner Rotation and "Time-Out" Provisions. The final rules require the lead and concurring partners on an audit engagement team to rotate after five years.  Upon rotation, these partners will be subject to a five-year, "time-out" period before being eligible to return to that engagement. This requirement will be effective for lead partners on the fiscal year beginning after May 6, 2003, and should take into account time already served in that position prior to such date.  The rules will apply to "concurring partners" on the fiscal year beginning after May 6, 2004.

Other "audit partners" who have certain responsibilities for decision making or who maintain regular contact with management and the audit committee are required to rotate after no more than seven years, and are subject to a two-year "time out" period. 

Prohibition on Cross-Selling Compensation. An accounting firm’s independence will be considered impaired if any audit partner receives compensation based on cross-selling to an audit client services other than audit, review and attest services.

Audit Committee Communication. Under the final rules, an auditor is required to communicate the following matters to the audit committee before filing an audit report with the SEC under the relevant securities laws:

• "critical accounting policies"
• alternative accounting treatments, and
• other written or documented material communications

"Critical Accounting Policies" consist of those policies and estimates most important to the audit client’s results of operations and financial condition that require the most difficult, subjective, or complex management judgment.

In addition to critical accounting policies, the auditor must inform the audit committee of the available accounting treatments under GAAP and the bases for the chosen approaches regarding all material items discussed with management, including recognition, measurement and disclosure issues and general accounting policies. 

Accounting Fee Disclosure. Under the final rules, companies that file proxy statements with the SEC must disclose their principal accountant’s fees for the two most recent fiscal years.  The fees to be disclosed include:

• audit fees
• audit-related fees
• tax fees, and
• all other fees

Lawyer Conduct

On January 29, 2003, the SEC issued final rules pursuant to Section 307 of the Sarbanes-Oxley Act establishing standards of professional conduct for lawyers who appear and practice on behalf of companies before the SEC.  The SEC had issued proposed rules concerning this matter on November 21, 2002.  The final rule requires lawyers to report evidence of a "material" violation of securities laws, a breach of fiduciary duty, or similar violation by the company "up-the-ladder" within the company to the chief legal counsel or chief executive officer of the company (or someone holding an equivalent position).  If those individuals do not provide an "appropriate response" to the evidence, the lawyer is then required to bring the issue before the company’s audit committee, another committee of independent directors, or the full board of directors.

An "appropriate response" is one where the lawyer reasonably believes:

• the company provided evidence or demonstrated that no material violation has occurred, is ongoing, or is about to occur
• the company has adopted appropriate remedial measures to stop any material violations and minimized the likelihood of recurrence, or
• the company, with the consent of its board of directors or other committee, has retained or directed a lawyer to review the reported evidence of a material violation and either has substantially implemented any remedial recommendations made by the lawyer after a reasonable investigation and evaluation of the reported evidence or has been advised that such lawyer may assert a colorable defense on behalf of the company relating to the reported evidence of a material violation

"Noisy Withdrawal." The proposed rules contained a "noisy withdrawal" requirement, which required lawyers to notify the SEC in writing that they had withdrawn from the representation of the company based on professional considerations if the lawyer believed the company was not adequately addressing their concerns.  Because of extensive public comments received by the SEC regarding the "noisy withdrawal" proposal, the SEC has reissued proposed rules on this matter for further comment.

Qualified Legal Compliance Committees. Companies may establish "qualified legal compliance committees," composed of at least one member of the audit committee and two or more independent board members, who are responsible for notifying the SEC of the company’s failure to take proper action.

The professional conduct rule will become effective on August 5, 2003.

Off-Balance Sheet Activity Disclosure

The SEC issued final rules on January 27, 2003, regarding disclosure of off-balance sheet arrangements and aggregate contractual obligations pursuant to Section 401(a) of the Sarbanes-Oxley Act.  These final rules also amend existing MD&A requirements.  Companies are now required to disclose off-balance sheet financial arrangements in a separately captioned section of MD&A.  A tabular disclosure of future payments due under specific contractual obligations is also required.

An "off-balance sheet arrangement" includes contractual arrangements between a company and an unconsolidated entity that are:

• an obligation under certain "guarantee contracts" (e.g. agreements to indemnify based on modifications to assets, liabilities, equity securities, standby letters of credit and guarantees of stock prices)
• a retained or contingent interest in assets transferred to an unconsolidated entity or similar arrangement that serves as credit, liquidity or market risk support to that entity for such assets
• an obligation under specified derivative instruments, and
• a material variable interest in certain unconsolidated entities that provide financing, liquidity, market, or credit risk support, or engage in leasing, hedging, or research and development services

Disclosures under this rule are triggered only by contractual arrangements that have, or are reasonably likely to have, a material current or future effect on a company’s financial condition.  

Contractual Obligations Disclosure. The final rules promulgated by the SEC also require companies to provide a tabular summary of their contractual obligations in their registration statements, annual reports, and proxy and information statements.  Any material change outside the company’s ordinary course of business should be disclosed in the appropriate quarterly reports. The disclosures required under this rule may be in any MD&A section the company deems appropriate, provided that it provides the information as of the latest fiscal year-end balance sheet date, and the disclosures are in an appropriate tabular form as set forth in the rules.

Safe Harbor. Under the final rules, any disclosure made with respect to off-balance sheet activity can still be protected by a safe harbor from private litigation if such disclosures are "forward-looking statements" and are accompanied by "meaningful cautionary statements."   

Disclosures under the off-balance sheet activity rule are required for all SEC filings that include financial statements for fiscal years ending on or after June 15, 2003.  Tabular representation of contractual arrangements is required for all SEC filings that include financial statements ending on or after December 15, 2003. 

Record Retention

On January 24, 2003, the SEC issued final rules requiring accounting firms to retain records that relate to audits and reviews of company's financial statements for seven years.  Records to be retained include the firms' work papers and memoranda, correspondence, communications, other documents and records that are created, sent or received in connection with the audit or review.

At this time, a company will not be required to retain documents that the auditor examines, reviews, or otherwise considers during the audit or review.

The record retention rule is effective March 3, 2003, and compliance with the final rule is required for audits and reviews completed on or after October 31, 2003. 

 

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