Implementing The Sarbanes-Oxley Act
SEC adopts final rules on auditor independence, a key step in restoring
public confidence in the economy
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Kahle |
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McGuire |
By Brian J. Kahle
and Julie E. McGuire
After 2001's economic downturn was worsened by numerous Enron-type scandals,
Congress passed the Sarbanes-Oxley Act of 2002, 15 U.S.C. § 7201 et seq.,
(the "Act"). The Act was signed into law by President Bush on July
30, 2002, and as a result, the U.S. Securities and Exchange Commission ("SEC"),
the agency charged with promulgating rules and regulations to implement the
Act, has experienced the most extensive rulemaking period in its 70-year history.
On Jan. 22, 2003, the SEC voted to adopt final rules to implement Title II
of the Act: "auditor independence." Published in the Federal Register
(Securities and Exchange Commis-sion, 68 Fed. Reg. 6006 (Feb. 5, 2003) (to be
codified at 17 C.F.R. pts. 210, 240, 249, 274)) on Feb. 5, 2003, the rules became
effective on May 6. The issue of auditor independence is regarded by some commentators
as the focal point of the legislation and the most important step toward restoring
public confidence in the economy. This issue also is arguably the most controversial.
What follows is an overview of the highlights of these new rule provisions.
The Sarbanes-Oxley Act applies only to registered public accounting firms alone
and does not seek to regulate those small and medium-sized accounting firms
that do not perform audits of public companies. A "registered public accounting
firm," defined in Section 2 of the Act, is a public accounting firm that
must be registered with the newly formed Public Company Accounting Oversight
Board ("Oversight Board") before it is able to provide auditing services
to a public company registered with the SEC. (See, 15 U.S.C. § 7201(12)
(2003).)
Generally, then, the rules discussed here apply only to those accounting firms
that perform audits for publicly traded companies. (How-ever, this article still
has relevance to non-registered firms since they will be required to look to
state and other regulatory authorities that will likely be adopting regulations
similar to those discussed here.)
A violation by any person of the Act or the auditor independence rules discussed
here will subject the person to the same penalties as would a violation of the
Securities Exchange Act of 1934 and related SEC rules. (See, 15 U.S.C. §
7202(b)(1) (2003); 17 C.F.R. § 240.10A-2 (effective May 6, 2003).) This
could include civil penalties, criminal penalties or both. (See, e.g., 15 U.S.C.
§ 78u (2003); 18 U.S.C. § 1341 (2003).)
The SEC rules on audit independence can be organized into five key areas:
- Prohibited non-audit services;
- Audit committee pre-approval of services;
- Partner rotation;
- Conflict of interest; and
- Increased communication and disclosure.
Prohibited non-audit services
Congress enumerated in Section 201 of the Act nine non-audit services that
are prohibited from being contemporaneously performed for a public company client
by any registered public accounting firm that is also serving as auditor of
the client. (See, 15 U.S.C. § 78j-1(g) (2003).)
The SEC rules do not prohibit a firm from providing non-audit
services to clients they are not auditing. The prohibited non-audit services
are:
- BOOKKEEPING. Generally, all bookkeeping services, such
as maintaining accounting records, preparing financial statements or preparing
source data, are prohibited from being performed by an auditing firm.
- FINANCIAL INFORMATION SYSTEM DESIGN OR IMPLEMENTATION.
An accounting firm may not provide any service related to the audit client's
information system, unless it is reasonable to conclude that the results of
these services will not be subject to audit procedures during an audit of
the client's financial statements. (Id. at 6011 (to be codified at 17 C.F.R.
§ 210.2-01(c)(4)(ii)).)
- APPRAISAL AND VALUATION SERVICES. Generally, an accounting
firm is prohibited from performing services of appraising or valuing assets
or liabilities or performing services involving a fairness opinion or contribution-in-kind
report for an audit client, unless it is reasonable to conclude that the results
of the services will not be subject to audit procedures. (Id. at 6012 (to
be codified at 17 C.F.R. § 210.2-01(c)(4)(iii)).)
- ACTUARIAL SERVICES. An accounting firm is prohibited from
providing to an audit client any actuarially oriented advisory service involving
the determination of amounts recorded in the financial statements for the
audit client unless it is reasonable to conclude that the results of these
services will not be subject to audit procedures. (Id. at 6012-6013 (to be
codified at 17 C.F.R. § 210.2-01(c)(4)(iv)).)
- INTERNAL AUDIT OUTSOURCING. The SEC now prohibits an accounting
firm from providing to their audit client any internal audit service that
has been outsourced by the audit client and that relates to the audit client's
internal accounting controls, financial systems or financial statements. (Id.
(to be codified at 17 C.F.R. § 210.2-01(c)(4)(v)).)
- MANAGEMENT AND HUMAN RESOURCES FUNCTIONS. An accountant
is prohibited from acting as a director, officer or employee of an audit client
or performing any decision-making, supervisory or ongoing monitoring function
for the audit client. (68 Fed. Reg. 6006, 6013-6014 (Feb. 5, 2003) (to be
codified at 17 C.F.R. § 210.2-01(c)(4)(vi)).) The rules also prohibit
an accounting firm from searching for employee candidates, performing reference
checks of candidates, engaging in testing or evaluation programs or recommending
a specific candidate for a specific job. (Id. at 6014 (to be codified at 17
C.F.R. § 210.2-01(c)(4)(vii)).)
- INVESTMENT ADVISING SERVICES. It is impermissible for
an accounting firm to perform brokerage, investment advising or investment
banking services for an audit client.
- LEGAL SERVICES. An accounting firm is prohibited from
providing to an audit client any service that could only be provided by someone
licensed to practice law in the jurisdiction in which the service is provided.
(Id. at 6015 (to be codified at 17 C.F.R. § 210.2-01(c)(4)(ix)).) Impor-tantly,
because some countries have regulations requiring a license to practice law
in order to do tax work, this restriction on legal practice does not prohibit
foreign accounting firms that are so regulated from providing accounting services
that an American accounting firm could provide under these rules. (See, 68
Fed. Reg. 6006, 6015 (Feb. 5, 2003).)
- EXPERT SERVICES. Expert services are those where an accounting
firm's specialized knowledge and expertise are used to support the audit client's
positions in an adversarial proceeding. An accountant is prohibited from providing
expert opinions to an audit client, or a legal representative of an audit
client, for the purpose of advocating that audit client's interests in litigation
or administrative and regulatory proceedings.
Tax Services Exception
An accounting firm is permitted to provide tax services such as tax compliance,
tax planning and tax advice to audit clients; doing so is not deemed a violation
of auditor independence. It should be noted that such permitted services cannot
be performed without pre-approval by the audit committee. Further, such tax
services could be a violation of other SEC rules on auditor independence, where,
for example, the firm represents the audit client before tax court or federal
court of claims. (See, 68 Fed. Reg. 6006, 6016-6017 (Feb. 5, 2003).)
Audit committee pre-approval of services
An audit committee is defined in Section 2 of the Act as a committee established
by and among the board of directors of a publicly traded client for the purpose
of overseeing the accounting and financial reporting processes of the client
and audits of the financial statements of the client. If no such committee of
the board exists, the committee is deemed to be the entire board of directors
of the client. (See, 15 U.S.C. § 7201(3)(A) and (B) (2003).)
In order for a registered firm to provide audit or permitted non-audit services
to a public company, the audit committee of the company must give prior approval
pursuant to Section 202 of the Act. The rules require that the audit committee
pre-approve all permissible non-audit services and all audit, review or attest
engagements. (See, Fed. Reg. 6006, 6022 (Feb. 5, 2003) (to be codified at 17
C.F.R. § 210.2-01(c)(7).) The rules provide a de minimis exception for
certain non-audit related services. (Id. at 6022-6023 (to be codified at 17
C.F.R. § 210.2-01(c)(7)(i)(C)).)
Partner rotation
An audit engagement team is defined as all partners and professional employees
participating in an audit, review or attestation engagement of an audit client.
To preserve independence and maintain quality of audit services, Congress included
in Section 203 of the Act a requirement that audit partners "rotate off"
of a particular client engagement after a specific period of time. (See, 15
U.S.C. § 78j-1(j) (2003).)
In developing rules on partner rotation, the rule has classified partners into
different levels and established rules for each level of partner. The lead and
concurring partners are required to rotate after five years, and then are subject
to a five-year "time out" period when they cannot perform services
for that audit client. (68 Fed. Reg. 6006, 6018-6019 (Feb. 5, 2003) (to be codified
at 17 C.F.R. § 210.2-01(c)(6)(i)(B)(1)).)
Other audit partners are required to rotate after no more than seven years
and be subject to a two-year time out period. (Id. (to be codified at 17 C.F.R.
§ 210.2-01(c)(6)(i)(B)(2)).)
Small firm exception
In response to a significant number of comments, the SEC adopted a small firm
exception from the partner rotation rules. (See, 68 Fed. Reg. 6006, 6020 n.
143 (Feb. 5, 2003).) Audit firms that have fewer than five audit clients that
are public companies, and have fewer than 10 partners, are exempted from partner
rotation rules. These firms still must be subject to a full review by the board
at least once every three years, however. (68 Fed. Reg. 6006, 6020 (Feb. 5,
2003) (to be codified at 17 C.F.R. § 210.2-01(c)(6)(ii)).)
Conflicts of interest
Section 206 of the Act sets forth a conflict of interest rule whereby a one-year
cooling off period is required before a member of the audit engagement team
can begin working for the audit client in certain key positions. (See, 15 U.S.C.
§ 78j-1(l) (2003).)
Generally, the rule provides that when the lead partner, concurring partner,
or any other member of the audit engagement team who provides more than 10 hours
of audit, review or attest services for the client accepts a position with the
audit client in a financial reporting oversight role within one year after they
provided such services to the client, the accounting firm is not independent.
(68 Fed. Reg. 6006, 6007-6008 (Feb. 5, 2003) (to be codified at 17 C.F.R. §
210.2-01(c)(2)(iii)).)
The SEC has addressed conflicts of interest arising where an audit partner
receives compensation based on the act of selling non-audit services to the
client. It has adopted the rule that an accountant is not independent if, at
any point during the audit and professional engagement period, any audit partner
earns or receives compensation based on the audit partner procuring engagements
with the audit client to provide any products or services other than audit,
review or attest services. (Id. at 6024-6025 (to be codified at 17 C.F.R. §
210.2-01(c)(8)).)
Increased communication and disclosure
TO AUDIT COMMITTEES. Section 204 requires the SEC to issue
rules requiring timely reporting of specific information to audit committees
in order to assist the committee in overseeing both management and the accountants.
(See, 15 U.S.C. § 78j-1(k)(2003).) The SEC has added substance to this
rule by requiring disclosures for three types of information that must occur
prior to the filing of the audit report with the SEC.
First, firms are required to disclose to audit committees all critical accounting
policies and practices. (68 Fed. Reg. 6006, 6027-6028 (Feb. 5, 2003) (to be
codified at 17 C.F.R. § 210.2-07(a)(1)).)
Second, accounting firms are also required to communicate to the audit committee,
either orally or in writing, all alternative treatments within generally accepted
accounting principles ("GAAP") for policies and practices related
to material items that have been discussed with management. This includes discussions
of the ramifications of the use of such alternative treatments and the treatment
preferred by the accounting firm. (68 Fed. Reg. 6006, 6028 (Feb. 5, 2003) (to
be codified at 17 C.F.R. § 210.2-07(a)(2)).)
Third, the SEC also requires disclosure to the committee of material written
communications, such as management representation letters, engagement letters,
independence letters, reports on internal controls and schedules of unadjusted
audit differences. (Id. at 6029 (to be codified at 17 C.F.R. § 210.2-07(a)(3)).)
TO INVESTING PUBLIC. Beyond the disclosures to audit committees,
the new rule requires that additional information be provided to the public
as well. Public companies must disclose fees paid to their independent accountant(s)
for: (1) audit fees, (2) audit-related fees, (3) tax fees and (4) all other
fees. Further, the company must disclose a description of the type of services
being provided.
Disclosure must also be made of the audit committee's pre-approval policies
and procedures, if any. These disclosures are to be provided both in the company's
annual report and in their proxy statement, so that all investors have equal
information. The information must be included for the two most recent fiscal
years of the company. (Id. at 6030 (to be codified at 17 C.F.R. § 240.14a-101
Schedule 14A at Item 9(e)).)
Conclusion
This article has sought to provide an overview of the final auditor independence
rules. These rules were the subject of significant debate during the rulemaking
process and will surely be subject to further criticism as they begin to be
implemented.
However, public companies and registered public accounting firms will likely
take very seriously these rules, in view of the Act's harsh criminal penalties.
Whether they will prove effective and worth the burden will be determined in
the years, and hopefully bull markets, to come.
Brian J. Kahle is a law clerk and Julie E. McGuire is
a shareholder in Hull McGuire PC. The firm has offices in Pittsburgh, Washington,
D.C., and San Diego and practices in the areas of international law, taxation,
transactions, intellectual property, litigation, employment practices, environmental
and legislative. Copyright © 2003 Hull McGuire PC. All Rights Reserved.
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- The Securities and Exchange Commission ("SEC") recently promulgated
rules concerning "auditor independence" to implement the Sarbanes-Oxley
Act.
- The auditor independence rules issued by the SEC generally apply only to
accounting firms that provide auditing services to publicly traded companies
registered with the SEC.
- Violation of the auditor independence rules will never subject a person
to criminal penalties.
- As part of the Sarbanes-Oxley Act, Congress prohibited accounting firms
from performing certain non-audit services if that firm is also performing
audit services for the same publicly traded client.
- The SEC rules do not prohibit a firm from providing non-audit services
to clients they are not auditing.
- Under the new rules, it will be common for an accounting firm that audits
a publicly traded company to also perform bookkeeping services for that publicly
traded company, such as maintaining accounting records and preparing financial
statements.
- Under the new rules, it will be common for an accounting firm that audits
a publicly traded company to also perform human resources services for that
publicly traded company, such as searching for employee candidates, performing
reference checks of candidates, engaging in testing or evaluation programs,
or recommending a specific candidate for a specific job.
- Under the new rules, an accountant is generally prohibited from providing
expert opinions to a publicly traded audit client, or a legal representative
of that audit client, for the purpose of advocating that audit client's interests
in litigation or administrative and regulatory proceedings.
- An accounting firm is never permitted to provide tax services such as tax
compliance, tax planning and tax advice to audit clients; doing so is deemed
a per se violation of auditor independence.
- The rules require that the audit committee of a publicly traded company's
board of directors pre-approve all permissible non-audit services and all
audit, review or attest engagements.
- To preserve independence and maintain quality of audit services, Congress
included in the Sarbanes-Oxley Act a requirement that in the case of publicly
traded clients, audit partners "rotate off" of a particular client
engagement after a specific period of time.
- In developing rules on partner rotation, the SEC auditor independence rules
have classified partners into different levels and established rules for each
level of partner.
- The partner rotation rules require that lead and concurring partners are
required to rotate after 10 years, and then are subject to a five-year "time
out" period where they cannot perform services for that publicly traded
audit client.
- Audit firms that have fewer than five audit clients that are public companies,
and have fewer than 10 partners, are exempted from partner rotation rules.
- In addition to the partner rotation rules, the Sarbanes-Oxley Act includes
a conflict of interest prohibition whereby a three-year cooling off period
is required before a member of the audit engagement team can begin working
for a publicly traded audit client in certain key positions without risking
a loss of independence.
- The new rules require that all critical accounting policies and practices
be disclosed to audit committees of publicly traded companies.
- The new rules require that all alternative treatments within generally
accepted accounting principles ("GAAP") for policies and practices
related to material items that have been discussed with management be disclosed
to audit committees of publicly traded companies, either orally or in writing.
This includes discussions of the ramifications of the use of such alternative
treatments and the treatment preferred by the accounting firm.
- The new rules require that material written communications, such as management
representation letters, engagement letters, independence letters, reports
on internal controls, and schedules of unadjusted audit differences be disclosed
to audit committees of publicly traded companies.
- Beyond the disclosures to audit committees, the new rules require that
additional information be provided to the public as well. Public companies
must disclose fees paid to their independent accountant(s) for: (1) audit
fees, (2) audit-related fees, (3) tax fees and (4) all other fees.
- The auditor independence rules were the subject of significant debate during
the rulemaking process and will surely be subject to further criticism as
they begin to be implemented.
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