United States: SEC Issues Final Rules On Auditor Independence

One of the most significant aspects of the Sarbanes-Oxley Act of 2002 is the series of new and enhanced "independence" requirements to which accounting firms that audit issuer financial statements are subject. Section 201 of the Act sets forth several prohibitions to sustaining an auditor’s independence, and the Act directed the SEC to issue rules to implement these and other aspects of its independence initiatives. The SEC has now issued those final rules.

General Prohibitions and Related Requirements

Section 201 of the Act itself prohibits an accounting firm that audits an issuer’s financial statements from providing to that issuer, contemporaneously with the audit, any of the following non-audit services:

  • bookkeeping or other services related to the accounting records or financial statements of the issuer;
  • 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;
  • broker or dealer, investment adviser, or investment
  • banking services;
  • legal services and expert services unrelated to the audit; and
  • any other service that the Public Company Accounting Oversight Board (PCAOB) determines, by regulation, to be impermissible.

Rules promulgated under the Act include a de minimis exception to the pre-approval requirements for non-audit services. To qualify under that exception, all such services (1) must not total more than five percent of total revenues paid by the audit client to the auditor in the fiscal year when services are provided, (2) must not be recognized as non-audit services at the time of the engagement, and (3) must promptly be brought to the attention of the audit committee and approved prior to the completion of the audit by the audit committee.

Other provisions of the Act (a) require an issuer’s audit committee to pre-approve all audit and non-audit services provided by the issuer’s auditor that are not otherwise prohibited; (b) prohibit partners on an audit engagement team from providing audit services to an issuer for more than five consecutive years; (c) prohibit an accounting firm from auditing an issuer’s financial statements if certain members of the issuer’s management had been members of the accounting firm’s audit engagement team within the one-year period preceding commencement of the audit; and (d) require auditors to report certain matters to an issuer’s audit committee.

Many of the items covered under the Act already were prohibited under existing SEC rules. However, the new rules expand on or clarify many of the existing standards.

Four Principles Underlying Prohibitions

In compiling the list of prohibited items, Congress sought to limit situations which could create a fundamental conflict of interests for the accounting firm. Accordingly, the list of prohibited items is based on four guiding principles:

  • an auditor should not audit its own work
  • an auditor should not function as part of management or as an employee of the audit client
  • an auditor should not act as an advocate for the audit client
  • an auditor should not be a promoter of the audit client’s stock or other financial interests.

These principles are especially important to decision-making about several types of non-audit services that are not categorically prohibited – such as legal services, expert services and tax services – but would be prohibited if they involved certain factors that compromise or tend to compromise independence. Of particular note in the SEC rules are their application of these principles to implement standards for these three types of conditionally prohibited services.

The principles also led to the adoption of an exception in the final rules to the prohibition of certain services. Specifically, under the final rules, auditors may provide bookkeeping, financial systems design and implementation, appraisal or valuation services, actuarial services, and internal audit outsourcing services, without affecting their independence, where it is reasonable for the accounting firm to conclude that these services will not be subject to audit procedures.

Certain Conditionally Prohibited Services

Neither the Act nor the SEC rules uses the term "conditionally prohibited," but that concept aptly describes the treatment afforded to the following three types of services that had become common for accounting firms to offer to clients.

Legal Services. The rule on legal services provides that an auditor will not be deemed independent if the firm provides any service to the audit client that, under circumstances in which the service is provided, could be provided only by someone licensed, admitted or otherwise qualified to practice law in the jurisdiction in which the service is provided.

The SEC expressed the view that an auditor cannot be an advocate for a client while at the same time remain objective and impartial in performing its audit services. So, for example, auditors will be prohibited from representing an audit client in tax court. However, the SEC indicated that auditor representation of a client during the examination phase of an IRS audit will be permitted, even though such work might be considered to involve advocacy.

Expert Services. The final rule on expert services provides that an auditor will not be considered independent if the firm provides expert opinions or other expert services for the audit client for the purpose of advocating the audit client’s interests in litigation, regulatory or administrative investigations or proceedings.

The prohibition will extend to situations where the auditor is engaged by the audit client’s legal counsel to provide expert witness or other services, including accounting advice, opinions or forensic accounting services, in connection with the client’s participation in a legal, administrative or regulatory proceeding. However, an auditor will remain able to assist a client’s audit committee in fulfilling its responsibilities in connection with the financial reporting process. For example, an auditor’s independence will not be impaired if it assists an audit committee in conducting an investigation into an accounting impropriety, so long as the auditor does not assume the role of an advocate in the investigation. Additionally, an auditor will remain able to serve as a factual witness for a client in litigation or related legal proceedings.

Tax Services. Tax services, like any other non-prohibited, non-audit service, may be provided by an auditor to an audit client if the services are pre-approved by the audit committee. The auditor may provide tax services such as tax compliance, tax planning and tax advice to audit clients, subject to normal pre-approval procedures.

Some had interpreted the SEC’s proposed rules on this issue to preclude auditors from performing "tax shelter" strategy work for an audit client, because that work might require the auditor to audit his or her own work, to assume a management function, or to become a client’s advocate on a particular tax issue. Likewise, the proposed rules might have prohibited auditors from providing tax opinions in situations where the auditor was serving as an advocate for the client. In the final rules, however, the SEC relented to some extent to allow auditors to provide many of the tax services that they historically have offered to audit clients.

However, the SEC did emphasize that classifying a service as a "tax service" will not necessarily mean that such service will be permitted and will not impair the independence of the firm. For example, anauditor’s independence will be impaired if the auditor represented an audit client before a tax court.

Additionally, the rules direct audit committees to carefully examine any transaction recommended by the auditor where the sole business purpose of which may be tax avoidance.

To determine if a service is prohibited, the SEC recommended that the accounting firm and the audit committee evaluate whether the service falls under one of the prohibited categories, based on the four principles described above.

Cooling-Off Periods

The Act prohibits a registered accounting firm from performing an audit for an issuer if the chief executive officer, controller, chief financial officer or chief accounting officer of the issuer was employed by that accounting firm and participated in any capacity in the audit of that issuer during the one-year period preceding the date of initiation of the audit.

Under the final rules implementing that provision, an accounting firm will not be permitted to audit an issuer if the lead partner, the concurring partner, or any other member of the audit engagement team who provided more than ten hours of audit, review or attestation services was employed in a "financial reporting oversight role" by the issuer within the specified one-year period. The term "financial reporting oversight role" refers to a person who has direct responsibility for oversight over those who prepare the issuer’s financial statements and related information that is included in filings with the SEC.

For purposes of this rule, audit procedures are deemed to have commenced for the current audit engagement period the day after the prior year’s periodic annual report is filed with the SEC. The audit engagement period for the current year is deemed to conclude on the date the current year’s periodic annual report is filed with the SEC.

Partner Rotation

Section 203 of the Act prohibits an accounting firm from providing audit services to an issuer if the lead (or coordinating) audit partner, or the audit partner responsible for reviewing the audit (the concurring partner), has performed audit services for that issuer in each of the five previous fiscal years of that issuer.

As initially proposed, the rules would have expanded this provision to cover "line" partners directly involved in the performance of the audit, and certain tax partners, in addition to the lead and concurring audit partners. However, after receiving extensive comments concerning the potential loss of continuity and competence in audits, the SEC took a "middle of the road" approach in the final rules.

The final rules provide that all "audit partners" will be subject to the rotation requirements and will be prohibited from returning to the engagement for specified periods. "Audit partners" include the lead and concurring partner, as well as all partners on the engagement team who have responsibility for decision-making on significant auditing, accounting and reporting matters with management and the audit committee, or who maintain regular contact with management and the audit committee.

Lead and concurring partners will be required to rotate every five-years and will be subject to a five year cooling-off period before being permitted to return to the engagement. All other audit partners will be required to rotate every seven years and will be subject to a two-year cooling-off period.

The final rules provide that measurement of the period of service of lead and concurring partners will include all time during which the partner served as the lead or concurring partner prior to May 6, 2003. For other audit partners, however, the period of service will not include the time on the audit engagement team prior to the first day of the issuer’s fiscal year beginning on or after May 6, 2003.

Audit Committee Approval of Services

The final rules require each issuer’s audit committee to pre-approve all engagements for audit, review or attestation services. The rules also generally require approval of all permissible non-audit services, either by the full audit committee or through detailed pre-approval policies and procedures established by the audit committee. Pre-approval policies or procedures must be detailed with respect to the services to be pre-approved. The audit committee must be informed of each service that is pre-approved in accordance with the established policies and procedures. Under no circumstances may the audit committee delegate its pre-approval obligations to management.

Prohibited Compensation

The final rules provide that an accountant will not be considered independent if, at any point during the engagement period, any audit partner (as defined above) earns or receives compensation based on that partner selling services other than audit, review or attestation services. This rule is intended to reduce an accounting firm’s incentive to compromise its accounting judgments to avoid losing the prospect for future non-audit business from the client.

The final rules except "specialty partners" from this prohibition. "Specialty partners" are those partners who consult with others on the audit engagement team during the audit, review or attestation engagement regarding technical or industry-specific issues. Such partners include, for example, tax specialists and valuation specialists. The final rules permit specialty partners to be compensated for selling services within their discipline. The SEC reasoned that these partners have a low level of contact with senior management of an audit client, and that their responsibility for the overall presentation in the financial statements is relatively low.

Communications with Audit Committees

The SEC rules require each accounting firm that audits an issuer’s financial statements to report to the issuer’s audit committee, prior to the filing of an audit report with the SEC, the following:

  • all critical accounting policies and practices used by the issuer;
  • all material alternative accounting treatments of financial information under generally accepted accounting principles (GAAP) that have been discussed with management, including the ramifications of the use of such material alternative treatments and disclosures and the treatment preferred by the accounting firm; and
  • other material written communications between the accounting firm and management.
  • The SEC expects that these discussions will occur annually at a minimum, but permits and encourages more frequent communication.

New Disclosure Requirements

The SEC has expanded required disclosure of professional fees paid to auditors for audit and non-audit services. The expanded proxy statement disclosure will require a specific breakdown of (a) audit fees, (b) audit-related fees, (c) tax service fees, and (d) all other fees. The new rules require such disclosure for each of the two most recent fiscal years, rather than the current requirement of only the most recent fiscal year. Issuers also will be required to describe the nature of the services provided under audit-related fees, tax service fees and all other fees.

The final rules also require each issuer to disclose in its proxy statement the pre-approval policies and procedures of its audit committee in engaging an auditor to perform non-audit services. The final rules do not require the disclosure of the percentage of fees that were pre-approved, as initially proposed by the SEC.

To the extent that the audit committee uses the de minimis exception discussed above in failing to preapprove certain non-audit services, the issuer must disclose the percentage of the total fees paid to the auditor for which the de minimis exception was used.


The effective date for the final auditor independence rules is May 6, 2003. However, pursuant to transition periods set forth in the final rules release, an auditor’s independence will not be deemed impaired:

  • by employment relationships that begin prior to May 6, 2003;
  • by compensation earned or received during the accounting firm’s fiscal year that includes May 6, 2003;
  • by the provision of non-audit services before May 6, 2004, so long as those services are provided pursuant to contracts in existence as of May 6, 2003;
  • by the provision of services before May 6, 2003 that are not pre-approved by the audit committee;
  • by a lead partner's years of service as such before May 6, 2003 (regardless of how long), until the first day of the issuer's fiscal year that begins after May 6, 2003;
  • by a concurring partner’s years of service as such before May 6, 2004 (regardless of how long), until the first day of the issuer’s fiscal year that begins after May 6, 2004; and
  • by an audit partner's years of service as such, other than a lead or concurring partner, prior to May 6, 2003.

The information contained in this Legal Alert is not intended as legal advice or as an opinion on specific facts. For more information about these issues, please contact the author through our Web site at www.KilpatrickStockton.

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