24 - SEC Adopts New Rules on Auditor Independence


On January 28, 2003, the SEC published additional rules regarding the independence of accounting firms that audit the financial statements of public companies.  These rules are a result of the Sarbanes-Oxley Act of 2002 (the “Act”) and were adopted by the SEC in accordance with Section 208(a) of the Act, although certain aspects of the rules expand upon the auditor independence provisions of the Act.  The revised SEC auditor independence rules address:

  • potential conflicts of interest related to the employment of a member of an audit engagement team by an audit client;

  • restrictions on the ability of accounting firms to provide non-audit services to audit clients;

  • the need for audit committee pre-approval of audit and non-audit services;

  • the implementation of mandatory rotation periods for audit partners;

  • internal compensation arrangements relating to non-audit services that may impair an accounting firm’s independence;

  • the need for effective communications between the auditor and the audit committee; and

  • additional public disclosures regarding the services provided by audit firms.

Conflicts of Interest Resulting from Employment Relationships

The rules adopted by the SEC generally require a one year “cooling off” period before the lead partner, the concurring partner or other members of the audit engagement team of a company’s auditor that have provided more than ten hours of audit, review or attest services may be employed by the company in a capacity where they would oversee the preparation of the company’s financial statements or related information (such as MD&A disclosures).  The cooling off period begins on the day after the end of the audit engagement period for the last fiscal year in which the employed individual participated as a member of the company’s audit engagement team.

Under the rules, the audit engagement period for a fiscal year begins the day after the company’s periodic annual report for the prior fiscal year is filed with the SEC.  Similarly, the audit engagement period for a fiscal year ends on the date that the company files their periodic annual report for that year.  As a result, the rules essentially require the completion of one continuous audit engagement period after the employed individual leaves the audit engagement team.  For example, if a company files its Form 10-K for fiscal 2002 with the SEC on March 25, 2003, hires the lead partner of its audit engagement team for fiscal 2003 to serve as its Chief Financial Officer on October 30, 2003, and files its Form 10-K for fiscal 2003 with the SEC on March 25, 2004, the company would generally be required to use a different auditing firm until March 26, 2005.

Non-Audit Services

Section 201(a) of the Act prohibits accounting firms from providing the following types of non-audit services to their public company audit clients:

  • Bookkeeping or other services related to the 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 services;

  • Management functions or human resources services;

  • Broker-dealer, investment advisor, or investment banking services;

  • Legal services; and

  • Expert services unrelated to the audit.

In addition, auditors are prohibited from providing any other type of service that the Public Company Accounting Oversight Board (PCAOB) determines, by regulation, is impermissible.

According to the SEC, this list of prohibited services is based upon three core concepts: (1) an auditor should not audit his or her own work, (2) an auditor should not perform management functions, and (3) an auditor should not act as an advocate for the audit client. 

The SEC auditor independence rules in effect prior the adoption of the Act prohibited accounting firms from providing many of these services on behalf of their audit clients, but contained specific categorical exceptions that would allow accounting firms to otherwise provide selected prohibited services if certain conditions were met.  The new rules adopted by the SEC incorporate the additional non-audit services prohibited by the Act and eliminate most of the categorical exceptions permitted by the previous rules, although the rules preserve exceptions for several of these services if it is reasonable to conclude that the results of the service will not be subject to audit procedures during a financial statement audit.  In addition, these new rules contain more specific guidance on the scope of the services that are prohibited. 

Unlike previous SEC auditor independence rules, the new rules prohibit auditors from providing “expert services” to audit clients.  Specifically, an auditor may not provide expert opinions for an audit client in connection with legal, administrative, or regulatory proceedings or act as an advocate for an audit client in these types of proceedings.  This restriction also precludes an auditor from providing consulting services to an audit client’s legal counsel in connection with legal, regulatory or administrative proceedings.  The rules do not, however, prohibit an auditor from assisting an audit committee in connection with the financial reporting process or from testifying as a fact witness to its audit work for a particular audit client. 

Neither the Act nor the new SEC rules place direct restrictions on the ability of auditors to provide tax services to audit clients.  Subject to audit committee pre-approval, an accounting firm may continue to provide tax services to its audit clients as long as the tax services do not involve non-audit services that are otherwise prohibited, such as legal or expert services.  For example, it would be permissible for an accounting firm to provide an audit client with tax compliance, tax planning or tax return preparation services, but an auditor cannot represent an audit client in tax court or in other situations including public advocacy.

It is important to note that the neither the Act nor the new SEC rules have any impact on the non-audit services that may be provided by accounting firms for non-audit clients.

Audit Committee Pre-Approval 

The new SEC rules require that a company’s audit committee pre-approve all permissible non-audit services and all audit, review or attest engagements required under federal securities laws.  Express approval may be given by the audit committee for each individual service or engagement in advance of its performance.  Alternatively, a service or engagement may be provided without individual pre-approval if it is provided in compliance with detailed pre-approval policies and procedures established by the audit committee and the audit committee is promptly informed of the service or engagement.  The Act allows an audit committee to delegate all pre-approval matters to one committee member as long as the approval of each service or engagement is reported to the entire audit committee during scheduled meetings.

Partner Rotation

The new SEC rules require the rotation of all “audit partners” after they provide services for an audit client for a specified period of time.  The rules define “audit partners” to include lead and concurring partners, as well as all other partners on a company’s audit engagement team who have responsibility for decision-making on significant matters that affect the company’s financial statements or who maintain regular contact with management and the audit committee.  This group of partners encompasses lead partners for subsidiary audits if the subsidiary accounts for 20% or greater of the company’s consolidated assets, but excludes “specialty” and “national office” partners who provide consultation on specific issues.

The rules require the rotation of lead and concurring audit partners after they have provided audit services for an audit client for five consecutive years.  Once rotated, these partners may not provide audit services for the same audit client until a five year “time out” period has passed. Other audit partners are subject to a seven year rotation requirement followed by a two-year “time out” period.  The rules exempt auditing firms with less than ten partners from these rotation requirements in certain circumstances.

Prohibited Compensation Arrangements

The new SEC rules also prohibit “audit partners” from receiving any form of compensation based on the provision of services to an audit client other than audit, review, or attest services.  This prohibition is not required by the provisions of the Act, and shows potential concern regarding the influence that service-related compensation may have on auditor independence. 

Audit Committee Communication

Prior to the filing of an audit report with the SEC, a company’s auditor must now report to the audit committee:

  • all critical accounting policies and practices used by the company;

  • all alternative GAAP accounting treatments that have been discussed with management, the ramifications of the alternative treatments and the treatment preferred by the auditor; and

  • other material written communications between the accounting firm and management of the company.

Examples of material written communications between the auditor and management include the management representation letter, reports on internal controls, schedules of unadjusted audit differences, audit engagement letters and auditor independence letters.  The intention of the required communications is to facilitate a more open dialogue between the auditor and the audit committee.  While these communications are now required to take place during the annual audit, the SEC expects that audit committees will prefer to hold these types of discussions on a quarterly or real-time basis.

Expanded Disclosure Regarding Auditor Matters

Under former SEC rules, public companies were required to disclose in their proxy statements the amount of certain types of fees paid to their auditors during the last completed fiscal year.  The revised rules expand upon this requirement and call for disclosure of the following types of fees paid to a company’s auditor during each of the last two most recent fiscal years:

  • Audit Fees

  • Audit-Related Fees

  • Tax Fees

  • All Other Fees.

In addition, companies must provide a description of the types of services received in connection with the payment of the amounts of audit related fees, tax fees, and all other fees that are disclosed.

The rules also require companies to disclose in detail any policies and procedures developed by the audit committee regarding pre-approval of both audit and non-audit services.  Most companies would be allowed to make these disclosures in their annual proxy statements.  Public reporting entities that are not subject to the SEC’s proxy rules would be required to disclose this information in other periodic reports that are filed with the SEC.

Effective Time and Transition Periods

The new rules become effective 90 days after they are published in the Federal Register.  As of Friday, January 31, 2003, the rules had not been published in the Federal Register.  However, subject to compliance with pre-existing requirements, the SEC has adopted the following transition periods and “grandfathering” provisions to aid in the implementation of the rules:

  • the mandatory one year “cooling off” period for former audit engagement team members will not apply to employment relationships that commence prior to the effective date of the rules;

  • audit partners will be permitted to receive compensation for the sale of non-audit services to audit clients until the end of the fiscal year of the auditing firm during which the rules become effective;

  • auditing firms may provide services under contracts that are entered into prior to the effective date of the rules, but all prohibited non-audit services must be completed within 12 months from the effective date;

  • the rotation requirements for lead audit partners will begin on the first day of the company’s next fiscal year that begins after the effective date of the rules, with periods of service prior to the effective date counting toward the five-year service limit;

  • the rotation requirements for concurring audit partners will begin on the first day of the company’s next fiscal year that begins 12 months after the effective date of the rules, with periods of service prior to the effective date counting toward the five-year service limit; and

  • the rotation requirements for other audit partners will begin on the first day of the company’s next fiscal year that begins after the effective date of the rules, but periods of service prior to the effective date will not count toward the seven-year service limit. 

Further Information

This Alert is a publication of Haynes and Boone, LLP and should not be construed as legal advice on any particular facts or circumstances.  This Alert is for general informational purposes only, and may not be quoted or referred to in any other documents or legal proceeding without our prior written consent.  The publication of this Alert is not intended to create an attorney-client relationship.

This Client Alert summarizes certain key points of the new rules.  You are encouraged to review the full text of the rules at http://www.sec.gov/rules/final/33-8183.htm.  If you would like to learn more about the Act and the rules and regulations relating to the Act, please feel free to contact your regular Haynes and Boone attorney.

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