The SEC´s New Rules On Auditor Independence Issues For Audit Committees To Consider When Hiring Audit Firms To Perform Non-Audit Services

On February 5, 2001, the Securities and Exchange Commission’s long awaited rules on auditor independence requirements went into effect. The public perception that consulting and other financial services that audit firms provide to their clients affects the professional skepticism required of independent auditors in performing audits and opining upon financial statements, while not the sole reason for the new rules, was a critical factor in the SEC’s decision to adopt the new rules.

Given the increased emphasis on the role of audit committees in monitoring the independence of auditors and maintaining for investors the actual and perceived integrity of audited financial statements, and the duties imposed upon them in recent years with respect to disclosure, the codification by the SEC of factors to consider in determining whether auditor independence is impaired by the performance of non-audit services is useful guidance for both registrants and accountants.

The potential conflicts created by non-audit services on auditor independence has been an area of concern on the part of the SEC, the investor community and other users of financial statements. This concern was compounded in recent years by the dramatic transformation of the accounting industry which led to significant increases in the amounts and types of non-audit services provided by audit firms to their audit clients, as well as to increases in the absolute and relative size of the fees charged for non-audit services. As accounting firms expanded the menu of services offered to their audit clients, companies increasingly turned to their auditors to perform, among other services, their internal audit, pension, tax, legal, financial, administrative, sales, data processing, and marketing functions. The rapid rise in the growth of non-audit services has been perceived by some as increasing the economic incentives for the auditor to preserve a relationship with the audit client, thereby increasing the risk that auditors’ objectivity would be impaired. These developments, combined with the pressures on companies to meet earnings expectations during the most recent bull market, raised significant questions about auditor independence and investor confidence in audited financial statements.

The new rules generally require internal analysis on a case-by-case basis both by audit firms and their clients to determine whether an independence conflict exists. The new rules also revise disclosure obligations for public companies, anticipating that audit committees will consider the potential implications that the provision of services that are subject to disclosure will have on investor confidence in the auditors’ reports.

This article (1) lists matters that an audit committee should consider in assessing the independence of a registrant’s audit firm, (2) highlights the services that the rules identify as creating a conflict, and the exceptions, and (3) summarizes the new disclosure obligations relating to services provided by audit firms.

The SEC expects that audit committees of registrants will continue to have a critical oversight role in maintaining the integrity of the financial reporting process and financial statements. To emphasize this, the SEC stated, in the adopting release for the new rules, that "[w]e believe that audit committees, as well as management, should engage in active discussions of independence-related issues with outside auditors." While the new rules do not expressly impose any new legal requirements on audit committees, the new rules sharpen certain aspects of audit committees’ responsibilities in performing oversight obligations.

The SEC acknowledges that audit committee assessments of the independence of a company’s auditors, and their decisions to hire the company’s auditors to perform non-audit services, are ultimately business judgments. Accordingly, absent special circumstances that would require heightened scrutiny, deference would be given to an audit committee’s conclusions regarding the independence of its auditors.

The SEC’s basic standard for determining whether an auditor is independent is set forth in the rule as a reasonable investor test. In other words, if a reasonable investor with knowledge of all relevant facts and circumstances regarding the audit engagement would conclude that the accountant is not capable of exercising objective and impartial judgments on all issues encompassed within the accountant’s engagement, then the SEC would consider the auditor’s independence with respect to that engagement to be impaired.

In determining whether an independence conflict exists, the SEC states, in a preliminary note to Rule 2-01 of Regulation S-X, that the first factors it would consider are whether the existence of a relationship or provision of a service: (a) creates a mutual or conflicting interest between the accountant and the audit client; (b) places the accountant in the position of auditing his or her work; (c) results in the accountant acting as management or an employee of the client; or (d) places the accountant in a position of being an advocate for a client.

Section (c) of Rule 2-01 includes a non-exclusive list of circumstances that could cause the SEC to find that the auditor’s relationship to an audit client is inconsistent with the independence standards, including (a) financial relationships with the client, (b) employment relationships with the client, (c) business relationships with the client, (d) non-audit services provided to the client, and (e) contingent fee relationships. The SEC concluded that the existence of such relationships could taint an auditor’s independence, but also provided for reasonable exceptions to the general rules. In the preliminary note to the new rules, the SEC also encourages registrants and accounting firms to consult with the SEC’s Office of the Chief Accountant before entering into relationships, including relationships for the provision of services that are not explicitly covered by the rules.

While not exhaustive, the new rules identify specific non-audit services that impair an auditor’s independence. Rule 2-01(c)(4) of Regulation S-X states that an accountant is not independent if, at any time during the audit and professional engagement period, the accountant provides the following non-audit services to an audit client, subject, of course, to the exceptions listed in the rules:

1. Bookkeeping or other services related to the audit client’s accounting records or financial statements, except for:

• emergency/unusual situations, provided no managerial involvement;
• limited, routine, or ministerial services to foreign divisions if:

• other arrangements are impractical;
• not material to the consolidated financial statements;
• client’s employees are not capable or competent to perform the services;
• services are consistent with local professional ethics rules; and
• collective fees for services do not exceed the greater of 1% of consolidated audit fee or $10,000. Rule 2-01(c)(4)(i)(A)-(B).

2. Information systems: directly or indirectly operating, or supervising the operation of, the audit client’s information system or managing the audit client’s local area network, and designing or implementing a hardware or software system that aggregates source data underlying the financial statements or generates information that is significant to the financial statements taken as a whole, unless management:

• acknowledges in writing its responsibility to establish and maintain internal accounting controls;
• designates a competent employee as responsible for all management decisions with respect to design and implementation;
• makes all decisions with respect to the design and implementation including, but not limited to:

• systems to be evaluated and selected

• controls and system procedures to be implemented,

• scope and timetable of system implementation, and
• testing, training, and conversion plans;

• evaluates the adequacy and results of the design and implementation; and
• does not rely on the accountant’s work as primary basis for determining adequacy of its internal controls and financial reporting systems.

An accountant may perform services in connection with the assessment, design, and implementation of internal accounting controls and risk management controls, so long as the auditor does not act as an employee or perform management functions. Rule 2-01(c)(4)(ii).

3. Appraisal or valuation services or fairness opinions where it is reasonably likely that the results of these services, individually or in the aggregate, would be material to the financial statements, or where the results of these services will be audited by the accountant during an audit of the audit client’s financial statements. However, the auditor’s independence will not be impaired when:

• a valuation expert reviews the work of the audit client or a specialist, and the audit client or the specialist provides the primary support for the balances recorded in the financial statements;
• the accounting firm’s actuaries value an audit client’s pension, post-employment benefit or similar liabilities, where the audit client determines and is responsible for all significant assumptions and data;
• the valuation is performed in the context of the planning and implementation of a tax-planning strategy or for tax compliance services; or
• the valuation is for non-financial purposes and does not affect the financial statements. Rule 2-01(c)(4)(iii).

The SEC is permitting a phase-in period for appraisal services which continues through August 5, 2002, during which such services will be evaluated under the standards in existence prior to the effectiveness of the new rules. Rule 2-01(e)(1)(i).

4. Actuarial Services involving the determination of insurance company policy reserves and related accounts for the audit client, unless the audit client uses its own actuaries or third-party actuaries to provide management with the primary actuarial capabilities, management accepts responsibility for any significant actuarial methods and assumptions, and the accountant’s involvement is not continuous. Subject to the foregoing, independence also will not be impaired if the accountant assists management:

• in developing appropriate methods, assumptions, and amounts for policy and loss reserves and other actuarial items presented in financial reports based on the client’s historical experience, current practice, and future plans;
• in converting financial statements from a statutory basis to GAAP;
• by analyzing actuarial considerations and alternatives in federal income tax planning; or
• by assisting management in the financial analysis of matters such as proposed new policies, new markets, business acquisitions, and reinsurance needs. Rule 2-01(c)(4)(iv).

5. Internal audit services excluding operational internal audit services unrelated to the internal accounting controls, financial systems, or financial statements in an amount greater than 40% of the total hours expended on the audit client’s internal audit activities in any one fiscal year, unless the audit client has less than $200 million in total assets. Such services and operational internal audit services will still impair independence unless the audit client’s management:

• acknowledges in writing its responsibility to establish and maintain internal accounting controls;
• designates a competent employee as responsible for the internal audit function;
• determines the scope, risk, and frequency of internal audit activities;
• evaluates the findings and results arising from the internal audit activities;
• evaluates the adequacy of the audit procedures performed and the findings resulting from the performance of those procedures; and
• does not rely on the accountant’s work as the primary basis for determining adequacy of internal controls. Rule 2-01(c)(4)(v).

As it is doing for appraisal services, the SEC is permitting a phase-in period for internal audit services which continues through August 5, 2002, during which such services will continue to be evaluated under the standards in existence prior to the effectiveness of the new rules. Rule 2-01(e)(1)(i).

6. Management services: acting temporarily or permanently as a director, officer, or employee of an audit client, or performing any decision-making, supervisory, or ongoing monitoring function for the audit client. Rule 2-01(c)(4)(vi).

7. Recruiting: assisting in performing recruiting functions such as searching for or seeking out prospective candidates for managerial, executive, or director positions; engaging in psychological testing, or other formal testing or evaluation programs; undertaking reference checks of prospective candidates for an executive or director position; acting as a negotiator on the audit client’s behalf; or recommending, or advising the audit client to hire, a specific candidate for a specific job (except for, upon request by the client, interviewing candidates and advising the client on the candidate’s competence for the position). Rule 2-01(c)(4)(vii).

8. Investment services: acting as a broker-dealer, promoter, or underwriter on behalf of an audit client, making investment decisions on behalf of the audit client or otherwise having discretionary authority over an audit client’s investments, executing a transaction to buy or sell an audit client’s investment, or having custody of assets of the audit client, such as taking temporary possession of securities purchased by the audit client. Rule 2-01(c)(4)(viii).

9. Legal services: providing any service to an audit client under circumstances in which the person providing the service must be admitted to practice before the courts of a United States jurisdiction. Rule 2-01(c)(4)(ix).

The rules also provide that an accountant is not independent if, at any point during the audit and professional engagement period, the accountant provides any service or product to an audit client for a contingent fee or a commission. Rule 2-01(c)(5).

The disclosures that public companies must make regarding the activities of their audit committees became effective on January 31, 2000. These rules included changes to proxy disclosure requirements mandating audit committees to report whether (1) the audit committee has discussed the audited financial statements with management; (2) the audit committee has discussed with the independent auditors the matters required to be discussed by Statement on Auditing Standards No. 61 ("SAS 61"); and (3) the audit committee has received the written disclosures and letter from independent accountants required by Independence Standards Board Standard No. 1 ("ISB No. 1"), and has discussed with the independent accountant its independence.

SAS 61 requires the independent auditor to inform an audit committee as to (1) the auditor’s responsibility in performing an audit in accordance with generally accepted auditing standards; (2) selection of and changes to significant accounting policies; (3) judgments used by management in making accounting estimates, and the auditor’s assessment of those judgments; (4) significant audit adjustments, including booked as well as unbooked adjustments; (5) the auditor’s responsibility for review of other information in documents containing audited financial statements; (6) disagreements with management; (7) management’s consultation with other accountants relating to audit and accounting matters; (8) major issues discussed with management prior to being retained; and (9) difficulties encountered in performing the audit.

ISB No. 1 requires the independent auditor to: disclose, in writing, all relationships between the auditor and its related entities and the registrant that in the auditor’s professional judgment may reasonably bear on the auditor’s independence; confirm, in writing, that in its professional judgment, it is independent within the meaning of the securities laws administered by the SEC; and discuss the auditor’s independence with the audit committee.

Based on the review with the independent auditor described above, the audit committee is required to report whether it has recommended to the full board of directors that the audited financial statements be included in the registrant’s Annual Report on Form 10-K for the last fiscal year for filing with the SEC.

In addition to the changes in the proxy rules that became effective in 2000, the new independence rules that became effective in 2001 require registrants to disclose:

The scope of coverage of the new rules is quite broad, although they relate only to audits of public companies. The restrictions apply to accounting firms and their "associated entities," a term which is not specifically defined in the rules, including associated entities located outside the United States. Rule 2-01(f)(2). With respect to the audit client, the scope of coverage extends to all affiliates of the audit client, which not only includes the standard formulation of entities "controlled by, controlling or under common control with" the audit client, but also includes (1) entities that exert "significant influence" over the audit client, which the adopting release indicates would be presumed at ownership of 20% of the voting equity of an entity, (2) entities over which the audit client exerts "significant influence," subject to materiality considerations, and (3) investment companies and their affiliates, including sponsors, advisers and affiliates exempt from registration under the Investment Company Act of 1940. Rule 2-01(f)(4). Accordingly, the providing of non-audit services to an affiliate of an audit client, even outside of the United States, could impair independence.

Further, the SEC’s adopting release for the new rules is clear that legal services provided outside of the U.S. raise "serious independence concerns" except under circumstances where local law does not preclude such services, and where the services relate to matters that are not material to the consolidated financial statements of an SEC registrant or are routine and ministerial.

While the new rules do not prohibit the continued providing of tax services traditionally provided to audit clients, commentators have noted that the final rules do not address whether providing tax opinions, lobbying for tax law changes or whether representing audit clients before state and local government tax authorities will impair independence, or representing audit clients before the U.S. Tax Court will violate the rules. Presumably the effect that the providing of these services would have on the independence of the relationship between auditor and client should be evaluated on a case by case basis based on the principles set forth in the preliminary notes to the rules, or by consultation with the SEC.

Shades of gray will always exist in the assessment of independence. The SEC’s articulation of services that create conflicts, and its willingness to participate in the determination of whether conflicts will be created in other circumstances, indicate that the SEC considers the issue of whether auditors are able to function independently of their economic interests or could be overwhelmed by them to be a critical element in the auditing process.

This information has been prepared by Schulte Roth & Zabel LLP ("SRZ") for general informational purposes only, it does not constitute legal advice, and is presented without any representation or warranty as to its accuracy, completeness or timeliness.

Transmission or receipt of this information does not create an attorney-client relationship with SRZ. Electronic mail or other communications with SRZ cannot be guaranteed to be confidential and will not (without SRZ agreement) create an attorney-client relationship with SRZ. Parties seeking advice should consult with legal counsel familiar with their particular circumstances.

Links to other sites are for your convenience only and SRZ does not take any responsibility for those sites, nor does SRZ make any representation or warranty whatsoever with respect to those sites. Under the rules or regulations of some jurisdictions this material may constitute advertising.

© 2001 Schulte Roth & Zabel LLP