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Securities and Exchange Commission17 CFR PARTS 210, 240, 249 and 274[Release No. 33-8154; 34-46934; 35-27610; IC-25838; IA-2088, FR-64, File No. S7-49-02]RIN 3235-AI73Strengthening the Commission's Requirements Regarding Auditor IndependenceAgency: Securities and Exchange Commission Action: Proposed rule Summary: The Securities and Exchange Commission ("SEC" or "Commission") is proposing amendments to its existing requirements regarding auditor independence to enhance the independence of accountants that audit and review financial statements and prepare attestation reports filed with the Commission. The proposed rules recognize the critical role played by audit committees in the financial reporting process and the unique position of audit committees in assuring auditor independence. As directed by Section 208(a) of the Sarbanes-Oxley Act of 2002, we are proposing rules to:
In addition to the provisions required by the Act, we also are proposing rules defining an accountant as not being independent from an audit client if any partner, principal or shareholder of the accounting firm who is a member of the engagement team received compensation based on any service provided or sold to that client other than audit, review and attest services. Further, we proposed to amend and require additional disclosures to investors of information related to the audit and non-audit services provided by, and fees paid by the issuer to, the auditor of the issuer's financial statements. Dates: Comments should be received no later than January 13, 2003. Addresses: You should send three copies of your comments to Jonathan G. Katz, Secretary, U.S. Securities and Exchange Commission, 450 Fifth Street, NW, Washington, DC, 20549-0609. You also may submit your comments electronically to the following address: rule-comments@sec.gov. To help us process and review your comments more efficiently, comments should be submitted by one method only. All comment letters should refer to File No. S7-49-02; this file number should be included in the subject line if you use electronic mail. Comment letters will be available for public inspection and copying at the Commission's Public Reference Room, 450 Fifth Street, NW, Washington, DC 20549-0102. We will post electronically-submitted comment letters on the Commission's Internet Web site (). We do not edit personal identifying information, such as names or electronic mail addresses, from electronic submissions. Submit only information you wish to make publicly available. For Further Information Contact: Samuel L. Burke, Associate Chief Accountant, or Robert E. Burns, Chief Counsel, at (202) 942-4400, Office of the Chief Accountant, or, with respect to questions about investment companies, Brian D. Bullard, Chief Accountant, at (202) 942-0590, Division of Investment Management, U.S. Securities and Exchange Commission, 450 Fifth Street, NW, Washington, DC 20549. Supplementary Information: We are proposing to add Rule 2-07 to Regulation S-X1 and to amend Rule 2-01 of Regulation S-X,2 to amend Item 9 of Regulation S-K,3 to amend Forms 10-K, 10-KSB, 20-F and 40-F4 and to amend proposed Form N-CSR.5 I. Introduction and BackgroundOn July 30, 2002, the Sarbanes-Oxley Act of 2002 ("Sarbanes-Oxley Act" or "the Act") was enacted.6 Title II of the Sarbanes-Oxley Act, entitled "Auditor Independence," requires the Commission to adopt, by January 26, 2003, final rules, under which certain non-audit services will be prohibited, conflict of interest standards will be strengthened, auditor partner rotation and second partner review requirements will be strengthened, and the relationship between the independent auditor and the audit committee will be clarified and enhanced. As directed by the Sarbanes-Oxley Act, the proposed rules focus on key aspects of auditor independence:7 the provision of certain non-audit services and the unique ability of the audit committee to insulate the auditor from the pressures that may be exerted by management, the potential conflict of interest that can be created when a former member of the audit engagement team accepts a key management position with the audit client, and the need for effective communications between the auditor and audit committee. The proposed rules also address the possibility of any partner, principal or shareholder who is a member of the audit engagement team being unduly influenced by financial incentives to sell non-audit services to the audit client. Title II of the Sarbanes-Oxley Act adds new sub-sections (g) through (l) to Section 10A of the Securities Exchange Act of 1934 as follows:
In addition to the mandate under Title II of the Act, these proposed rules address situations where partners, principals, or shareholders of the firm who work on the audit of a company are compensated for selling non-audit services to the same audit client. As noted above, the proposed rules establish and clarify the important roles and responsibilities of registrant audit committees as well as the registrant's independent accountant.10 We have proposed a separate rule under Exchange Act Section 10A [240.10A-2] to implement Section 3(b)(1) of the Sarbanes-Oxley Act and clarify that our rules implementing Title II of Sarbanes-Oxley not only define conduct that impairs independence but also constitute separate violations under the Exchange Act. We have otherwise drafted the proposed rules (except for the proxy disclosure changes) as part of Regulation S-X, and propose to place them among the current auditor independence provisions. These provisions are generally based on whether an accountant is "independent" in the conduct of the audit. We are considering changing the format from rules defining actions that impair the auditor's independence to rules prohibiting such actions and placing them with other Exchange Act rules. The Act supplemented Section 10A of the Exchange Act and gave us express authority to adopt rules to implement these new statutory provisions. Among the reasons to move these rules under that provision is to: (1) organize the related statutory and regulatory provisions more logically, and (2) make explicit that violations would be punishable as Exchange Act violations, as contemplated by Sections 3(b)(1) and 208 of the Sarbanes-Oxley Act, with all the remedies available for Exchange Act violations, including penalties. Even if we were to move the rules out of Regulation S-X, we would intend for these provisions also to remain professional standards of independence. If we move them to be Exchange Act rules, we are considering a new provision in Regulation S-X that would state that a violation of these rules would also render the auditor not independent under Regulation S-X. Violations of these provisions could therefore also result in professional discipline in the event of a violation and cause the issuer's financial statement to fail to conform to Regulation S-X. We seek comment on this alternative approach. We recognize that auditors have traditionally looked to Regulation S-X as the place where rules relating to audits are placed, and we do not intend to make reference to and compliance with the rules more difficult. We seek comment on whether any conforming changes in other parts of the securities laws would be necessary if we adopted these rules and made them Exchange Act rules. We also seek comment on whether any of the current auditor independence rules or definitions under Regulation S-X, the substance of which we do not propose to change in light of the Sarbanes-Oxley Act, should also be made into Exchange Act rules, or conversely, whether any of the particular proposed or existing rules relating to audits should stay in Regulation S-X even if all or most of the remaining proposed rules are adopted as Exchange Act rules. II. Discussion of Proposed RulesA. Conflicts of Interest Resulting from Employment RelationshipsThe Commission's existing rules deem a firm to not be independent with respect to an audit client if a former partner, principal, shareholder, or professional employee of an accounting firm11 accepts employment with a client if he or she has a continuing financial interest in the accounting firm or is in a position to influence the firm's operations or financial policies. These proposed rules renumber, but do not otherwise change, that existing requirement.12 Consistent with Section 206 of the Sarbanes-Oxley Act, we propose adding a restriction on employment with audit clients by former employees of the accounting firm. The Act specifies that an accounting firm cannot perform an audit for a registrant:
Consistent with that directive, we propose that the employment of audit engagement team14 members of an accounting firm in a financial reporting oversight role at an audit client within one year prior to the commencement of procedures for the current audit engagement would cause the accounting firm not to be independent with respect to that registrant. The rules that we are proposing would apply to employment relationships entered into between audit engagement team members and their audit clients.15 As discussed later in this release, the term "financial reporting oversight role" refers to any individual who has direct responsibility for oversight over those who prepare the registrant's financial statements and related information (e.g., management's discussion and analysis) that are included in filings with the Commission. The concept of a "cooling-off" period before an auditor can take a position at the audit client was previously considered by the Independence Standards Board.16 In considering a cooling-off period, the Independence Standards Board noted that a mandated cooling-off period for partners and professional staff might create a greater appearance of independence between the accounting firm and the registrant.17 Ultimately, however, the Independence Standards Board provided for an alternative to a strict cooling-off period. The Independence Standards Board concluded that:
Independence Standards Board's Standard No. 3 specifically notes that additional caution is warranted when it has been less than one year since the professional disassociated him or herself from the firm.19 The provisions of the Sarbanes-Oxley Act reflect the view that the passage of time is the only appropriate safeguard to reduce the perceived loss of independence for the audit firm caused by the acceptance of employment by a member of the engagement team with an audit client. The Act specifies that the cooling off period must be one year. Under our proposed rules, the prohibition would commence one year prior to the earlier of either when the accountant began the current fiscal year's audit or when the accountant began review procedures necessary to conduct a timely review of the registrant's quarterly financial information associated with the current fiscal year. The measurement period is based upon the year the former employee commenced initial employment. For example, if audit engagement team member A last worked on the audit engagement on January 31, 2002 (audit report filed with the Commission on 2/19/02) and joined audit client B on September 1, 2003 and the review procedures for B commenced on February 20, 2003 the accounting firm would not lose its independence with respect to the audit client since audit engagement team member A did not participate as an audit engagement team member subsequent to February 19, 2002. With respect to determining commencement dates, generally accepted auditing standards require that an audit engagement be properly planned. As such, procedures associated with the planning of the engagement constitute the commencement of an audit.20 Additionally, SAS No. 71 establishes the procedures necessary to conduct a timely review of interim information.21 The Commission is also considering whether it should provide an exemption from these requirements for companies meeting certain criteria, in order to address the practical difficulties that some companies to hire qualified personnel. The criteria might include the available pool of candidates for a position, the size of the company, and the audit committee's role in ensuring the independence of the auditor.
B. Services Outside the Scope of the Practice of AuditorsSection 201(a) of the Sarbanes-Oxley Act adds new Section 10A(g) to the Securities Exchange Act of 1934. This section states that it shall be unlawful for a registered public accounting firm that performs an audit of an issuer's financial statements (and any person associated with such a firm) to provide to that issuer, contemporaneously with the audit, any non-audit service, including nine services set forth in the Act. There is an exception, however, for "any non-audit service, including tax services, that is not described" as a prohibited service "only if" the service has been pre-approved by the issuer's audit committee. The nine prohibited non-audit services included in the Act are:
Many of these services are already the subject of our rules. As explained more fully below, we interpret the legislative history as indicating (1) Congress did not intend the rules to contain broad categorical exceptions and (2) the scope of the prohibited services should be judged against three basic principles. Those three broad principles are that an auditor cannot (1) audit his or her own work, (2) perform management functions, or (3) act as an advocate for the client. To do so would impair the auditor's independence. Under Section 201(b) of the Act, the Board,23 on a case-by-case basis, may exempt any issuer, accounting firm or transaction from the prohibition on the provision of services under Section 10A(g) to the extent that the exemption is "necessary or appropriate in the public interest and is consistent with the protection of investors, and subject to review by the Commission." The Senate Report on the bill that was the primary foundation for the Act,24 states, in part: The intention of this provision is to draw a clear line around a limited list of non-audit services that accounting firms may not provide to public company audit clients because their doing so creates a fundamental conflict of interest for the accounting firms. The list is based on simple principles. An accounting firm, in order to be independent of its audit client, should not audit its own work, which would be involved in providing bookkeeping services, financial information systems design, appraisal or valuation services, actuarial services, and internal audit outsourcing services to an audit client. The accounting firm should not function as part of management or as an employee of the audit client, which would be required if the accounting firm provides human resources services such as recruiting, hiring, and designing compensation packages for the officers, directors, and managers of an audit client. The accounting firm should not act as an advocate of the audit client, which would be involved in providing legal and expert services to an audit client in legal, administrative, or regulatory proceedings, or serving as a broker-dealer, investment adviser, or investment banker to an audit client, which places the auditor in the role of promoting a client's stock or other interests.25 In statements made on the floor of the Senate on July 25, 2002, the day the Senate passed the final bill, Senator Sarbanes discussed the auditor independence provisions in the bill and stated, in part:
The Commission last amended its auditor independence rules in November 2000. In so doing, the Commission identified many of the same services included in the Act that would impair an auditor's independence. In doing so, after public comment, the Commission included certain exceptions and qualifications to these services in those rules. As part of that rulemaking, the Commission utilized concepts similar to those expressed in the Senate Report in evaluating independence matters. Rule 2-01 of Regulation S-X27 contains a preliminary note that is comprised of concepts that are similar to those outlined in the legislative history to the Sarbanes-Oxley Act. The preliminary note is used to evaluate independence matters that arise but that are not specifically addressed in Rule 2-01. The proposals that we are considering are based on the same factors that have been utilized by the staff in evaluating independence matters. The Commission had proposed more restrictive independence rules in June 2000.28 In the period between publication of the proposed rules and the adoption of the final rules, the Commission conducted public hearings at which over 100 persons testified, a congressional hearing was held, and over 3,000 comment letters were received. It seems clear that Congress did not intend to codify unchanged the current auditor independence rules, as the Commission adopted them in November 2000. In Senator Sarbanes' statements, quoted above, he notes the debate with Senator Gramm about the use of "categorical exemptions" from the prohibitions in the Act and states that the Act was not intended to give the Commission "broad exemption authority." We assume, therefore, that Congress intended the Commission to revise its existing rules, at a minimum, to eliminate categorical exceptions and exemptions. We note that the terms used by Congress could be construed very broadly. We nevertheless believe that Congress did not intend to ban any service that could conceivably fall within one of the prohibited categories of services. Both the language in the Act and the legislative history argue against such a broad construction. Each service as properly interpreted would be banned; however, proper interpretation must be made in light of the three basic principles. For example, the statute prohibits "expert" services. A broad interpretation of this prohibition could lead one to conclude that almost all services provided by a certified public accountant (CPA) could be considered to be "expert" services. For example, tax services would seem to be among the services that are provided by an "expert." However, it is clear that Congress did not wish to ban all expert services because the Act specifically provided for an auditor to be able to perform certain services, including tax services, if the audit committee approves them in advance. Both the Senate Report and Senator Sarbanes' statements on the Senate floor describe each service as fulfilling one of the enumerated "simple principles." In the Senate Report, these principles are that an accounting firm should not (1) audit its own work, (2) function as a part of management or as an employee of the audit client, or (3) act as an advocate of the audit client. In his July 25th floor statement, Senator Sarbanes added a fourth principle, the notion that an accounting firm should not be a promoter of the issuer's stock or other financial interests.29 We therefore propose to amend the auditor independence rules to remove categorical exemptions and to define each term in the list of prohibitions in Section 201(a) of the Act in relation to the "simple principle" that is at the foundation of that prohibition. In doing so, we intend to prohibit any service or scenario that reasonably could create one or more of the conflicts identified in the principles. The proposed rules, like our current independence requirements, govern non-audit services provided by an accountant to an audit client during the audit and professional engagement period.30 They do not govern non-audit services when provided to non-audit clients. The proposed rule does not provide an all-inclusive list of the services that are incompatible with proposed Rule 2-01(b). Whether the provision of a non-audit service not specified in the proposed rule impairs an accountant's independence will be measured against the four general principles set forth in the preliminary note to Rule 2-01 and the "simple principles" in the legislative history noted above.
1. Bookkeeping or Other Services Related to the Audit Client's Accounting Records or Financial Statements of the Audit ClientCurrently, an auditor's independence is impaired if the auditor provides bookkeeping services to an audit client except in limited situations, such as in an emergency or where the services are provided in a foreign jurisdiction and certain conditions are met.31 Proposed Rule 2-01(c)(4)(i) continues the prohibition on bookkeeping, but we propose to eliminate the limited situations where bookkeeping services may be provided under the current rules. As noted earlier, the proposed rules are predicated on three basic principles. One of those principles is that an auditor cannot audit his or her own work and maintain his or her independence. When an auditor performs bookkeeping services for a client, he or she is placed in a situation of auditing his or her own work. Accordingly, we are proposing that all bookkeeping services would cause the auditor to lack independence. The proposed rules utilize the existing definition of bookkeeping or other services, which focuses on the provision of services involving: (1) maintaining or preparing the audit client's accounting records, (2) preparing financial statements that are filed with the Commission or the information which forms the basis of financial statements filed with the Commission, (3) preparing or originating source data underlying the audit client's financial statements. When an accounting firm provides bookkeeping services for an audit client, the firm may be put in the position of later auditing the accounting firm's work. If, during an audit, an auditor must audit the bookkeeping work performed by his or her accounting firm, it is questionable that the auditor could, or that a reasonable investor would believe that the auditor could, remain objective and impartial. If the auditor found an error in the bookkeeping, the auditor could well be under pressure not to raise the issue with the client if raising the issue could jeopardize the firm's contract with the client for bookkeeping services or result in heightened litigation risk for the firm. In addition, keeping the books is a management function, the performance of which leads to an inappropriate mutuality of interests between the auditor and the audit client.32 We understand that auditors are sometimes asked to prepare statutory financial statements for foreign companies, and these are not filed with us. Consistent with the Commission's existing rules, an accountant's independence would be impaired where the accountant prepared the statutory financial statements if those statements form the basis of the financial statements that are filed with us. Under these circumstances, an auditor or accounting firm who has prepared the statutory financial statements of an audit client is put in the position of auditing its own work when auditing the resultant U.S. GAAP converted financial statements.
2. Financial Information Systems Design and ImplementationCurrently, paragraph (c)(4)(ii) identifies certain information technology services that, if provided to an audit client, impair the accountant's independence. The proposed rules identify the information technology services that would impair the auditor's independence. Under paragraph (c)(4)(ii)(A) of the proposed rule, an accountant is not independent if the accountant directly or indirectly operates or supervises the operation of the audit client's information system or manages the audit client's local area network or information system. Further, paragraph (c)(4)(ii)(B) of the proposed rule provides that an accountant is not deemed independent if the accountant designs or implements a hardware or software system that aggregates source data underlying the financial statements or generates information that is significant to the audit client's financial statements taken as a whole. These services impair an accountant's independence under existing Commission rules.33 However, consistent with the Commission's existing rules, the proposed rules do not preclude an audit firm from working on hardware or software systems that are unrelated to the audit client's financial statements or accounting records as long as those services are pre-approved by the audit committee. By "significant" to the financial statements taken as a whole, we refer to information that is reasonably likely to be material to the financial statements of the audit client. Since materiality determinations may not be complete before financial statements are generated, the audit client and accounting firm by necessity will need to evaluate the general nature of the information rather than only system output during the period of the audit engagement. An accountant, for example, would not be independent of an audit client for which it designed an integrated Enterprise Resource Planning ("ERP") system. Operating, designing or implementing systems affecting the financial statements may place the auditor in a management role, or result in the accountant auditing his or her own work or attesting to the effectiveness of internal control systems designed or implemented by that accountant.34 For example, if an auditor designs and installs a computer system that generates the financial records, and that system generates incorrect data, the accountant is placed in a position of having to report on his or her firms' own work. Investors may perceive that the accountant would be unwilling to challenge the integrity and efficacy of the client's financial or accounting information collection systems that the accountant designed or installed.
3. Appraisal or Valuation Services, Fairness Opinions, or Contribution-in-Kind ReportsUnder the Commission's current independence rules, an accountant is deemed to lack independence when providing appraisal or valuations services, fairness opinions, or contribution-in-kind reports for audit clients. However, the current rules contain certain exemptions that we propose to eliminate.35 These proposals would provide that the auditor is not independent if the auditor provides appraisal or valuation services, or contribution-in-kind reports,36 where there is a reasonable likelihood that the results of the service will be subject to audit procedures by the auditor because the auditor is in a position of auditing his or her own work. Additionally, an auditor is not independent under the proposal if he or she provides a fairness opinion because to do so requires the auditor to function as a part of management and may require the auditor to audit the results of his or her own work. Appraisal and valuation services include any process of valuing assets, both tangible and intangible, or liabilities. They include valuing, among other things, in-process research and development, financial instruments, assets and liabilities acquired in a merger, and real estate. Fairness opinions and contribution-in-kind reports are opinions and reports in which the firm provides its opinion on the adequacy of consideration in a transaction. Providing these services to audit clients raises several auditor independence concerns. When it is time to audit the financial statements, the accountant could likely end up reviewing his or her own work, including key assumptions or variables that underlie an entry in the financial statements. Also, where the appraisal methodology involves projection of future results of operations and cash flows, some believe that the accountant that prepares the projection could have a mutuality of interest with the client in attaining forecast results.37 The auditor may feel constrained by the valuation and appraisal issued by the firm, and as a result, the auditor may be unable to evaluate skeptically and without bias the accuracy of that valuation or appraisal. Our proposals do not prohibit an accounting firm from providing such services for non-financial reporting (e.g., transfer pricing studies, cost segregation studies) purposes. The proposed rule does not limit an accounting firm from utilizing its own valuation specialist to review the work done by the audit client itself or an independent, third-party specialist employed by the audit client, provided the audit client or the client's specialist (and not the specialist used by the accounting firm) provides the technical expertise that the client uses in determining the required amounts recorded in the client financial statements. In those instances, because a third party or the audit client is the source of the financial information subject to the review or audit, the accountant will not be reviewing or auditing his or her own work. Additionally, the quality of the audit may be improved where specialists are utilized in such situations.
4. Actuarial ServicesThe current rules generally bar auditors only from providing actuarial services related to insurance company policy reserves and related accounts. Consistent with our approach to implementing the Act, we are proposing to broaden this prohibition by providing that the accountant is not independent if the auditor provides any advisory service involving the amounts recorded in the financial statements and related accounts for the audit client where it is reasonably likely that the results of these services will be subject to audit procedures during an audit of the audit client's financial statements because providing these services may cause an accountant later to audit his or her own work. Additionally, accountants providing these services assume a key management task. Stated differently, to perform these services would violate two of the three basic principles espoused in the legislative history of the Act. In addition, actuarially oriented advisory services may affect amounts reflected in some company's financial statements, such as an insurance company's financial statements. The proposed rules provide that the accountant may utilize his or her own actuaries to assist in conducting the audit provided the audit client uses its own actuaries or third-party actuaries to provide management with the primary actuarial capabilities.
5. Internal Audit OutsourcingOur current rules allow a company to outsource part of its internal audit function to the independent audit firm subject to certain exemptions. For example, smaller businesses are exempted from the internal audit outsourcing prohibition because there have been concerns about the potentially disproportionate impact on such companies. The line between performing management functions and performing an audit is not always clear. Some companies "outsource" internal audit functions by contracting with an outside source to perform, among other things, all or part of their audits of internal controls. As emphasized by the Committee of Sponsoring Organizations ("COSO"), internal auditors play an important role in evaluating and monitoring a company's internal control system.39 As a result, some argue that internal auditors are, in effect, part of a company's system of internal accounting control.40 Since the external auditor generally will rely, at least to some extent, on the internal control system when conducting the audit of the financial statements,41 the auditor may be relying on his or her firm's own work, which was performed as part of the internal controls and internal audit function. In essence, by outsourcing the internal audit function, the auditor assumes a management responsibility and becomes part of the company's control system. Proposed Rule 2-01(c)(4)(v) provides that an auditor is not independent when the auditor performs internal audit services related to the internal accounting controls, financial systems, or financial statements, for an audit client. This does not include nonrecurring evaluations of discrete items or programs that are not in substance the outsourcing of the internal audit function. It also does not include operational internal audits unrelated to the internal accounting controls, financial systems, or financial statements. We are concerned about the effect of the proposed rule on small businesses that have no internal audit department or staff. Smaller firms may not have sufficient need for full-time internal auditors but nonetheless, may need some services that internal auditors typically provide, which they obtain from their external auditors. We understand that, unless these companies can turn to their external auditors, the work may not be done at all or only at a significant cost to the company because the company would have to engage a separate accounting firm to provide these services.42 Existing Commission independence rules contain an exception for small businesses identified as those with assets totaling less than $200 million.43 However, our proposed rules contain no such exception because, regardless of the entity's size, the Act appears to view the auditor as being in a position of auditing his or her own work.
6. Management Functions.We are not proposing any significant change to our current rule on management functions. Proposed Rule 2-01(c)(4)(vi) provides that an accountant's independence is impaired with respect to an audit client for which the accountant acts, temporarily or permanently, as a director, officer, or employee of an audit client, or performs any decision-making, supervisory, or ongoing monitoring functions for the audit client. This provision is consistent with the provisions of existing Rule 2-01(c)(4)(vi).44 We believe, however, that provided the auditor does not act as an employee or perform management functions, services in connection with the assessment of internal accounting and risk management controls as well as providing recommendations for improvements do not impair an auditor's independence. Accountants must gain an understanding of their audit clients' systems of internal accounting controls when conducting an audit in accordance with generally accepted auditing standards.45 With this insight, auditors often become involved in diagnosing, assessing, and recommending to audit committees and management, ways in which their audit client's internal controls can be improved or strengthened.46 These services can be extremely valuable to companies, and they may also facilitate the performance of a high quality audit. For these reasons, we are proposing to continue to allow auditors to assess the effectiveness of internal controls and to recommend improvements in the design and implementation of internal controls and risk management controls. At the same time, we recognize that when an auditor designs and implements its audit client's internal accounting and risk management control systems, some believe that the auditor will lack objectivity if called upon to audit financial statements that are derived, at least in part, from data from those systems or when reporting on those controls or on management's assessment of those controls. As such, we believe that design and implementation of internal accounting and risk management controls are fundamentally different from obtaining an understanding of the controls and testing the operation of the controls which is an integral part of any audit of the financial statements of a company. Likewise, design and implementation of these controls is different from recommending improvements in the internal accounting and risk management controls of an audit client. Because of this fundamental difference, we believe that designing and implementing internal accounting and risk management controls impairs the auditor's independence because it places the auditor in the role of management. Conversely, obtaining an understanding of, assessing effectiveness of, and recommending improvements to the internal accounting and risk management controls is fundamental to the audit process and does not impair the auditor's independence.
7. Human ResourcesOur current rules deem an auditor to lack independence when performing certain human resources functions, and we do not propose any significant change to those rules. Consistent with our current rules, proposed Rule 2-01(c)(4)(vii) provides that an auditor's independence is impaired with respect to an audit client when the auditor searches for or seeks out prospective candidates for managerial, executive or director positions; acts as negotiator on the audit client's behalf, such as determining position, status, compensation, fringe benefits, or other conditions of employment; or undertakes reference checks of prospective candidates. Under the proposed rule, an auditor's independence also is impaired when the auditor advises an audit client about the design of its management or organizational structure, when it engages in psychological testing, or other formal testing or evaluation programs, or recommends or advises the audit client to hire a specific candidate for a specific job. Assisting management in human resource selection or development places the auditor in the position of having an interest in the success of the employees that the auditor has selected, tested, or evaluated. Accordingly, observers may perceive that an auditor would be reluctant to suggest the possibility that those employees failed to perform their jobs appropriately, or at least reasonable investors might perceive the auditor to be reluctant, because doing so would require the auditor to acknowledge shortcomings in its human resource service. The auditor also would have other incentives not to report such employees' ineffectiveness, including that the auditor would identify and be identified with the recruited employees.
8. Broker-Dealer, Investment Adviser Or Investment Banking ServicesOur current rules deem an auditor to lack independence when performing brokerage or investment advising services for an audit client.47 We are proposing to add serving as an unregistered broker-dealer48 to our rules that prohibit serving as a promoter or underwriter, making investment decisions on behalf of the audit client or otherwise having discretionary authority over an audit client's investments, or executing a transaction to buy or sell an audit client's investment, or having custody of assets of the audit client. The proposed rule is substantially the same as the Commission's existing rule related to the provision of these types of services to audit clients.49 We are including unregistered broker-dealers within the proposed rules because the nature of the threat to independence is unchanged whether the entity is or is not a registered broker-dealer. Selling - directly or indirectly - an audit client's securities is incompatible with the auditor's responsibility of assuring the public that the company's financial condition is fairly and accurately presented. When an accountant, in any capacity, recommends to anyone (including non-audit clients) that they buy or sell the securities of an audit client or an affiliate of the audit client, the accountant has an interest in whether those recommendations were correct. That interest could affect the audit of the client whose securities, or whose affiliate's securities, were recommended. These concepts are echoed in the "simple principles" included in the legislative history to the Sarbanes-Oxley Act.50 For example, if an auditor uncovers an accounting error in a client's financial statements, and the auditor, in an investment adviser capacity, had recommended that client's securities to investment clients, the auditor performing the audit may be reluctant to recommend changes to the client's financial statements if the changes could negatively affect the value of the securities recommended by the auditor to its investment adviser clients. Broker-dealers51 often give advice and recommendations on investments and investment strategies. The value of that advice is measured principally by the performance of a customer's securities portfolio. When the customer is an audit client, the accountant has an interest in the value of the audit client's securities portfolio, even as the accountant values the portfolio as part of an audit. Thus, the auditor would be placed in a position of auditing his or her own work. Furthermore, the auditor is placed in a position of acting as an advocate on behalf of the client.
9. Legal ServicesOur current rule states that an auditor is deemed to lack independence when he or she provides legal services to an audit client. The proposed rule provides that an accountant is not independent of an audit client if the accountant 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 proposed rules would apply to foreign and U.S. accounting firms equally, minimizing the instances where legal services are provided by the auditor to the audit client. A lawyer's core professional obligation is to advance clients' interests. Rules of professional conduct require the lawyer to "represent a client zealously and diligently within the bounds of the law."52 The lawyer must "take whatever lawful and ethical measures are required to vindicate a client's cause or endeavor. . . . In the exercise of professional judgment, a lawyer should always act in a manner consistent with the best interests of the client."53 Unlike an auditor, a lawyer takes basic direction from the client. We have long maintained that an individual cannot be both a zealous legal advocate for management or the client company, and maintain the objectivity and impartiality that are necessary for an audit.54 The Supreme Court has agreed with our view. In Arthur Young, the Supreme Court emphasized, "If investors were to view the auditor as an advocate for the corporate client, the value of the audit function itself might well be lost."55 We recognize that there may be implications for some foreign registrants from this proposal. For example, we understand that in some jurisdictions it is mandatory that someone licensed to practice law perform tax work, and that an accounting firm providing such services, therefore, would be deemed to be providing legal services. Accordingly, we are interested in understanding the implications of this proposal on foreign private issuers.
10. Expert ServicesOur current rules do not provide that an auditor is deemed to lack independence when providing expert services to an audit client. The Act, however, includes expert services in the list of prohibited services. As discussed earlier, the legislative history, particularly related to expert services, is focused on the auditor's role when serving in an advocacy capacity. Our proposed rules interpret the legislative prohibition in light of the three basic principles of independence discussed previously. During the Senate Floor debate, Senator Sarbanes stated, " A public company auditor, to be independent, should not act as an advocate of its audit client (as it would if it provided legal and expert services to an audit client in judicial or regulatory proceedings)."56 The proposed rule, therefore, states that an accountant's independence is impaired as to an audit client if the accountant provides expert opinions for an audit client in connection with legal, administrative, or regulatory proceedings or acts as an advocate for an audit client in such proceedings. Clients retain experts to lend authority to their contentions in various proceedings by virtue of the expert's specialized knowledge and experience. The provision of expert services by the accountant may create the appearance that the accountant is acting as the client's advocate in pursuit of the client's interests. The appearance of advocacy (and the corresponding appearance of mutual interest) created by providing expert services is sufficient to deem the accountant's independence impaired. Our prohibition on the provision of expert services would include providing consultation and other services to an audit client's legal counsel in connection with litigation, administrative or regulatory proceedings. As discussed above in the context of the provision of legal services, legal counsel have an ethical duty to "represent a client zealously and diligently within the bounds of the law" and to "take whatever lawful and ethical measures are required to vindicate a client's cause or endeavor."57 An auditor who takes on such duties, either directly or by being engaged by the audit client's legal counsel, takes on a role as an advocate for the client. The prohibition on providing "expert" services included in this rule proposal covers services that result in the accounting firm's specialized knowledge, experience and expertise being used to support the contentions of the audit client in various adversarial proceedings. Therefore, under our proposed rule, an auditor's independence would be impaired if the auditor were 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. For example, an auditor could not provide forensic accounting services to the audit client's legal representative in connection with an investigation by the Commission's Division of Enforcement. Nor could an accounting firm appear as an expert witness in a utility rate setting proceeding in support of an audit client's request for an increase in fees. Our proposals, however, would not prohibit an auditor from assisting the audit committee in fulfilling its responsibilities in connection with the financial reporting process.58 Although under our proposals, an auditor's independence would be impaired if it were engaged by the audit client's counsel to provide advice or forensic accounting services in connection with a legal, administrative or regulatory proceeding,59 the auditor's independence would not be impaired if it were assisting the audit committee in fulfilling its responsibility to conduct its own investigation of a potential accounting impropriety, so long as the auditor did not take on the role of an advocate in such an investigation.60 For example, an audit committee may engage the auditor to render forensic services, and should the audit committee choose to engage counsel, the work product of the auditor may be provided to the audit committee's counsel without impairing the auditor's independence. We believe it is important that auditors be allowed to assist the audit committee in their capacity as investors' representatives. In this regard, our proposals also would not prohibit an auditor from testifying as a fact witness to its audit work for a particular audit client. In those instances, the auditor is merely providing a factual account of what he or she observed and the judgments he or she made. An accounting firm that, after receiving appropriate authorization from an audit client's audit committee, had prepared an audit client's tax returns, also could appear as a fact witness in tax court to explain how the returns were prepared.
11. Tax ServicesSection 201 of the Sarbanes-Oxley Act identifies specific categories of non-audit services that are prohibited for accounting firms to provide for their audit clients. Additionally, the Act specifies that the audit committee must pre-approve all non-prohibited non-audit services. In particular, the Act states that:
Nothing in these proposed rules is intended to prohibit an accounting firm from providing tax services to its audit clients when those services have been pre-approved by the client's audit committee. As discussed in our previously proposed rules62 on independence, tax services are unique, not only because there are detailed tax laws that must be consistently applied, but also because the Internal Revenue Service has discretion to audit any tax return.63 In addition, the Congressional intent behind the above quoted reference to "tax services" would appear to be that auditor independence is not impaired by an accountant providing traditional tax preparation services to an audit client or an affiliate of an audit client. While we do not define "tax services," we understand that tax services can include a range of activities including the preparation of tax returns, tax compliance, tax planning, tax recovery, and other tax-related services. In addition, many engagements will require that an auditor review the tax accrual that is included in the financial statements. Reviewing tax accruals is part of audit services and is not, in and of itself, deemed to be a tax compliance service. Classifying a service as a "tax service" however, does not mean that the service may not be within one of the categories of prohibited services or may not result in an impairment of independence under Rule 2-01(b). The accounting firm and the registrant's audit committee should consider, for example, whether the proposed non-audit service is an allowable tax service or constitutes a prohibited legal service or expert service. As part of this process, the accounting firm and the audit committee should be mindful of the three basic principles which cause an auditor to lack independence with respect to an audit client: (1) the auditor cannot audit his or her own work, (2) the auditor cannot function as a part of management, and (3) the auditor cannot serve in an advocacy role for the client.64 For example, where an accountant provides representation before a tax court the accountant serves as an advocate for his or her client and the accountant's independence would be impaired. Another example would be the formulation of tax strategies (e.g. tax shelters) designed to minimize a company's tax obligations.65 The provision of these types of services may require the accountant to audit his or her own work, to become an advocate for the client's position on novel tax issues, or to assume a management function. We also are considering whether special considerations apply when the auditor provides a tax opinion for the use of a third party in connection with a business transaction between the audit client and the third party. The tax opinion may be vital in the audit client's efforts to induce the third party to enter into the transaction, particularly when the transaction is tax-driven. Under those circumstances, the auditor may be acting as an advocate for the audit client by actively promoting the client's interests.
C. Partner RotationSection 301 of the Sarbanes-Oxley Act specifies that the audit committee has the responsibility for appointment, compensation, and oversight of the work of the company's audit firm. In that capacity, the audit committee has the responsibility for evaluating and determining that the audit engagement team has the competence necessary to conduct the audit engagement in accordance with GAAS. The Sarbanes-Oxley Act also requires rotation of certain audit partners on a five-year basis in order to continue to provide audit services for a registrant. Section 203 of the Sarbanes-Oxley Act of 2002 specifies that:
The concept of audit partner66 rotation is not new. Indeed, accounting firms that audit registrants are currently subject to audit partner rotation requirements. The current requirements of the AICPA's SEC Practice Section ("SECPS") call for the engagement partner to rotate off the engagement after seven years to remain off the engagement for two years.67 The Sarbanes-Oxley Act clearly specifies that the lead audit partner and reviewing partner should serve on the engagement in that capacity for no more than five consecutive years. The Commission is proposing rules to clarify the five-year rotation requirement specified in the Sarbanes-Oxley Act. As noted above, existing SECPS membership requirements stipulate that a rotated partner may not serve on the audit engagement for two consecutive years following rotation.68 In addition to covering more partners,69 the proposed rules expand this requirement and require that, following rotation, a partner may not provide such services for a period of five consecutive years. We believe that partners should not return to the engagement for five-years in order to ensure investors that there will be a periodic fresh look at the accounting and auditing issues confronting the company. If a shorter "time-out" provision is used, investors might believe that partners merely would be placed in secondary role for a year or two, only to resume the same roles that they previously occupied and to return to the prior engagement team's approach to the accounting and auditing issues. If a partner is removed from an engagement for five-years, it would appear more likely that the partner will be placed on a different engagement and not held in abeyance only to return to the previous engagement. While we anticipate that accounting firms, when possible, would stagger the rotation of partners to provide a continuity of knowledge about the company, we believe the five-year period in the proposed rule would assure a complete turnover of personnel every five years. With respect to determining which partners, principals and shareholders should be included, the proposed rules would go beyond the minimum specified by the Act. As noted above, the Act requires that the lead or coordinating audit partner and the audit partner responsible for reviewing the audit rotate every five years. Clearly, the lead partner as well as the concurring review partner perform critical functions that affect the conduct and effectiveness of the engagement. However, in many larger engagements, the engagement team will include more than just the lead partner and the concurring review partner. Obviously, the larger the registrant and the more diversified the registrant's activities, the more likely that the engagement team will include multiple partners, principals or shareholders. While under this proposal, firms would be required to rotate multiple partners in these situations, nothing in this proposal is intended to imply that all partners would need to be rotated at the same time. Indeed, we would expect that firms would stagger the rotation of partners to ensure that the engagement team continues to have appropriate expertise to allow the audit engagement to be conducted in accordance with GAAS. Partners, principals or shareholders who are members of the audit engagement team70 make significant decisions that can affect the conduct and effectiveness of the audit. As a result, the proposed rules would require rotation not just of the lead and reviewing partner,71 but of partners who perform audit services for the issuer.72 This rotation requirement would include the lead partner, the concurring review partner, the client service partner, and other "line" partners directly involved in the performance of the audit. The proposed rules ensure that professionals do not "grow-up" or spend their entire career on one engagement. Since most registrants are taxable entities, an assessment of the registrant's tax provision accounted for in accordance with GAAP73 is a necessary part of the audit engagement. As a consequence, there may be "tax" partners who perform significant services related to the audit engagement. To the extent that such services are a necessary part of the accounting firm's ability to complete the audit, partners providing those services would be subject to these rotation requirements. However, the accounting firm may also perform tax services for the registrant. These services can include tax compliance services as well as certain tax planning services.74 Such services are not, in and of themselves, deemed to be part of the audit or other attest engagement.75 Thus, a partner who only provides tax services for the registrant would not be subject to the rotation requirements. However, since the financial statements typically include the amount currently payable or refundable, the accounting firm must carefully evaluate whether "tax" partners are performing exclusively tax services or whether their services play a role in the audit engagement. In many cases, registrants have complex business transactions and other situations which may require that the engagement team consult with the accounting firm's national office or others on technical issues. Partners assigned to "national office" duties (which can include both technical accounting and centralized quality control functions) who may be consulted on specific accounting issues related to a client are not considered members of the audit engagement team even though they may consult on client matters regularly.76 While these partners play an important role in the audit process, they serve, primarily, as a technical resource for members of the audit team. Because these partners are not involved in the audit per se and do not routinely interact or develop relationships with the audit client, we do not believe that it is necessary to rotate the involvement of these personnel. In addition to the audit, registrants are required to have their quarterly financial information subjected to a timely review by the accounting firm. Such review is typically conducted according to the provisions required by generally accepted auditing standards.77 Furthermore, Section 404 of the Sarbanes-Oxley Act, as well as the Commission's proposed rules,78 would require the accounting firm to attest to management's report on the registrant's internal controls. Both a timely review engagement and an attestation engagement require the accounting firm to be independent with respect to the registrant. Accordingly, the Commission's proposed rules for partner rotation extend to partners who serve on the engagement team that conducts the timely review of the registrant's interim financial information as well as the engagement team that conducts the attest engagement on management's report on the registrant's internal controls. Under the proposed rules, a partner performing audit, review or attest services to an investment company could only do so if they had not performed such services for any entity within the investment company complex, as defined in rule 2-01(f)(14) of Regulation S-X during the previous five consecutive years. For example, the proposed rule would prohibit a partner from rotating between two separate investment company issuers within an investment company complex. The proposed rule also would prohibit a partner from rotating between an investment company issuer and any other entity within the investment company complex. While we are proposing that all partners on the engagement team who perform a continuing audit function be subject to the partner rotation requirements, we are interested in understanding the implications of this proposed requirement on audit firms. For example, it has been suggested by some that the need for the audit firm to rotate its audit partners might be obviated by having a second audit firm periodically perform a forensic audit to evaluate the work of the existing auditor, the condition of the company's internal controls, the company's accounting and reporting practices, and other matters. Forensic audits are typically conducted by specialized accountants and are designed to go beyond the scope of a financial statement audit. Indeed, forensic audits are typically conducted when there is already reason to suspect wrongdoing or fraud. Some believe that having a separate set of examiners conduct periodic forensic audits would encourage financial statement auditors to take greater responsibility for the detection of fraud and illegal acts when auditing financial statements due to the fact that another set of auditors would be critically evaluating their role. Additionally, forensic audits conceivably could give the audit committees a tool to better evaluate the quality of the financial statement auditors. A possible consequence of the auditor rotation requirement is that some firms may be unable staff the audit engagement team with sufficient partners who are qualified to understand some of the difficult issues that the audit client faces. This may be particularly true in industries where there are specialized transactions, regulatory processes, or accounting principles. Nonetheless, the auditor is required to conduct the audit in accordance with generally accepted auditing standards. In particular, the third general standard requires that the auditor exercise due professional care in the conduct of the audit (see AU 150.02). In order to exercise due professional care, it would be necessary to ensure that the engagement was properly staffed with individuals competent to understand the unique issues relevant to that audit. Additionally, the quality control standards require that the firm have processes in place to ensure that appropriate personnel are assigned to each audit engagement (see QC 20.13).
D. Audit Committee Administration of the EngagementThe proposed rules recognize the critical role played by audit committees in the financial reporting process and the unique position of audit committees in assuring auditor independence. An effective audit committee may enhance the auditor's independence by, among other things, providing a forum apart from management where the auditors may discuss their concerns. It may facilitate communications among the board of directors, management, internal auditors and independent accountants. An audit committee also may enhance auditor independence from management by appointing, compensating and overseeing the work of the independent auditors. The audit committee should approve the engagement of the independent accountant to audit the issuer and its subsidiary's financial statements and have ongoing communications with the accountant. The proposals would require that the audit committee pre-approve all permissible non-audit services and all audit, review or attest engagements required under the securities laws. The proposals require that either:
As provided in the Sarbanes-Oxley Act, the proposed rules recognize audit services to be broader than those services required to perform an audit pursuant to generally accepted auditing standards. For example, the Act identifies services related to the issuance of comfort letters and services related to statutory audits required for insurance companies for purposes of state law as audit services.79 We recognize that domestically and internationally there are various requirements for statutory audits. These proposals contemplate this fact; accordingly, such engagements are viewed as audit services in the context of these proposals. These rules require that the audit committee pre-approve all such services. These proposals do anticipate that the audit committee may approve broadly the provision of audit, review and attest services by the auditor to the issuer and its subsidiaries. The audit committee also would have the sole authority to pre-approve the engagement of the company's independent accountant to expressly perform particular non-audit services. The audit committee also could establish policies and procedures provided they are detailed as to the particular service and designed to safeguard the continued independence of the auditor. Additionally, the Sarbanes-Oxley Act allows for one audit committee member to pre-approve the service. Unlike other issuers, the investment adviser to the investment company issuer will generally engage the issuer's accountant to perform non-auditing services that might impact the accountant's independence. The proposed rule would require pre-approval not only of the non-auditing services provided to the investment company issuer, but also require pre-approval by the investment company issuer's audit committee of the non-auditing services provided to the investment adviser of an investment company issuer and any entity controlling, controlled by, or under common control with the investment adviser that provides services to the investment company. The proposed rule would not, however, require the audit committee of an investment company to approve the auditing or non-auditing services provided: (i) to another investment company registrant within an investment company complex as defined in Rule 2-01(f)(14); (ii) to a sub-adviser that primarily provides portfolio management services and is under the direction of another investment adviser; and (iii) to other entities within the investment company complex that do not provide services to the fund. Under the proposed rule, the investment company's audit committee would be able to establish policies and procedures for pre-approving non-auditing services provided not only to the investment company issuer, but also its investment adviser and related entities that provide services to the fund. The proposed rule would permit, for purposes of determining whether a non-auditing service meets the de minimis exception, the investment company's audit committee to aggregate the total amount of revenues paid to the investment company's accountant by the investment company, its investment adviser and any entity controlling, controlled by, or under common control with the investment adviser that provides services to the investment company. Also, as discussed later in this release, these provisions are supplemented as a result of the proposed proxy disclosure requirements. We believe that disclosure of the procedures the audit committee uses to pre-approve audit services will provide investors valuable information that may be used to evaluate the relationships that exist between the auditor and the audit client.
E. CompensationWe propose to amend the auditor independence rules to address the practice of auditors being compensated by their firms for selling non-audit services to their audit clients. The new rule would provide that an accountant is not independent if, at any point during the audit and professional engagement period,80 any partner, principal or shareholder of the accounting firm who is a member of the audit engagement team earns or receives compensation based on the performance of, or procuring of, engagements with that audit client, to provide any services, other than audit, review, or attest services. Some accounting firms offer their professionals cash bonuses and other financial incentives to sell products or services, other than audit, review, or attest services to audit clients. We view such incentive programs as inconsistent with the independence and objectivity of external auditors that is necessary for them to maintain, both in fact and in appearance. The Commission believes that any partner, principal or shareholder who is a member of the audit engagement team could be influenced adversely as a result of the economic benefits that may be derived by promoting the firm's non-audit services to audit clients. We are concerned that an auditor might be viewed as compromising accounting judgments in order not to jeopardize the potential for increased income from sales of non-audit services. "Compensation," as used in the proposed rule, would include any form of income or monetary benefit distributed to the partner, principal or shareholder. Compensation would be based on the performance or sale of non-audit services if the partner, principal, or shareholder were financially rewarded in any way for the performance or sale of such services. For example, this provision would result in accounting firms removing the sale of non-audit services to a partner's audit clients from the criteria used to allocate partnership "units" to that partner. It also would apply to any other vehicle used in determining compensation for any partner, principal or shareholder who is a member of the engagement team. This provision also reinforces the position that accountants at the partner level should be viewed as skilled professionals and not as conduits for the sale of non-audit services. This proposal recognizes and focuses on the need for independence of the most senior members of the engagement team as well as the accounting firm.
F. Definitions1. AccountantThe term "accountant" currently is defined under the rules of the Commission as a "certified public accountant or public accountant performing services in connection with an engagement for which independence is required."81 The proposed rules add to the definition the phrase a "registered public accounting firm." Under the provisions of the Sarbanes-Oxley Act, public accounting firms must register with the Public Company Accounting Oversight Board (the "Board") in order to prepare or issue, or to participate in the preparation or issuance of any audit report with respect to any issuer.82 Thus, the term "registered public accounting firm" refers to a firm that has registered in accordance with the requirements of the Sarbanes-Oxley Act. Accordingly, the proposals would include registered public accounting firms within the definition of accountants. 2. Accounting RoleUnder the existing rules of the Commission, accounting role and financial reporting oversight role were included as a single definition. However, because the proposed rules that require a cooling-off period relate only to those performing a financial reporting oversight role, the Commission proposes to define separately "accounting role" and "financial reporting oversight role." As proposed, the term "accounting role" refers to a role where a person can or does exercise more than minimal influence over the contents of the accounting records or over any person who prepares the accounting records. All persons in a "financial reporting oversight role" (defined below) are also in an "accounting role." However, persons in an accounting role include individuals in clerical positions responsible for accounting records (e.g., payroll, accounts payable, accounts receivable, purchasing, sales) as well as those who report to individuals in financial reporting oversight roles (e.g., assistant controller, assistant treasurer, manager of internal audit, manager of financial reporting).
3. Financial Reporting Oversight RoleThe term "financial reporting oversight role" refers to a role in which an individual has direct responsibility or oversight of those who prepare the registrant's financial statements and related information (e.g., management discussion and analysis), which will be included in a registrant's document filed with the Commission. As noted above, "accounting role and financial reporting oversight role" previously was one definition. In order to subject the appropriate individuals to certain portions of the proposed rules, we are proposing to bifurcate the definitions.
4. Audit CommitteeSection 205 of the Sarbanes-Oxley Act defines an audit committee as:
The Act further stipulates that if no such committee exists, then the audit committee is the entire board of directors. The Commission proposes to adopt the same meaning for audit committee as used in the Act. The audit committee serves as an important body, serving the interests of investors, to help ensure that the registrant and its auditors fulfill their responsibilities under the securities laws. Because the definition of an audit committee includes the entire board of directors if no such committee of the board exists, these rules do not require registrants to establish audit committees. Some companies do not have boards of directors and therefore do not have audit committees. For example, some limited liability companies and limited partnerships that do not have a corporate general partner may not have an oversight body that is the equivalent of an audit committee. We do not propose to exempt these entities from the proposed requirements. Rather, such issuers should look through each general partner of the limited partnerships acting as general partner until a corporate general partner or an individual general partner is reached. With respect to a corporate general partner, the registrant should look to the audit committee of the corporate general partner or to the full board of directors as fulfilling the role of the audit committee. With respect to an individual general partner, the registrant should look to the individual as fulfilling the role of the audit committee. We do, however, propose to exempt asset-backed issuers83 and unit investment trusts84 from this proposed requirement. Because of the nature of these entities, such issuers are subject to substantially different reporting requirements. Most significantly, asset-backed issuers are not required to file financial statements like other companies. Similarly, unit investment trusts are not required to provide shareholder reports containing audited financial statements. Also, such entities typically are passively managed pools of assets. Therefore, we do not propose to apply the requirements related to audit committees in this release to such entities.
G. Communication with Audit CommitteesSection 204 of the Sarbanes-Oxley Act directs the Commission to issue rules requiring timely reporting of specific information by auditors to audit committees. We are proposing to amend Regulation S-X to require each public accounting firm registered with the Public Company Accounting Oversight Board that audits an issuer's financial statements to report, prior to the filing of such report with the Commission, to the issuer or registered investment company's audit committee: (1) all critical accounting policies and practices used by the issuer or registered investment company, (2) all alternative accounting treatments of financial information within generally accepted accounting principles ("GAAP") that have been discussed with management, including the ramifications of the use of such alternative treatments and disclosures and the treatment preferred by the accounting firm, and (3) other material written communications between the accounting firm and management of the issuer or registered investment company. We believe that this section of the Sarbanes-Oxley Act and these proposed rules largely codify current requirements under Generally Accepted Auditing Standards ("GAAS") for auditors of public companies to discuss matters with management and audit committees. We further believe that specifying the timing of these communications will facilitate more open dialogue between auditors and audit committees. Certain specific oral or written communications with audit committees are currently required by GAAS, including:
Auditors are required under GAAS to provide these communications in a timely manner but not necessarily before the issuance of the audit report.86 Auditors also may communicate with audit committees on matters in addition to those specifically required by AU § 380, including auditing issues, engagement letters, management representation letters, internal controls, auditor independence, and others.
1. Critical Accounting Policies and PracticesWe are proposing rules requiring communication by auditors to audit committees of all critical accounting policies and practices. This communication can be oral or written. In December 2001, we issued cautionary advice regarding each issuer disclosing in the Management's Discussion and Analysis88 Section of its annual report those accounting policies that management believes are most critical to the preparation of the issuer's financial statements.89 The cautionary advice indicated that "critical" accounting policies are those that are both most important to the portrayal of the company's financial condition and results and require management's most difficult, subjective or complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain.90 As part of that cautionary advice, we stated: Prior to finalizing and filing annual reports, audit committees should review the selection, application and disclosure of critical accounting policies. Consistent with auditing standards, audit committees should be apprised of the evaluative criteria used by management in their selection of the accounting principles and methods. Proactive discussions between the audit committee and the company's senior management and auditor about critical accounting policies are appropriate.91 In May 2002, the Commission proposed rules to require disclosures that would enhance investors' understanding of the application of companies' critical accounting policies.92 The May 2002 proposed rules cover (1) accounting estimates a company makes in applying its accounting policies and (2) the initial adoption by a company of an accounting policy that has a material impact on its financial presentation. Under the first part of those proposed rules, a "critical accounting estimate" is defined as an accounting estimate recognized in the financial statements (1) that requires the registrant to make assumptions about matters that are highly uncertain at the time the accounting estimate is made and (2) for which different estimates that the company reasonably could have used in the current period, or changes in the accounting estimate that are reasonably likely to occur from period to period, would have a material impact on the presentation of the registrant's financial condition, changes in financial condition or results of operations. The May 2002 proposed rules outline certain disclosures that a company would be required to make about its critical accounting estimates. In addition, under the second part of the May 2002 proposed rules, a company would be required to make certain disclosures about its initial adoption of accounting policies, including the choices the company had among accounting principles. Auditors may want to read and refer to the December 2001 Cautionary Guidance as well as the May 2002 proposed rules as a guide to determining the types of matters that should be communicated to the audit committee under this proposed rule. We do not propose to require that those discussions follow a specific form or manner, but we expect, at a minimum, that the discussion of critical accounting estimates and the selection of initial accounting policies will include the reasons why certain estimates or policies are or are not considered critical and how current and anticipated future events impact those determinations. In addition, we anticipate that the communications regarding critical accounting policies will include an assessment of management's disclosures along with any significant proposed modifications by the auditors that were not included.
2. Alternative Accounting TreatmentsWe recognize that the complexity of financial transactions results in accounting answers that are often the subject of significant debate between management and the auditors. We believe that these discussions of accounting alternatives that occur between management and the auditors should be shared with the audit committee in their oversight role. The report by the Senate Committee on Banking, Housing, and Urban Affairs on the bill that later became the foundation for the Sarbanes-Oxley Act, in addressing Section 204, stated, in part: The Committee believes that it is important for the audit committee to be aware of key assumptions underlying a company's financial statements and of disagreements that the auditor has with management. The audit committee should be informed in a timely manner of such disagreements, so that it can independently review them and intervene if it chooses to do so in order to assure the integrity of the audit.93 Therefore, we are proposing rules requiring communication, either orally or in writing, by auditors to audit committees of alternative accounting treatments of financial information within GAAP that have been discussed with management, including the ramifications of the use of such alternative treatments and disclosures and the treatment preferred by the accounting firm. This proposed rule is intended to cover recognition, measurement, and disclosure considerations related to the accounting for specific transactions as well as general accounting policies. We believe that communications regarding specific transactions should identify, at a minimum, the underlying facts, financial statement accounts impacted, and applicability of existing corporate accounting policies to the transaction. In addition, if the accounting treatment proposed does not comply with existing corporate accounting policies, or if an existing corporate accounting policy is not applicable, then an explanation of why the existing policy was not appropriate or applicable and the basis for the selection of the alternative policy should be discussed. Regardless of whether the accounting policy selected preexists or is new, the entire range of alternatives available under GAAP that were discussed by management and the auditors would be communicated along with the reasons for not selecting those alternatives. If the accounting treatment selected is not the preferred method in the auditor's opinion, we would expect that the reasons why the auditor's preferred method was not selected by management also would be discussed. Communications regarding general accounting policies would focus on the initial selection of and changes in significant accounting policies, as required by AU § 380, and would include the impact of management's judgments and accounting estimates, as well as the auditor's judgments about the quality of the entity's accounting principles. The discussion of general accounting policies would include the range of alternatives available under GAAP that were discussed by management and the auditors along with the reasons for selecting the chosen policy. If an existing accounting policy is being modified, then the reasons for the change would also be communicated. If the accounting policy selected is not the auditor's preferred policy, then we would expect the discussions to include the reasons why the auditor considered one policy to be preferred but that policy was not selected by management. The separate discussion of critical accounting policies and estimates is not considered a substitute for communications regarding general accounting policies, since the discussion about critical accounting policies and estimates might not encompass any new or changed general accounting policies and estimates. Likewise, this discussion of general accounting policies and estimates is not intended to dilute the communications related to critical accounting policies and estimates, since the issues affecting critical accounting policies and estimates, such as sensitivities of assumptions and others, may be tailored specifically to events in the current year, and the selection of general accounting policies and estimates should consider a broad range of transactions over time.
3. Other Material Written CommunicationsWe understand written communications between auditors and management range from formal documents, such as engagement letters, to informal correspondence, such as administrative items. We also acknowledge that not all forms of written communications provided to management also are provided to the audit committee. The decision whether to provide written communications to the audit committee is subjective and is influenced by auditing standards. Our proposed rule is intended to clarify the substance of information that would be provided by auditors to audit committees to facilitate auditor and management oversight by those committees. We anticipate that the proposed rule would result in auditors and audit committees having more robust discussions of accounting and auditing matters. The Sarbanes-Oxley Act specifically cites the management letter and schedules of unadjusted difference |