On January 22, 2003, as required by the Sarbanes-Oxley Act of 2002, the Securities and Exchange Commission adopted final rules regarding auditor independence. (See SEC Release No. 33-8183, available at http://www.sec.gov/rules/final/33-8183.htm.)
The new rules impose more rigorous standards of independence for the external auditors of SEC reporting companies (including foreign private issuers) than under existing SEC rules by:
- Expanding the list of prohibited non-audit services
- Requiring more frequent partner rotation off an audit engagement team and expanding the scope of partners subject to rotation
- Disqualifying an accounting firm if any member of the company's management having a "financial reporting oversight role" was a member of the firm's "audit engagement team" within the one-year period preceding commencement of the audit procedures
- Requiring that a company's audit committee pre-approve all audit and non-audit services;
- Disqualifying an accounting firm if an audit partner is compensated for selling non-audit services to the audit client;
- Mandating that, before an audit report is included in a filing with the SEC, auditors must report to a company's audit committee on critical accounting policies and practices, alternative accounting treatments and material written communications between the auditor and management; and
- Expanding a company's disclosure obligations regarding fees paid to, and services provided by, its auditor.
The new rules became effective on May 6, 2003, subject to various transition periods as discussed below.
Prohibited Non-Audit Services
As mandated by Section 201(a) of the Sarbanes-Oxley Act, the new rules revise and expand the scope of non-audit services that an independent auditor is prohibited from providing to an audit client. While the new rules are generally consistent with existing SEC rules, they expand upon the types of prohibited conduct and eliminate previous exceptions. Whether or not specifically enumerated by the rules, services are prohibited if they:
- result in an auditor auditing its own work,
- create a mutual or conflicting interest between auditor and client,
- result in an auditor performing management functions or
- place the auditor in a position of advocating for a client.
Accounting firms are not prevented under the rules from providing a full range of non-audit services to an SEC reporting company for which they do not act as the independent auditor.
Treatment of Tax Services
In adopting the final rules, the SEC backed away from its controversial proposal suggesting that certain tax services might be prohibited. The adopting release affirms that independent auditors can provide tax services, such as tax compliance, tax planning and tax advice, to their audit clients without impairing their independence. The release cautions, however, that some services, such as representing an audit client before a tax court or promoting a novel tax avoidance (i.e., "tax shelter") transaction, would orcould impair an auditor's independence.
Prohibited Services
The new rules enumerate ten categories of non-audit services that an independent auditor may not provide to an audit client, including bookkeeping and related services, financial systems design and implementation services, appraisal or valuation services, actuarial services, internal audit outsourcing and human resources and other managerial services.
Transition Date
Providing one or more of the services prohibited by the new rules will not impair an accounting firm's independence until May 6, 2004, provided that those services are performed pursuant to contracts in existence on May 6, 2003.
Partner Rotation
Lead and Concurring Partners
As mandated by Section 203 of the Sarbanes-Oxley Act, the new rules provide that an accounting firm will not be independent if either the lead audit partner or the concurring partner perform audit services for more than five consecutive fiscal years of an audit client. Extending beyond the mandate of Section 203, the final rules also require a five-year "time-out" period before a partner may return to a particular audit engagement.
Other Audit Partners
The new rules also require partner rotation for "audit partners," which is a new defined term. Audit partners, other than the lead and concurring partners, must rotate off an audit engagement after seven years and are subject to a two-year time-out period. As defined by the rules, an "audit partner" is any partner on the audit engagement team with responsibility for decision-making on any significant audit, accounting or reporting matters affecting the company's financial statements or who maintains regular contact with management and the audit committee of the audit client. Audit partners also include all partners who provide more than 10 hours of audit services during a fiscal year to the parent public company, or lead partners on the audit of the company's subsidiaries whose assets or revenues account for 20% or more of the company's consolidated assets or revenues. The definition of audit partner excludes "specialty" partners who consult on technical or industry-specific issues, the lead partners on subsidiaries below the 20% threshold and partners assigned to "national office" duties who may be consulted on specific accounting issues related to an audit client.
Small Firm Exemption
The final rules contain an exception to partner rotation for firms with no more than five public company audit clients and fewer than ten partners.
Transition Dates
The partner rotation rules for lead partners apply as of the first day of a company's first fiscal year beginning after May 6, 2003, with time served as the lead partner prior to May 6, 2003 being included in determining rotation periods. The partner rotation rules for concurring partners apply as of the first day of a company's second fiscal year beginning after May 6, 2003, with time served as the concurring partner prior to May 6, 2003 being included in determining rotation periods. For all other "audit partners" in the United States and all partners with accounting firms outside the United States who are subject to the rotation rules, the rules are effective as of the first day of a company's first fiscal year beginning after May 6, 2003, with such first fiscal year being counted as the first year of service for purposes of determining rotation periods.
Conflicts of Interest Resulting from Employment Relationships
The new rules will significantly affect the employment by an SEC reporting company of the former employees of its independent auditor. Under the rules, an accounting firm will not be independent if a person who was a member of the firm's "audit engagement team" is employed by the audit client in a "financial reporting oversight role" before the company has completed a full one-year audit cycle after such person was no longer a member of the audit engagement team.
The term "audit engagement team" means the lead and concurring partners and any other member of the team providing over 10 hours of audit services to the client during an audit cycle. The term "financial reporting oversight role" refers to any position that has direct oversight responsibility for the preparation of a company's financial statements and related information, such as the MD&A, included in filings with the SEC. The term covers the chief executive officer, chief financial officer, chief accounting officer, controller and other key positions, such as members of the board of directors. The final rules provide an exception for conflicts that are created through merger or acquisition, as long as the audit committee is aware of the conflict.
Transition Date
These rules are effective for employment relationships beginning on or after May 6, 2003.
Audit Committee Pre-Approval of Audit and Non-Audit Services
The final rules require audit committee pre-approval of all audit, review or attest engagements and all engagements for permissible non-audit services for an SEC reporting company. The final rules permit engagements entered into pursuant to pre-approval policies and procedures established by the audit committee, provided that:
- the policies and procedures are detailed as to the particular services covered by the polices,
- the audit committee is informed of each service performed pursuant to this form of approval and
- such policies and procedures do not include delegation of the audit committee's responsibility to management.
The final rules provide a de minimis exemption from the pre-approval requirements for non-audit services totaling less than five percent of the aggregate fees paid to the auditor in the fiscal year, so long as the services were not identified as non-audit services at the time of engagement and the audit committee is promptly notified and approves them before fiscal year-end.
Transition Date
The pre-approval rules apply to all audit services and non-audit services that are entered into after May 6, 2003. Arrangements for non-audit services entered into prior to May 6, 2003 will not violate this requirement if the non-audit services are completed by May 6, 2004.
Audit Partner Compensation
Under the final rules, an accounting firm will not be independent if, during its engagement period, any audit partner earns or receives compensation based on the act of selling non-audit services to an audit client. The rules do not preclude an audit partner from sharing in the profits of the firm's audit practice and the profits of the overall accounting firm.
Transition Date
The compensation rules will be effective in fiscal periods of the accounting firm that commence after May 6, 2003.
Communication With Audit Committees
The final rules require that an independent auditor communicate specified information to the audit committee of its audit client. Specifically, the new rules require that independent auditors report to audit committees in the following three categories prior to any filing of an audit report with the SEC pursuant to applicable securities laws:
- Critical Accounting Policies - The discussion with the audit committee of critical accounting policies should include the reasons for determining if a policy is critical and how current and anticipated future events impact those determinations. In addition, the communication should include the auditor's assessment of management's disclosures of critical accounting policies along with any significant modifications proposed by the accountants that were not included in such disclosures.
- Alternative GAAP Treatments - The communication should discuss the effect that alternative treatments within GAAP for material items would have on the company's financial statements and identify the treatments preferred by the accounting firm. The communications should focus on the initial selection of, and changes in, significant accounting policies and should address how management's judgments and accounting estimates impact the financial statements. The report to the audit committee should also cover the auditor's judgment about the quality of the company's accounting principles. If an existing accounting policy is being modified, then the reasons for the change also should be communicated.
- Material Communications - The independent auditor must report on all material written communications between the auditor and management. These written communications include: management letters, management representation letters, reports and recommendations on internal controls, schedule of unadjusted audit differences, engagement letters and independence letters.
The final rules do not specify the form of the communication. However, the communication will need to be documented in some fashion by the independent auditor and the audit committee and, as a practical matter, a written record of the communication will need to be preserved by both parties. These communications will occur prior to the filing of annual reports on Form 10-K, 20-F or 40-F, and proxy statements, as well as prior to filing registration statements or current reports on Form 8-K in which audit reports are included. The rules also cover filings in which the audit report is incorporated by reference, such as registration statements on Forms S-3 and S-8.
Transition Date
The rules for auditor communications with the audit committee are effective on May 6, 2003.
Expanded Disclosure
The new rules expand an SEC reporting company's obligation to disclose fees paid to its independent auditor for both audit and non-audit services. In addition, the new rules require a company to describe the services provided by its independent auditor within each non-audit service category for which fees are reported. Fees must be reported in four categories:
- audit fees
- audit-related fees
- tax fees
- all other fees.
The audit fees category includes all services necessary to perform an audit in accordance with GAAS, services provided in connection with statutory and regulatory filings or engagements and other services generally provided by independent auditors, such as comfort letters, statutory audits, attest services, consents and assistance with, and review of, documents filed with the SEC. In general, the audit-related fees category covers assurance and due diligence services, including, employee benefit plan audits, due diligence related to mergers and acquisitions, consultations and audits in connection with acquisitions, internal control reviews and consultations concerning financial accounting and reporting standards. The tax fee category captures services performed by a professional staff in the accounting firm's tax division, except those services related to the audit. These fees would include tax compliance, tax planning and tax advice. The category of all other fees would remain the same as existing rules, except to include financial information systems implementation and design.
The required disclosure must be included in the reporting company's annual report on Form 10-K, 20-F or 40-F and its proxy statement. U.S. reporting companies may incorporate the required disclosure from the proxy statement into its annual report. The disclosure must include information on fees paid for the last two fiscal years in order to provide investors with comparative information. The company must also provide "clear, concise and understandable" descriptions of the audit committee's pre-approval policies and procedures. As an alternative, companies may attach a copy of the policies and procedures to its annual report or proxy statement. In addition, if a company uses the de minimis exception to audit committee pre-approval of non-audit services, it must disclose the percentage of total fees paid to the independent auditor under that exception by fee category.
Transition Date
The disclosure provisions are effective for annual filings for the first fiscal year ending after December 15, 2003.
Conclusions
The new auditor independence rules present new challenges to the relationship between public companies and their independent auditors. Despite the transition periods permitted by the rules, public companies should begin planning for the adjustments they will need to make. Among other things, public companies should begin to:
- Identify any prohibited non-audit services currently provided by the company's independent auditor and make plans to engage a new entity to provide those services
- Understand how its independent auditor intends to manage audit partner rotation in a way that avoids any disruption in audit services
- Review hiring guidelines for management positions with financial oversight roles to avoid recruiting members of the company's audit engagement team during the cooling off period
- Review audit committee charters with a view to updating them in conjunction with the coming stock exchange listing requirements to require pre-approval of all engagements for audit and permissible non-audit services, and revise other internal policies in a corresponding manner as appropriate
- Receive assurance from the company's independent auditor that its compensation arrangements will comply with the new rules
- Meet with its auditor to ensure that appropriate procedures are in place for the auditor to report to the board on critical accounting policies prior to filing of audit reports
- Work with its auditor to update its procedures to track and report the information required by the new disclosure obligations regarding auditor fees and services
Article Courtesy of Dorsey & Whitney LLP.