[Federal Register: December 13, 2002 (Volume 67, Number 240)]
[Proposed Rules]
[Page 76779-76817]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr13de02-21]
[[Page 76779]]
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Part II
Securities and Exchange Commission
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17 CFR Parts 210, 240, 249, and 274
Strengthening the Commission's Requirements Regarding Auditor
Independence; Proposed Rule
[[Page 76780]]
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SECURITIES AND EXCHANGE COMMISSION
17 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-AI73
Strengthening the Commission's Requirements Regarding Auditor
Independence
AGENCY: Securities and Exchange Commission.
ACTION: Proposed rule.
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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: Revise the
Commission's regulations related to the non-audit services that, if
provided to an audit client, would impair an accounting firm's
independence; define the circumstances whereby an issuer's audit
committee can and should pre-approve all audit and allowable non-audit
services provided to the issuer by the auditor of an issuer's financial
statements; prohibit partners on the audit engagement team from
providing audit services to the issuer for more than five consecutive
years; prohibit an accounting firm from auditing an issuer's financial
statements if certain members of management of that issuer had been
members of the accounting firm's audit engagement team within the one-
year period preceding the commencement of audit procedures; and require
that the auditor of an issuer's financial statements report certain
matters to the issuer's audit committee, including ``critical''
accounting policies used by the issuer.
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 on or before 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 (http://www.sec.gov
). 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-X \1\ 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-F \4\ and to amend proposed form N-CSR.\5\
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\1\ 17 CFR 210.2-07.
\2\ 17 CFR 210.2-01.
\3\ 17 CFR 240.14a-101.
\4\ 17 CFR 249.310; 17 CFR 249.310b; 17 CFR 249.220f; 17 CFR
249.240f.
\5\ 17 CFR 249.331; 17 CFR 274.128.
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I. Introduction and Background
On 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.
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\6\ Pub. L. 107-204, 116 Stat. 745 (2002).
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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.
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\7\ Consistent with the Commission's existing independence
rules, these proposals would apply to foreign audit firms as well as
firms domiciled in the United States. Additionally, these proposals
coupled with the Commission's existing independence rules are
proposed with the Principles of Auditor Independence and the Role of
Corporate Governance in Monitoring an Auditor's Independence issued
by the International Organization of Securities Commissions (IOSCO)
in October 2002 in mind.
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Title II of the Sarbanes-Oxley Act adds new subsections (g) through
(l) to section 10A of the Securities Exchange Act of 1934 as follows:
[sbull] Section 201 adds subsection (g), which specifies that a
number of non-audit services are prohibited. Many of these services
were previously prohibited by the Commission's independence standards
adopted in November 2000 (with some exceptions and qualifications).\8\
These proposed rules amend the Commission's existing rules on auditor
independence and clarify the meaning and scope of the prohibited
services under the Sarbanes-Oxley Act.
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\8\ The Commission adopted a comprehensive set of rules
governing auditor independence on November 21, 2000. See Release No.
33-7919 (Nov. 21, 2000); 65 FR 76008 (Dec. 5, 2000) (hereinafter
``November 2000 release'').
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[sbull] Section 201 also adds subsection (h) and requires that non-
audit services that are not prohibited under the Sarbanes-Oxley Act and
the Commission's rules be subject to pre-approval by the registrant's
audit committee. These proposed rules specify the requirements
[[Page 76781]]
for obtaining such pre-approval from the registrant's audit committee.
[sbull] Section 202 adds subsection (i), which requires an audit
committee to pre-approve allowable non-audit services and specifies
certain exceptions to the requirement to obtain pre-approval. These
proposed rules specify the requirements of the registrant's audit
committee for pre-approving non-audit services by the auditor of the
registrant's financial statements.
[sbull] Section 203 adds subsection (j), which establishes
mandatory rotation of the engagement partner, and the reviewing (or
``concurring'') partner every five years. These proposed rules expand
the number of engagement personnel covered by the rotation requirement
and clarify the ``time out'' period.
[sbull] Section 204 adds subsection (k), which requires that the
auditor report on a timely basis certain information to the audit
committee. In particular, the Sarbanes-Oxley Act requires that the
auditor report to the audit committee on a timely basis (a) all
critical accounting policies used by the registrant, (b) alternative
accounting treatments that have been discussed with management along
with the potential ramifications of using those alternatives, and (c)
other written communications provided by the auditor to management,
including a schedule of unadjusted audit differences.\9\ These proposed
rules strengthen the relationship between the audit committee and the
auditor.
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\9\ Statement on Auditing Standards No. 89, ``Audit
Adjustments,'' (Dec. 1999).
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[sbull] Section 206 adds subsection (l) addressing certain conflict
of interest provisions. The Sarbanes-Oxley Act prohibits an accounting
firm from performing audit services for a registrant if certain key
members of management have recently been employed in an audit capacity
by the audit firm. These proposed rules clarify which members of
management are covered by these conflict of interest rules.
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\
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\10\ The Commission's proposals respond not only to the
provisions of the Sarbanes-Oxley Act but also the rulemaking
petitions filed by the AFL-CIO on December 11, 2001, and The
Honorable H. Carl McCall on January 21, 2002. Both petitions are
available on the Commission's Web site (http://www.sec.gov).
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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 Rules
A. Conflicts of Interest Resulting From Employment Relationships
The 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 firm \11\
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\
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\11\ The terms accounting firm and accountant are used
interchangeably in this proposing release. The term ``accountant''
is defined in 210.2-01(f) below.
\12\ 17 CFR 210.2-01(c)(2)(iii)(A).
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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:
* * * [i]f a chief executive officer, controller, chief financial
officer, chief accounting officer, or any person serving in an
equivalent position for the issuer, was employed by that registered
independent public accounting firm and participated in any capacity
in the audit of that issuer during the 1-year period preceding the
date of the initiation of the audit.\13\ (Emphasis added.)
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\13\ See section 206 of the Sarbanes-Oxley Act.
Consistent with that directive, we propose that the employment of
audit engagement team \14\ 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\
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\14\ 17 CFR 210.2-01(f)(7).
\15\ 17 CFR 210.2-01(f)(6).
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As discussed later in this release, the term ``financial reporting
oversight role'' refers to any individual who has direct responsibility
for oversight over those
[[Page 76782]]
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:
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\16\ The Independence Standards Board was a private sector body
that, from 1997 to 2001, was charged with the responsibility to set
auditor independence standards for auditors of the financial
statements of SEC registrants. See Financial Reporting Release Nos.
50 (February 18, 1998) and 50A (July 17, 2001).
\17\ Independence Standards Board, ``Employment with Audit
Clients,'' Discussion Memorandum 99-1 (March 12, 1999).
An audit firm's independence is impaired with respect to an
audit client that employs a former firm professional who could, by
reason of his or her knowledge of and relationships with the audit
firm, adversely influence the quality or effectiveness of the audit,
unless the firm has taken steps that effectively eliminate such
risk.\18\
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\18\ Independence Standards Board, ``Employment with Audit
Clients,'' Standard No. 3 (July 2000).
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.
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\19\ Id., ]2(b)(iii).
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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 February 19, 2002), 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\
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\20\ Considerations necessary to plan an audit engagement are
discussed in SAS Nos. 22, ``Planning and Supervision'' (AU Sec.
311), 47, ``Audit Risk and Materiality in Conducting an Audit''
(AUSec. 312), 48, ``The Effects of Computer Processing on the Audit
of Financial Statements'' (AU Sec. Sec. 311, 326), 54, ``Illegal
Acts by Clients'' (AU Sec. 317), 55, ``Consideration of Internal
Control in a Financial Statement Audit'' (AU Sec. 319), 56,
``Analytical Procedures'' (AU Sec. 329), 65, ``The Auditor's
Consideration of the Internal Audit Function in an Audit of
Financial Statements'' (AU Sec. 322), 70, ``Service Organizations''
(AU Sec. 324), 73, ``Using the Work of a Specialist'' (AU Sec.
336), 78, ``Consideration of Internal Control in a Financial
Statement Audit'' (AU Sec. 319), 82, ``Consideration of Fraud in a
Financial Statement Audit'' (AU Sec. 312), 83, ``Establishing an
Understanding With the Client'' (AU Sec. 310), 84, ``Communications
Between Predecessor and Successor Auditors'' (AU Sec. 315), 89,
``Audit Adjustments'' (AU Sec. 310), and 94, ``The Effect of
Information Technology on the Auditor's Consideration of Internal
Control in a Financial Statement Audit'' (AU Sec. 319) as well as
amendments to these documents.
\21\ SAS No. 71, ``Interim Financial Information'' (AU Sec.
722). In November 2002, the Auditing Standards Board issued SAS No.
100, ``Interim Financial Information.'' SAS No. 100 supercedes SAS
No. 71 and is effective for interim periods within fiscal years
beginning after December 15, 2002.
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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.
[sbull] Is the one-year cooling-off period sufficiently long to
achieve an appearance of independence by the accounting firm? If not,
what period would be appropriate?
[sbull] Is the term audit engagement team sufficiently clear? If
not, what changes would improve the description to describe the group
of accountants who would be covered?
[sbull] Is the phrase commencement of the audit sufficiently clear?
If not, what changes would improve the description? Is that the
appropriate time to mark the commencement of the period? Is there a
better mark?
[sbull] Is the phrase commencement of review procedures
sufficiently clear? If not, what changes would improve the description?
[sbull] Is it appropriate that the cooling-off period provisions
apply to employment relationships involving audit engagement team
members and their audit clients? Should the requirements be limited to
audit clients who are issuers as defined in section 205 of the Act?
[sbull] Are the appropriate officers covered by the proposed rule?
If not, which additional individuals should be subject to the cooling-
off period provision? For example, should national office personnel who
would be excluded under the proposal be included?
[sbull] Should the proposed rules apply equally to large firms/
companies as small firms/companies? Would the proposed rules impose a
cost on smaller issuers that is disproportionate to the benefits that
would be achieved? Why or why not? Should there be an exemption to this
requirement for smaller businesses?
[sbull] The ``cooling off'' period applies to all entities in the
investment company complex. Is this too broad? Why or why not?
[sbull] Should the Commission include exceptions subject to certain
criteria? If so, what should these criteria be?
B. Services Outside the Scope of the Practice of Auditors
Section 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:
[sbull] Bookkeeping or other services related to the accounting
records or financial statements of the audit client;
[[Page 76783]]
[sbull] Financial information systems design and implementation;
[sbull] Appraisal or valuation services, fairness opinions, or
contribution-in-kind reports;
[sbull] Actuarial services;
[sbull] Internal audit outsourcing services;
[sbull] Management functions or human resources;
[sbull] Broker or dealer, investment adviser, or investment banking
services;
[sbull] Legal services and expert services unrelated to the audit;
and
[sbull] Any other service that the Board \22\ determines, by
regulation, is impermissible.
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\22\ As used in this section of the Act, the term Board refers
to the Public Company Accounting Oversight Board.
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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.''
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\23\ Id.
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The Senate Report on the bill that was the primary foundation for
the Act,\24\ states, in part:
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\24\ Report of the Senate Comm. on Banking, Housing, and Urban
Affairs to Accompany S. 2673, Public Company Accounting Reform and
Investor Protection Act of 2002, S. Report 107-205, 107th Cong., 2d
Sess. (July 3, 2002).
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\
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\25\ Id. at 18.
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
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auditor independence provisions in the bill and stated, in part:
What has happened in recent years is that the fees earned from
the consulting work have dwarfed the fees earned from the auditors,
which inevitably leads to concerns that punches be pulled on the
audit to accommodate the significant and remunerative involvement on
the consulting side. Certain enumerated consulting practices are
therefore not allowed, with the exception that a case-by-case
exemption can be obtained from the oversight board that this
legislation establishes.* * *
Senator Gramm has suggested that the conference report should be
changed to give the SEC or the Oversight Board authority to grant
broad categorical exemptions from the list of non-audit services
that section 201 of the bill prohibits registered public accounting
firms to provide to public company audit clients. Such a change, in
my view, would weaken one of the fundamental objectives of the
conference report: to draw a bright 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.
This list is based on a set of simple principles:
A public company auditor, in order to be independent, should not
audit its own work (as it would if it provided internal audit
outsourcing services, financial information systems design,
appraisal or valuation services, actuarial services, or bookkeeping
services to an audit client).
A public company auditor should not function as part of
management or as an employee of the audit client (as it would if it
provided human resources services such as recruiting, hiring, and
designing compensation packages for the officers, directors, and
managers of an audit client).
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).
A public company auditor should not be a promoter of the
company's stock or other financial interests (as it would be if it
served as a broker-dealer, investment adviser, or investment banker
for the company).
The exemptive authority provided to the Board is intentionally
narrow to apply to individual cases where the application of the
statutory requirement would impose some extraordinary hardship or
circumstance that would merit an exemption consistent with the
protection of the public interest and the protection of investors.
But the fundamental presumption of the provision is that these non-
audit services, by their very nature, present a conflict of interest
for an accounting firm if provided to a public company audit
client.* * *
The conference report chose not to follow the approach of
imposing a complete prohibition on the provision of non-audit
services to audit clients. Instead it chose the approach of
identifying the non-audit services which by their very nature pose a
conflict of interest and should be prohibited.* * *
In my view granting broad exemption authority to the Oversight
Board or the SEC to permit these non-audit services would undermine
the separation the conference report is intended to establish.\26\
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\26\ 148 Cong. Rec. S7351 and S7364 (July 25, 2002).
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(Emphasis added.)
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-X \27\ 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.
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\27\ See Release No. 33-7870 (June 30, 2000), proposed rules 2-
01(b)(1)-(4), and preliminary note to rule 2-01 of Regulation S-X,
17 CFR 210.2-01. As stated in the preliminary note, in making
independence determinations ``the Commission looks in the first
instance to whether a relationship or the 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 own work; (c) results in the accountant acting
as management or an employee of the audit client; or (d) places the
accountant in the position of being an advocate for the audit
client.''
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The Commission had proposed more restrictive independence rules in
June 2000.\28\ In the period between
[[Page 76784]]
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.
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\28\ Release No. 33-7870 (June 30, 2000); 65 FR 43148 (July 12,
2000).
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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\
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\29\ These principles are similar to those that the Commission
proposed in June 2000 as part of the auditor independence rules and
subsequently adopted as a preliminary note to those rules. See
Release No. 33-7870 (June 30, 2000), proposed rules 2-01(b)(1)-(4),
and preliminary note to rule 2-01 of Regulation S-X, 17 CFR 210.2-
01. As stated in the preliminary note, in making independence
determinations ``the Commission looks in the first instance to
whether a relationship or the 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 own work; (c) results in the accountant acting as management or
an employee of the audit client; or (d) places the accountant in the
position of being an advocate for the audit client.''
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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.
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\30\ Audit client is a term defined generally in Sec. 2-
01(f)(6) of Regulation S-X, as the entity whose financial statements
or other information is being audited and any affiliates of the
audit client. Affiliates of the audit client, as defined in Sec. 2-
01(f)(4), are entities that have control relationships or other
significant influence relationships with the audit client, which in
the case of registered investment companies includes all entities in
the investment company complex, as defined under Sec. 2-01(f)(14).
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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.
[sbull] Are there other non-audit services that are incompatible
with rule 2-01(b) or that raise independence concerns? If so, what are
they, and why do they raise independence concerns?
[sbull] Is the meaning of the general principles sufficiently
clear?
1. Bookkeeping or Other Services Related to the Audit Client's
Accounting Records or Financial Statements of the Audit Client
Currently, 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.
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\31\ 17 CFR 210.2-01(c)(4)(i).
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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\
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\32\ Letter of Samuel L. Burke, Associate Chief Accountant, SEC,
to Florida Institute of Certified Public Accountants re: bookkeeping
(March 4, 2002).
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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
[[Page 76785]]
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.
[sbull] Should the definition of bookkeeping be further clarified?
If so, how?
[sbull] Does the definition cover all the bookkeeping services that
would impair an accountant's independence?
[sbull] Should an auditor be permitted to provide bookkeeping
services to an audit client if it is not reasonably likely that the
results of those services will be subject to audit procedures during
the audit of the client's financial statements? Why or why not?
[sbull] Is the standard of reasonably likely sufficiently clear? If
not, should we use some other standard? If so, what standard should we
use?
[sbull] Is the phrase ``preparing statutory statements which form
the basis of U.S. GAAP statements'' sufficiently clear? If not, how
might the phrase be revised?
2. Financial Information Systems Design and Implementation
Currently, 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.
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\33\ 17 CFR 210.2-01(c)(4)(ii).
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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.
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\34\ See Section 404(b) of the Sarbanes-Oxley Act.
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[sbull] Is an auditor's independence impaired when the auditor
helps select or test computer software and hardware systems that
generate financial data used in or underlying the financial statements?
Why or why not?
[sbull] Whether a system is used to generate information that is
``significant'' to the audit client's financial statements may depend
on the size of the engagement. Does the magnitude as a percentage of
either audit fees or total fees of the fees for such services make a
difference on whether performance of the service impairs independence?
3. Appraisal or Valuation Services, Fairness Opinions, or Contribution-
in-Kind Reports
Under 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.
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\35\ Current exemptions include: (1) Firm's valuation expert can
review the work of a client's specialist; (2) firm's actuaries can
value a client's pension or other post-retirement benefit obligation
provided that the client assumes responsibility for significant
assumptions; (3) valuations performed for planning and implementing
tax-planning strategies; and (4) valuations for non-financial
purposes which do not affect the financial statements.
\36\ Contribution-in-kind reports in certain foreign countries
require the auditor to express an opinion on the fairness of the
transaction, the value of a security, or the adequacy of
consideration to shareholders.
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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
[[Page 76786]]
the accuracy of that valuation or appraisal.
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\37\ As discussed in the preliminary note to rule 2-01, the
Commission considers the impact on the auditor's independence of
situations where the auditor has a mutuality of interest with its
auditor client. This concept was not included in the legislation.
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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.
[sbull] Does providing valuation or appraisal services that are
unrelated to the financial statements, such as for certain regulatory
purposes, impair an accountant's independence?
[sbull] Does providing valuation or appraisal services for tax
purposes impair an accountant's independence?
[sbull] Are there certain types of appraisal or valuation services,
or certain instances in which they are provided, that do not raise
auditor independence concerns? Are there circumstances in which an
accounting firm may be required by law or regulation to provide such
services, either in the United States or abroad?
[sbull] Should we provide an exemption for such services provided
to a foreign private issuer by its accountant where local law requires
such services (e.g. contribution in-kind reports)?
[sbull] The Commission staff, when providing interpretations of the
application of the auditor independence rules to contribution in-kind
reports, has worked with foreign jurisdictions to accommodate the
statutory requirements in those jurisdictions.\38\ Should the
Commission's rules provide that similar practices or arrangements be
permitted where contribution in-kind reports are required by foreign
statute?
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\38\ Letter of Lynn Turner, Chief Accountant, SEC, to
Commissione Nazionale per la Societa Sonieta e la Borsa re:
statutory procedures (August 24, 2000).
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4. Actuarial Services
The 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.
[sbull] Are there certain circumstances under which an accountant
can provide actuarial services to an audit client without impairing
independence?
[sbull] Have we appropriately described the actuarial services
prohibited by the Act?
5. Internal Audit Outsourcing
Our 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\
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\39\ See Committee of Sponsoring Organizations of the Treadway
Commission (COSO), Internal Control--Integrated Framework, at 7
(1992) (the ``COSO Report'').
\40\ See SAS No. 65, ``The Auditor's Consideration of the
Internal Audit Function in an Audit of Financial Statements,''
AUSec. 322.
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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.
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\41\ AICPA SAS No. 55, AU Sec. 319 (effective for audits on or
after January 1, 1990).
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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.
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\42\ See Release No. 33-7919.
\43\ 17 CFR 2-01(c)(4)(v) currently includes a $200 million
threshold.
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[sbull] Is the definition of the ``internal audit function''
sufficiently clear?
[sbull] We solicit comment on whether an exception should be
provided for small
[[Page 76787]]
businesses. If so, what criteria should we consider in providing such
an exception?
[sbull] Does it impair an auditor's independence if the auditor
does not provide to the client outsourcing services related to the
internal audit function of the audit client, but rather performs
individual audit projects for the client?
[sbull] Are there safeguards that can be established by the auditor
that would allow the audit client to outsource the internal audit
function to the auditor without impairing its independence?
[sbull] Would it impair the auditor's independence if the auditor
performs only operational audits that are unrelated to the internal
controls, financial systems, or financial statements?
[sbull] Is additional guidance necessary to distinguish the
services that would be prohibited under this proposed rule from those
services that would be permitted as operational audits?
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\
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\44\ 17 CFR 210.2-01(c)(4)(vi).
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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.
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\45\ AU 319, ``Consideration of Internal Control in a Financial
Statement Audit.'' In addition, section 404(b) of the Act requires a
company's audit to attest to the internal control report provided
annually by management.
\46\ AU 325, ``Communication of Internal Control Related Matters
Noted in an Audit,'' requires the auditor to communicate reportable
conditions and material weaknesses in internal control to the
company's audit committee or equivalent.
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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.
[sbull] Do services related to designing or implementing internal
accounting controls and risk management controls result in the auditor
auditing his or her own work? Would such services impair an auditor's
independence when the auditor is required to issue an opinion on the
effectiveness of the control systems that he or she designed or
implemented?
[sbull] Do services related to assessing or recommending
improvements to internal accounting controls and risk management
controls result in the auditor auditing his or her own work? Would such
services impair an auditor's independence when the auditor is required
to issue an attestation report on the effectiveness of the control
systems that he or she has assessed or evaluated for effectiveness?
[sbull] We request comment on whether there are circumstances under
which an accounting firm can perform or assume management functions or
responsibilities for an audit client without impairing independence?
7. Human Resources
Our 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.
[sbull] Are there additional types of human resource and employee
benefit services that impair an auditor's independence?
[sbull] Would an auditor's independence be impaired if the auditor
provided personnel hiring assistance for only non-executive or non-
financial personnel?
[[Page 76788]]
[sbull] Does it impair an auditor's independence if the auditor
provides consultation with respect to the compensation arrangements of
the company's executives?
8. Broker-Dealer, Investment Adviser Or Investment Banking Services
Our 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-
dealer \48\ 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.
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\47\ These proposed rules are not meant to change the
Commission's current position that an audit firm's broker-dealer
division can cover an industry which includes an audit client when
performing analyst functions. However, analysis of a specific audit
client's stock places the auditor in the position of acting as an
advocate for the client and would cause the auditor to lack
independence.
\48\ Accountants and the companies that retain them should
recognize that the key determination required here is a functional
one (i.e., is the accounting firm or its employee acting as a
broker-dealer?). The failure to register as a broker-dealer does not
necessarily mean that the accounting firm is not a broker-dealer. In
relevant part, the statutory definition of ``broker'' captures
persons ``engaged in the business of effecting transactions in
securities for the account of others.'' Securities Exchange Act of
1934 Sec. 3(a)(4). Unregistered persons who provide services
related to mergers and acquisitions or other securities-related
transactions should limit their activities so they remain outside of
that statutory definition. A person may ``effect transactions,''
among other ways, by assisting an issuer to structure prospective
securities transactions, by helping an issuer to identify potential
purchasers of securities, or by soliciting securities transactions.
A person may be ``engaged in the business,'' among other ways, by
receiving transaction-related compensation or by holding itself out
as a broker-dealer. Involvement of accounting personnel as
unregistered broker-dealers not only can impair auditor
independence, but also would violate section 15(a) of the Exchange
Act.
\49\ 17 CFR 210.2-01(c)(4)(viii) and Release No. 33-7919, at
Section D.
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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 financialstatements, 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.
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\50\ Floor Statement of Senator Sarbanes, 148 Cong. Rec. S7364
(July 25, 2002) ``. * * * A public company auditor should not be a
promoter of the company's stock or other financial interest (as it
would be if it served as broker-dealer, investment adviser, or
investment banker for the company).''
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Broker-dealers \51\ 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.
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\51\ In the past, some have expressed concern that terms such as
``securities professional'' and ``analyst'' are not defined in the
securities laws and use of the terms could cause confusion. Because
of that concern, we have not used those terms in these proposed
rules. We note, however, that broker-dealers provide an array of
services that may include certain analyst activities.
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[sbull] We solicit comment on the scope of the proposal. Are there
other securities professional services that the rule should expressly
identify as impairing independence?
[sbull] Would an auditor's independence be impaired if the auditor
acted as a securities analyst covering the sector or industry of an
audit client?
[sbull] Should we adopt rules that would clarify when the auditor
is acting as an unregistered broker-dealer? If so, what should those
rules be?
9. Legal Services
Our 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\
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\52\ See, e.g., D.C. Rules of Professional Conduct, rule 1.3(a).
\53\ Id. at rule 1.5.
\54\ In the Matter of Charles Falk, AAER No. 1134 (May 19, 1999)
(formally disciplining an attorney/accountant who gave legal advice
to an audit client of another partner in his accounting firm).
\55\ United States v. Arthur Young, 465 U.S 805 (1984) at 819-20
n.15.
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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.
[sbull] Are there any particular legal services that should be
exempted from the rule?
[sbull] Would making the rule's application depend upon the
jurisdiction in which the service is provided leave the rule subject to
any
[[Page 76789]]
significant uncertainty, or pose the prospect of any significant
complexity or unfairness?
[sbull] Should there be any exception for legal services provided
in foreign jurisdictions? For example, in some countries only a law
firm may provide tax services. Should a foreign accounting firm be
permitted to provide, through an affiliated law firm, tax or other
services that a U.S. accounting firm could provide to a U.S. audit
client without impairing the firm's independence? Why or why not?
[sbull] Should there be an exception for legal services provided to
issuers in foreign jurisdictions? Should any such exception be tailored
to avoid undermining the purpose of the restriction? For example, could
fees for legal services be limited to a small percentage (e.g., 5% or
10%) of the amount of fees for audit services? Could partners providing
audit services be prohibited from being involved in the provision of
legal services or from receiving compensation based on such services?
[sbull] Should any such exception have a ``sunset'' provision that
would both allow foreign private issuers a transition period and allow
the Commission to review the situation regarding legal services?
10. Expert Services
Our 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.
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\56\ See Floor Statement of Senator Sarbanes, 148 Cong. Rec.
S7364 (July 25, 2002).
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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.
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\57\ See, e.g., D.C. Rules of Professional Conduct, rule 1.3(a)
and 1.5.
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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.
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\58\ For example, section 301 of the Act stipulates that each
audit committee shall have the authority to engage independent
counsel and other advisers, as it determines necessary to carry out
its duties.
\59\ In October 2001, we set forth some of the criteria that we
considered important to assessing whether to credit self-policing,
self-reporting, remediation and cooperation in SEC enforcement
investigations. One of the criteria we identified related to whether
the company had undertaken a thorough review of the conduct at
issue:
10. Did the company commit to learn the truth, fully and
expeditiously? Did it do a thorough review of the nature, extent,
origins and consequences of the conduct and related behavior? Did
management, the Board or committees consisting solely of outside
directors oversee the review? Did company employees or outside
persons perform the review? If outside persons, had they done other
work for the company? Where the review was conducted by outside
counsel, had management previously engaged such counsel? Were scope
limitations placed on the review? If so, what were they?
Report of Investigation Pursuant to Section 21(a) of the
Securities Exchange Act of 1934 and Commission Statement on the
Relationship of Cooperation to Agency Enforcement Decisions,
Accounting and Auditing Enforcement Release (``AAER'') No. 1470
(Oct. 23, 2001).
Depending on the conduct at issue, it may be necessary for a
company to engage an accountant to conduct a forensic accounting
review or audit. While our proposal does not set forth independence
requirements for forensic consultants, consistent with the
principles we set forth in October 2001, we will consider the
objectivity of the forensic accountant as to the issues being
investigated in assessing whether to credit the forensic work.
\60\ An auditor's independence would, however, be impaired if
its assistance to the audit committee included defending, or helping
to defend, the audit committee or the company generally in a
shareholder class action or derivative lawsuit, other than as a fact
witness.
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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
[[Page 76790]]
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.
[sbull] Are there circumstances in which providing audit clients
with expert services in legal, administrative, or regulatory filings or
proceedings should not be deemed to impair independence?
[sbull] Should an auditor be permitted to serve as a non-testifying
expert for an audit client in connection with a proceeding?
[sbull] Is the definition of prohibited expert services
appropriate? Why or why not?
[sbull] Is the distinction between advocacy and providing
appropriate assistance to an audit committee sufficiently clear?
11. Tax Services
Section 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:
A registered public accounting firm may engage in any non-audit
service, including tax services, that is not described in any of
paragraphs (1) through (9) of subsection (g) for an audit client,
only if the activity is approved in advance by the audit committee
of the issuer.\61\ (Emphasis added.)
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\61\ Sarbanes-Oxley Act of 2002, section 201.
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 rules \62\ 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.
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\62\ Release Nos. 33-7870, ``Revision of the Commission's
Auditor Independence Requirements,'' (June 30, 2000) (65 FR 43148).
\63\ Id.
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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.
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\64\ These principles are similar to the four governing
principles included in the preliminary note to the Commission's
current independence rules. The four governing principles are
whether the accountant: (1) Has a mutual or conflicting interest
with the audit client, (2) audits his or her firm's own work, (3)
functions as management or an employee of the audit client, or (4)
acts as an advocate for the audit client.
\65\ U.S. v KPMG LLP (July 9, 2002) and U.S. v BDO Seidman (July
9, 2002).
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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.
[sbull] We request comment on whether providing tax opinions,
including tax opinions for tax shelters, to an audit client or an
affiliate of an audit client under the circumstances described above
would impair, or would appear to reasonable investors to impair, an
auditor's independence.
[sbull] Are there tax services that should be prohibited by the
Commission's independence rules?
[sbull] Is it meaningful to categorize tax services into permitted
and disallowed activities? If so, what categories and related
definitions would make the demarcation meaningful?
C. Partner Rotation
Section 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:
It shall be unlawful for a registered public accounting firm to
provide audit services to an issuer if the lead (or coordinating)
audit partner (having primary responsibility for the audit), or the
audit partner responsible for reviewing the audit, has performed
audit services for that issuer in each of the 5 previous fiscal
years of that issuer.
The concept of audit partner \66\ 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\
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\66\ For purposes of this portion of the release, the term
partner refers to an individual who is a proprietor, partner,
principal, or shareholder of the accounting firm.
\67\ American Institute of Certified Public Accountants (AICPA),
SEC Practice Section, Requirements of Members, at item e. The
membership requirements are available online at http://www.aicpa.org/members/div/secps/require.htm.
Audit firms which are
members of the SEC Practice Section must comply with its rules
(e.g., partner rotation) and undergo periodic peer review to ensure
that the firms' audit practice is consistent with both the rules of
the AICPA and those of the Commission.
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[[Page 76791]]
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.
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\68\ Id.
\69\ The current SECPS membership requirements stipulate that
the audit engagement partner be rotated every seven years except
that firms with less five SEC audit clients and less than ten
partners are exempted. The existing SECPS membership requirements
also do not require that the concurring partner be rotated.
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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 team \70\ 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.
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\70\ 17 CFR 210.2-01(f)(7).
\71\ For purposes of this requirement, references to partner
include principals, shareholders and other positions with equivalent
responsibility.
\72\ Under these proposals, we believe that those partners who
are involved on a continuous basis in the audit of material balances
in the financial statements would be subject to the rotation
requirements of this proposal. For example, an actuarial specialist
who assists in auditing the loss reserves for an insurance company
would be subject to the rotation requirement.
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Since most registrants are taxable entities, an assessment of the
registrant's tax provision accounted for in accordance with GAAP \73\
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.
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\73\ Statement of Financial Accounting Standards No. 109,
``Accounting for Income Taxes'' (Feb 1992).
\74\ These services would, of course, be subject to the audit
committee pre-approval requirements specified in section 202 of the
Sarbanes-Oxley Act and the accompanying rules proposed in this
release.
\75\ See the discussion in part B.11 of this release, supra.
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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.
---------------------------------------------------------------------------
\76\ 17 CFR 210.2-01(f)(7).
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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
[[Page 76792]]
information as well as the engagement team that conducts the attest
engagement on management's report on the registrant's internal
controls.
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\77\ See Codification of Statements on Auditing Standards
AUSec. 722.
\78\ Release No. 33-8138 (Oct. 22, 2002) (67 FR 66208).
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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).
[sbull] Should the Commission adopt rules requiring that issuers
engage forensic auditors periodically to evaluate the work of the
financial statement auditors? If so, how often should the forensic
auditors be engaged? What should be the scope of the forensic auditors'
work? Would doing so obviate the need to require partner rotation for
the audit firm? Alternatively, could the company obtain the necessary
expertise by engaging other outside consultants? If so, what type of
consultants should it engage?
[sbull] Would the establishment of rules requiring companies to
engage forensic auditors periodically provide an opportunity to other
firms to enter the market to provide these services?
[sbull] Should the Commission establish requirements for firms
conducting forensic audits? If so, what should those requirements be?
[sbull] Should issuers be given a choice between engaging forensic
auditors periodically and having the audit partners on their engagement
team be subject to the rotation requirements? Why or why not?
[sbull] What are the costs and benefits of engaging forensic
auditors to evaluate the work of the financial statement audit firm?
[sbull] This proposed rule would apply to the audits of the
financial statements of ``issuers.'' Should the Commission consider
applying this rule to a broader population such as audits of the
financial statements of ``audit clients'' as defined in 2-01(f)(6) of
Regulation S-X? Why or why not?
[sbull] For organizations other than investment companies, the
rotation requirements would apply to significant subsidiaries of
issuers. Should a different approach be considered? Is so, what
approach would be appropriate?
[sbull] Should the rotation requirements apply to all partners on
the audit engagement team? If not, which partners should be subject to
the requirements?
[sbull] Is the proposed guidance sufficiently clear as to which
audit engagement team partners would be covered by the rule? Is the
proposed approach appropriate? If not, how can it be improved?
[sbull] Is the exclusion of certain ``national office partner''
personnel from the rotation requirements appropriate?
[sbull] Is the guidance on national office partners who are
exempted from the rotation requirements sufficiently clear?
[sbull] Is the distinction between a member of the engagement team
and a national office partner who consults regularly (or even
continually) on client matters sufficiently clear?
[sbull] Should certain partners performing non-audit services for
the client in connection with the audit engagement be excluded from the
rotation requirements?
[sbull] Should additional personnel (such as senior managers) be
included within the mandatory rotation requirements?
[sbull] Is it appropriate to provide transitional relief where the
proposed rules are more restrictive that the provisions of the
Sarbanes-Oxley Act?
[sbull] Are there situations in foreign jurisdictions that extended
partner rotation could be modified with additional safeguards or
limitations that would recognize the jurisdictional requirements as
well as logistical limitations that may exist?
[sbull] Should the rotation requirements be different for small
firms? What changes would be appropriate and why? If so, how should
small firms be defined?
[sbull] Would the proposed rules impose a cost on smaller firms
that is disproportionate to the benefits that would be achieved?
[sbull] Is the five-year ``time out'' period necessary or
appropriate? Would some shorter time period be sufficient, such as two,
three or four years? Should there be different ``time out'' periods
based on a partner's role in the audit process?
[sbull] If a partner rotates off an engagement after fewer than
five years, should the ``time out'' period also be reduced? Why or why
not? If so, how much should the reduction in the time out period be?
[sbull] Are the partner rotation requirements, as proposed, for
investment company issuer's or other entities in the investment company
complex too broad? Should we only prohibit a partner from rotating
between investment company issuers within the same investment company
complex? Why or why not?
[sbull] The proposed rules would not require all partners on the
audit engagement team to rotate at the same time. Should it? Why or why
not?
[[Page 76793]]
D. Audit Committee Administration of the Engagement
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. 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:
[sbull] Before the accountant is engaged by the audit client to
provide services other than audit, review or attest services, the audit
client's audit committee expressly approve the particular engagement;
or
[sbull] Any such engagement be entered into pursuant to detailed
pre-approval policies and procedures established by the audit committee
and the audit committee is informed on a timely basis of each service.
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.
---------------------------------------------------------------------------
\79\ Section 202 of the Sarbanes-Oxley Act; 15 U.S.C 78j-
1(i)(1)(A).
---------------------------------------------------------------------------
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.
[sbull] Should the Commission create other exceptions (beyond the
de minimis exception) that would allow an audit committee to adopt a
policy that contracts that are recurring (e.g., due diligence
engagements in connection with a series of insignificant acquisitions)
and less than a stated dollar amount (such as $25,000) or less than a
stated percentage of annual revenues (such as 1% or 5%) could be
entered into by management and would be reviewed by the audit committee
at its next periodic meeting?
[sbull] Is allowing the audit committee to engage an auditor to
perform non-audit services by policies and procedures, rather than a
separate vote for each service, appropriate? If so, how do we ensure
that audit committees have rigorous, detailed procedures and do not, in
essence, delegate that authority to management?
[sbull] Should more or fewer aspects be left to the discretion of
the audit committee?
[sbull] Are there specific matters that should be communicated to
or considered by the audit committee prior to its engaging the auditor?
[sbull] What, if any, audit committee policies and procedures
should be mandated to enhance auditor independence, interaction between
auditors and the audit committee, and communications between and among
audit committee members, internal audit staff, senior management and
the outside auditor?
[sbull] Our proposed rules do not contain exemptions for foreign
filers. Are there legal or regulatory impediments which may make it
difficult for certain foreign filers to comply? If so, what safeguards
can these foreign filers employ to ensure that they comply with the
proposed rules?
[sbull] Our proposed rules requiring the audit committee to pre-
approve non-audit services to be provided by the company's auditor do
not contain an exemption for foreign filers. Are there legal or
regulatory impediments which may make it difficult for certain foreign
filers to comply? If so, what safeguards can these foreign filers
employ to ensure that there is an authorization process to
[[Page 76794]]
pre-approve such services that is separate from management?
[sbull] In addition to legal or regulatory impediments, are there
practical impediments which would make it difficult for certain foreign
filers to comply with the pre-approval requirements? If so, what are
these impediments? What safeguards can such an entity establish to
better implement the proposed rules (which is to separate the decision
to engage the auditor for non-audit services from management)?
[sbull] Should the Commission provide additional specific guidance
to assist audit committees when deliberating auditor independence
issues? What topics would be helpful?
[sbull] Our proposed rules would require the audit committee of an
investment company to pre-approve the non-auditing services provided by
the accountant of the investment company to the investment company's
investment adviser and any entity controlling, controlled by, or under
common control with the investment adviser that provides services to
the investment company. Should the audit committee of an investment
company registrant be required to approve any non-auditing services
provided to the investment adviser and any entity controlled,
controlled by, or under common control with the investment adviser that
provides services to the fund? Should the scope of the pre-approval
requirement be expanded or narrowed? Why or why not?
[sbull] Under the proposed rules, the pre-approval of non-auditing
services would permit, for purposes of determining whether a non-
auditing service meets the de minimis exception, the investment
company's audit committee to aggregate total revenues paid to the
investment company's accountant by the investment company, its
investment adviser and any entity controlled, controlled by, or under
common control with the investment adviser that provides services to
the fund. Should the de minimis exception be determined separately
based on the total revenues paid to the investment company's accountant
by each entity?
[sbull] This proposed rule would apply to ``issuers.'' Should the
Commission consider applying this rule to a broader population such as
``audit clients'' as defined in 2-01(f)(6) of Regulation S-X? Why or
why not?
[sbull] In addition to the requirement that a majority of the
directors who are not interested persons of the registered investment
company appoint the independent accountant of a registered investment
company under the Investment Company Act of 1940, the proposed rules
would also require the audit committee of an investment company to
separately approve the accountant. For registered investment companies,
who should approve the selection of the accountant, i.e. independent
directors, the audit committee, or both? If both, should the audit
committee nominate the independent accountant with the independent
directors making the selection?
E. Compensation
We 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.
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\80\ ``Audit and professional engagement period'' includes both
the period covered by the financial statements being audited or
reviewed and the period of engagement to audit or review the
client's financial statements or to prepare a report filed with the
Commission. The period of engagement begins when the auditor signs
an initial engagement letter or begins audit, review or attest
procedures, and ends when the client or the auditor notifies the
Commission that the client is no longer the auditor's audit client.
See rule 2-01(f)(5) of Regulation S-X, 17 CFR 210.2-01(f)(5).
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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.
[sbull] We seek comments on all aspects of incentive compensation
for audit partners, principals and shareholders and on the following:
[sbull] What economic impact will our proposal have on the current
system of partnership compensation in accounting firms?
[sbull] Are there other approaches that should be considered with
respect to compensation packages that pose a concern about auditor
independence? If so, what are they?
[sbull] Would the proposed rule change be difficult to put into
practice? If so, why? How could it be changed to be more effectively
applied?
[sbull] Should managers, supervisors or staff accountants who are
members of the audit engagement team also be covered by this proposal?
[sbull] Does this proposal cover the appropriate time period or
should a measure other than the audit and professional engagement
period be considered?
[sbull] Does the proposed rule cover the entire component of an
audit partner's compensation that gives rise to independence concerns?
[sbull] Will this compensation limitation disproportionately affect
some firms because of their size or compensation structure? If so, how
may we accomplish our goal while taking these differences into account?
[sbull] Our proposal references compensation based on the
performance or sale of non-audit services. Is there a better test that
permits partners to participate in the overall success of the firm
while addressing the influence that such services might have on a
particular auditor-client relationship?
[[Page 76795]]
F. Definitions
1. Accountant
The 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.
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\81\ 17 CFR 2-01(f)(1).
\82\ See section 102(a) of the Sarbanes-Oxley Act.
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2. Accounting Role
Under 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).
[sbull] Is this proposed definition sufficiently clear? If not,
what changes would make the definition clearer and more operational?
3. Financial Reporting Oversight Role
The 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.
[sbull] Is this proposed definition sufficiently clear? If not,
what changes would make the definition clearer and more operational?
4. Audit Committee
Section 205 of the Sarbanes-Oxley Act defines an audit committee
as:
A committee (or equivalent body) established by and amongst the
board of directors of an issuer for the purpose of overseeing the
accounting and financial reporting processes of the issuer and
audits of the financial statements of the issuer.
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 issuers \83\ and
unit investment trusts \84\ 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.
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\83\ As defined in 17 CFR 240.13a-14(g) and 240.15d-14(g).
\84\ As defined by section 4(2) of the Investment Company Act
(15 U.S.C. 80a-4(2)).
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[sbull] Some registrants may not have designated boards of
directors or audit committees (e.g. benefit plans required to file form
11-K). Does the definition of audit committee sufficiently describe who
should serve in this capacity where such situations exist? If not, what
additional guidance would be appropriate?
[sbull] Our proposed rules exempt unit investment trusts and asset-
backed issuers from the rule requiring the audit committee to approve
auditing and non-auditing services. Should unit investment trusts and
asset-backed issuers be subject to these requirements? If so, given
that unit investment trusts and asset-backed issuers are not actively
managed, who should be responsible for approving the auditing and non-
auditing services? Are there other, similar entities that should be
exempt from the pre-approval requirements?
[sbull] Are the existing definitions in Regulation S-X and rule 2-
01 of Regulation S-X of audit client, issuer, and subsidiary
sufficiently clear?
G. Communication With Audit Committees
Section 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
[[Page 76796]]
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:
(1) Methods used to account for significant unusual transactions,
(2) Effects of significant accounting policies in controversial or
emerging areas for which there is a lack of authoritative guidance or
consensus,
(3) Process used by management in formulating particularly
sensitive accounting estimates and the basis for the auditor's
conclusions regarding the reasonableness of those estimates,
(4) Material audit adjustments proposed and immaterial adjustments
not recorded by management,
(5) Auditor's judgments about the quality of the company's
accounting principles, and
(6) Disagreements with management over the application of
accounting principles, the basis for management's accounting estimates,
and the disclosures in the financial statements.\85\
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\85\ See Codification of Statement on Auditing Standards AU
Sec. 380, ``Communication with Audit Committees.''
---------------------------------------------------------------------------
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 Sec. 380,
including auditing issues, engagement letters, management
representation letters, internal controls, auditor independence, and
others.
---------------------------------------------------------------------------
\86\ Id.
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[sbull] In light of the requirements for the CEO and CFO to certify
information in the company's periodic filings,\87\ should the auditor
be required to communicate information on critical accounting policies
and practices and alternative accounting treatments to management as
well as to the audit committee?
---------------------------------------------------------------------------
\87\ See Release No. 33-8124, ``Certification of Disclosure in
Companies' Quarterly and Annual Reports,'' (Aug. 29, 2002).
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1. Critical Accounting Policies and Practices
We 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 Analysis \88\ 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:
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\88\ Item 303 of Regulation S-K, (17 CFR 229.303), which
requires disclosure about, among other things, trends, events or
uncertainties known to management that would have a material impact
on reported financial information.
\89\ Release No. 33-8040 (Dec. 12, 2001) (66 FR 65013).
\90\ Id.
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\
---------------------------------------------------------------------------
\91\ Id. (footnotes omitted).
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.
---------------------------------------------------------------------------
\92\ Release No. 33-8090 (May 10, 2002) (67 FR 35620).
---------------------------------------------------------------------------
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.
[sbull] Should the auditor be required to provide additional
information to the audit committee regarding the company's critical
accounting policies?
[sbull] When should the communication take place?
[sbull] Should the auditor be required to provide the communication
in writing?
[sbull] Is it appropriate that investment companies would be
subject to the rules regarding critical accounting policies?
[[Page 76797]]
2. Alternative Accounting Treatments
We 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\
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\93\ Report of the Senate Committee on Banking, Housing, and
Urban Affairs, ``Public Company Accounting Reform and Investor
Protection Act of 2002,'' Senate Report 107-205, 107th Cong., 2d
Sess., at 21 (July 3, 2002).
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 Sec. 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.
[sbull] Is the discussion of which accounting policies require
communication with the audit committee sufficiently clear?
[sbull] Should additional matters be required to be communicated to
the audit committee? If so, which matters?
[sbull] Is it appropriate that investment companies would be
subject to the proposed rules regarding alternative accounting
treatments?
3. Other Material Written Communications
We 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 differences as examples of material written
communications to be provided to audit committees. Examples of
additional written communications that we expect would be considered
material to an issuer include:
[sbull] Management representation letter; \94\
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\94\ See SAS 85 AUSec. 333, ``Management Representations.''
---------------------------------------------------------------------------
[sbull] Reports on observations and recommendations on internal
controls; \95\
---------------------------------------------------------------------------
\95\ See SAS 60 AU Sec. Communication of Internal Control
Related Matters Noted in an Audit.''
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[sbull] Schedule of material adjustments and reclassifications
proposed, and a listing of adjustments and reclassifications not
recorded, if any; \96\
---------------------------------------------------------------------------
\96\ See SAS 89, AUSec. 333, ``Audit Adjustments,'
---------------------------------------------------------------------------
[sbull] Engagement letter; \97\ and
---------------------------------------------------------------------------
\97\ See SAS 83 AUSec. 310, ``Establishing an Understanding
With the Client.''
---------------------------------------------------------------------------
[sbull] Independence letter.\98\
---------------------------------------------------------------------------
\98\ See SQCS 2 QCSec. 20, ``System of Quality Control for a
CPA Firm's Accounting and Auditing Practice.''
---------------------------------------------------------------------------
These examples are not exhaustive, and auditors are encouraged to
critically consider what additional written communications should be
provided to audit committees.
4. Timing of Communications
The Act requires that the aforementioned communications should be
timely reported to the audit committee. For purposes of the
requirements of this provision, the proposed rule specifies that the
proposed communications between the
[[Page 76798]]
auditor and the audit committee occur prior to the filing of the audit
report with the Commission pursuant to applicable securities laws. As a
result, these discussions will occur, at a minimum, during the annual
audit, but we expect that they could occur as frequently as quarterly
or more often on a real-time basis.
The timing of these communications is intended to occur before any
audit report is filed with the Commission pursuant to the securities
laws. We believe that this proposed rule will ensure that these
communications occur prior to filing of annual reports and proxy
statements, as well as prior to filing registration statements and
other periodic or current reports when audit reports are included.
[sbull] Should the timing of these communications be required to
occur before any audit report is filed with the Commission or at some
other time?
[sbull] Should these communications regarding critical accounting
policies be required to be in writing? If so, why?
[sbull] Should we include specific instructions within the proposed
rule regarding the nature of communications of critical accounting
policies? If so, what instructions should be provided and why?
[sbull] Do these required communications fulfill existing GAAS
requirements? If not, why?
[sbull] Should these communications regarding alternative
accounting treatments be required to be in writing? If so, why?
[sbull] Do these required communications fulfill the statutory
requirements? If not, why?
[sbull] Should the minimum requirements for discussion of
alternative accounting treatments be expanded or reduced? If so, how?
[sbull] Should the list of recommended other communications be
expanded or reduced? If so, what specific items should be added and
why?
[sbull] Should the list of recommended other communications be
required to be communicated to the audit committee? Why or why not?
[sbull] Are the appropriate entities included under the term
``issuer'' appropriate? If not, what entities should be included or
excluded?
[sbull] Is it appropriate that investment companies are required to
make these communications to their audit committees? Why or why not?
[sbull] This proposed rule would apply to ``issuers.'' Should the
Commission consider applying this rule to a broader population such as
``audit clients'' as defined in 2-01(f)(6) of Regulation S-X? Why or
why not?
H. Expanded Disclosure
1. Principal Accountants' Fees
To allow investors to be better able to evaluate the independence
of the auditor of a company's financial statements in which they
invest, the proxy disclosure rules currently require that a registrant
disclose the professional fees it paid to its principal independent
accountant in the most recent fiscal year. We propose to change both
the types of fees that must be detailed and the years of service that
are covered by the disclosure.\99\ The proposed rules would increase
the disclosed categories of professional fees paid for audit and non-
audit services from three to four. The categories of reportable fees
would be: (1) Audit Fees, (2) Audit-Related Fees, (3) Tax Fees, and (4)
All Other Fees.\100\ The new disclosure would show fees for each of the
two most recent fiscal years, rather than just the most recent fiscal
year. In addition, registrants will be required to describe in
subcategories the nature of the services provided that are categorized
as audit-related fees and all other fees. We are also proposing
disclosure requirements related to audit committee pre-approval
policies and procedures for audit and non-audit services provided by an
independent public accountant as well as the percentage of fees that
were pre-approved.
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\99\ See proposed item 9(e), schedule 14A.
\100\ Currently, registrants need disclose only ``Audit Fees,''
``Financial Systems Design and Implementation Fees'' and ``All Other
Fees.'' (17 CFR 240.14a-101, item 9(e)). We are proposing to delete
the category of ``Financial Systems Design and Implementation Fees''
because such services generally are prohibited. See section II.B.2
of this release.
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We are proposing these changes partly in response to public comment
on this disclosure since we adopted the requirement in 2000. For
example, the definition of ``Audit Fees'' restricts the fees reportable
in that category to the services necessary only to complete the basic
audit, sign the audit opinion and perform the required quarterly
reviews. This category was intended to include fees for only those
services specifically required under GAAS.\101\ Some have suggested
that the categories are not as clear as they can be and some
commentators have questioned the usefulness of the current fee
disclosures.
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\101\ See Application of Revised Rules on Auditor Independence:
Frequently Asked Questions. Office of the Chief Accountant, January
16, 2001, Question and answer no. 1.
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We recognize that there are certain accounting, audit, assurance
and related services that accountants, in effect, must perform for
their audit clients. Presently, registrants are required to combine
fees for those services with fees paid for consulting and present the
aggregate in the ``All Other Fees'' category. We recognize that this
framework may make it difficult for shareholders to distinguish between
fees for services traditionally performed by the accounting firm's
auditors and fees for services performed by the accounting firm's
consulting division. Some reporting companies have sought to add
clarity by including further subcategories under ``All Other Fees'' to
provide greater detail.
While the proposed rules continue to require issuers to disclose
fees paid to the principal accountant for audit services, we are
expanding the types of fees that should be included in this category.
In addition to including fees for services necessary to perform an
audit or review in accordance with GAAS,\102\ this category also may
include services that generally only the independent accountant can
reasonably provide, such as comfort letters, statutory audits, attest
services, consents and assistance with and review of documents filed
with the Commission.
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\102\ See also section 2(a)(2) the Sarbanes-Oxley Act which
defines the term ``audit''.
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We believe that the addition of a new category, ``Audit-Related
Fees,'' will enable registrants to present the audit fee relationship
with the principal accountant in a more transparent fashion. In
general, Audit-Related Fees are assurance and related services that are
traditionally performed by the independent accountant. More
specifically, these services would include, among others: employee
benefit plan audits, due diligence related to mergers and acquisitions,
accounting assistance and audits in connection with proposed or
consummated acquisitions, internal control reviews, consultation
concerning financial accounting and reporting standards.
We also believe it is appropriate to add transparency regarding a
second category of fees: ``Tax Fees.'' Tax services traditionally have
been viewed as closely related to audit services and as not being in
conflict with an auditor's independence. However, such services would
be subject to pre-approval by the audit committee. The review of a
registrant's tax accruals and reserves is a task that requires
extensive knowledge about the audit client--knowledge that has already
been assimilated by the audit and tax professionals. In many public
companies, the fee for tax services is substantial in relation to other
services. Investors may benefit from being able to consider those fees
[[Page 76799]]
separately from the ``All Other Fees'' category. The ``Tax Fees''
category would capture all services performed by professional staff in
the independent accountant's tax division. Typically, it would include
fees for tax compliance, consultation and planning. Tax compliance
generally involves preparation of original and amended tax returns,
claims for refund and tax payment-planning services. Tax consultation
and tax planning encompass a diverse range of services, including
assistance and representation in connection with tax audits and
appeals, tax advice related to mergers and acquisitions, employee
benefit plans and requests for rulings or technical advice from taxing
authorities.
The category of ``All Other Fees'' would remain unchanged from the
existing rule, except that to the extent that financial information
systems implementation and design exist they would be disclosed as a
component of ``All Other Fees.''
Thus, this proposal would add two new categories to the
disclosures: (1) Audit-related fees and (2) tax fees. This proposal
also would eliminate one of the current categories: financial
information technology consulting fees. This category would be
eliminated under this proposal because under the section of the
proposal addressing nonaudit services, auditors would no longer be
permitted to provide most of these consulting services to audit
clients. Thus, the Commission believes that this disclosure of fees
paid in this category would no longer be necessary.
For comparison purposes, two dollar amounts would be shown under
each one of the four categories--one for each of the two most recent
fiscal years. Each amount reported would represent the aggregate of all
fees billed by the principal independent accountant that is appropriate
to that category in one of those two years. As we note in the proposed
Item, registrants also are required to describe each subcategory of
services comprising the fees included in the ``audit related'' and
``all other fees'' categories.
The disclosures of the percentage of audit services that are not
provided by permanent, full-time employees of the independent public
accounting firm remain unchanged from previous rules.
2. Audit Committee Actions
We propose to require that registrants filing proxy statements
disclose any policies and procedures developed by the audit committee
of the board of directors concerning pre-approval of the independent
accountant to perform both audit and non-audit services. Section 202 of
the Sarbanes-Oxley Act states the pre-approval requirements for all
auditing and non-audit services, with exceptions provided for de
minimis amounts under certain circumstances, as described in the Act
and the proposed rules. This section also describes the delegation
authority of the audit committee related to pre-approvals. We believe
that investors should be informed of audit committee pre-approval
procedures and policies in place to give investors a better
understanding of how audit committees are managing relationships with
independent accountants, including evaluating engagements with the
accountant that could impair the accountant's independence.
The proposed disclosure would set out in detail the audit
committee's policies and procedures for engaging the independent
accountant to perform services other than audit, review and attest
services. We expect registrants to provide clear, concise and
understandable descriptions of the policies and procedures.
Alternatively, registrants could include a copy of those policies and
procedures with the proxy statement delivered to investors and filed
with the Commission. Either method should allow shareholders to obtain
a complete and accurate understanding of the audit committee's policies
and procedures. We expect the policies and procedures would address
auditor independence oversight functions in a prudent and responsible
manner. Additionally, these procedures would describe, if applicable,
the specific processes in place that permit and monitor activities
meeting the de minimis exception.
We also believe investors would benefit from knowing what
percentage of the fees reported in each of the ``Audit-Related Fees,''
``Tax Fees,'' and ``All Other Fees'' categories were pre-approved by
the audit committee pursuant to the policies and procedures instituted
by the audit committee. That disclosure would provide insight into the
extent to which the audit committee takes an active, direct role in
considering each category of non-audit fee engagements.
The Sarbanes-Oxley Act requires the Commission to promulgate rules
requiring companies to disclose the required information together with
periodic reports required pursuant to sections 13(a) and 15(d) of the
Exchange Act. In accordance with this mandate, we propose to require
the new disclosures in a company's annual report. However, because we
believe that this information is relevant to a decision to vote for a
particular director or to elect, approve or ratify the choice of an
independent public accountant, we propose to require this disclosure in
a company's proxy statement on schedule 14A or information statement on
schedule 14C. Because the information is proposed to be included in
part III of annual reports on forms 10-K and 10-KSB, domestic companies
would be able to incorporate the required disclosures from the proxy or
information statement into the annual report.
Our intent is that this information be made available to investors
of all registrants. However, not all registrants are required to file
proxy statements. Thus, consistent with the provisions in the Act,
registrants that do not issue proxy statements would be required to
include appropriate disclosures in their annual filing included in form
10-K, form 10-KSB, 20-F, form 40-F and proposed form N-CSR as
appropriate. For the reasons noted previously in this release, we
propose to exempt asset-backed issuers and unit investment trusts from
such disclosure requirements.
In addition, we propose to require parallel disclosure for
registered management investment companies (``funds'') in annual
reports on proposed form N-CSR.\103\ Like operating companies,
registered management investment companies would also be required to
include this information in proxy or information statements that relate
to the election of directors, or the election, approval, or
ratification of an independent public accountant.\104\ However, in
recent years, the proxy statement has become an ineffective vehicle for
making information available to fund shareholders on a regular basis
because many funds are no longer required to hold annual meetings.\105\
[[Page 76800]]
Accordingly, we believe that the disclosure regarding audit committee
pre-approval policies and procedures for audit and non-audit services
and professional fees billed by auditors should also be required in
annual reports on proposed form N-CSR, which would be filed with the
Commission and available to investors.
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\103\ Proposed form N-CSR would be used by registered management
investment companies to file certified shareholder reports with the
Commission under the Sarbanes-Oxley Act of 2002. See Investment
Company Act Release No. 25723 (Aug. 30, 2002) (67 FR 57298 (Sept. 9,
2002)); Sarbanes-Oxley Act of 2002, Pub. L. 107-204, 116 Stat. 745
(2002).
\104\ 17 CFR 240.14a-101, item 9(e).
\105\ For historical and other reasons, most funds are organized
under the laws of Massachusetts or Maryland. The organizational and
operational requirements of Massachusetts business trusts are not
specified by statute, and a fund's essential structure is contained
in the trust agreement, which generally includes a provision
eliminating the need for annual shareholder meetings to elect
directors. See generally Jones, Moret, and Storey, The Massachusetts
Business Trust and Registered Investment Companies, 13 DEL. J. CORP.
L. 421 (1988). Under Maryland corporate law, fund charters or by-
laws are not required to provide that annual meetings be held in any
year in which election of directors is not required by the
Investment Company Act. MD. CODE ANN., CORPS. & ASS'NS Code 2-
501(b)(1)(2002). In addition, Delaware, Minnesota, and California
also have business trust or special corporate law structures that
have the effect of not requiring shareholder meetings other than
those required by the Investment Company Act. DEL. CODE ANN. tit.
12, Sec. 3806 (2001); Minn Stat. 302A.431 (2001); CAL. CORP. CODE
600(b) (West 2001).
Closed-end funds registered on national securities exchanges,
however, are required to hold an annual meeting to elect directors
under the rules of the exchanges. See, e.g., American Stock Exchange
Company Guide Listing Standards, Policies and Requirements Sec.
704; New York Stock Exchange Listed Company Manual 302.00. Closed-
end fund shareholders therefore generally would receive annual proxy
statements.
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[sbull] Is the proxy statement the appropriate location for this
disclosure? If not, why?
[sbull] Should we permit incorporation by reference into the
company's annual report?
[sbull] Would expansion of the proxy disclosure of professional
fees paid to the independent auditor from three categories to four
provide more useful information to investors?
[sbull] Are the new categories of disclosure appropriate? Are they
well defined, or should they be more accurately defined? Should there
be additional (or fewer) categories?
[sbull] Is disclosure of two years of fees appropriate? Should the
proposed additional fee disclosures be expanded to three years or
remain at one year?
[sbull] What, if any, additional information about professional
fees would be useful to investors?
[sbull] For a registrant not subject to the proxy disclosure rules,
such as foreign private issuers, should we require that the same
disclosures be placed in annual reports?
[sbull] Is there any additional disclosure concerning the
activities of audit committees that would be beneficial to investors?
[sbull] Should companies be required to provide the information in
their quarterly reports? Should it be required that the information be
included in other filings such as form 10-Q or 10-QSB?
[sbull] Should registered investment companies be required to
provide the information in their semi-annual report to shareholders on
proposed form N-CSR?
[sbull] Registered investment companies are required to provide
disclosure of audit fees billed for the registrant only, but are
required to disclose other types of fees in the aggregate for the
registrant, its investment adviser, and certain other parties.\106\ Is
this appropriate, or should we also require disclosure of audit fees on
an aggregate basis? In the alternative, should we require disclosure of
audit-related fees or any other fees for the registrant only and not on
an aggregate basis?
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\106\ Item 9(e)(1), (2), and (3) of schedule 14A (17 CFR
240.14a-101, item 9(e)(1), (2), and (3)) (requiring disclosure under
the caption ``Audit Fees'' of fees billed for audit of registrant's
financial statements and disclosure under the captions ``Financial
Information Systems Design and Implementation Fees,'' and ``All
Other Fees'' of fees billed for services rendered to the registrant,
its investment adviser, and any entity controlling, controlled by,
or under common control with the adviser that provides services to
the registrant); proposed item 9(e)(1), (2), (3) and (4) of schedule
14A; proposed instruction 2 to item 9(e) of schedule 14A (proposing
to require disclosure under the caption ``Audit Fees'' of fees
billed for audit of registrant's financial statements, and
disclosure under the captions ``Audit-Related Fees,'' ``Tax Fees,''
and ``All Other Fees'' of fees billed for services rendered to the
registrant, the registrant's investment adviser, and any entity
controlling, controlled by, or under common control with the adviser
that provides services to the registrant).
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[sbull] If we adopt such a requirement, should we require or permit
registrants to recalculate and report fees already disclosed for more
than two years so that all fee information is consistently reported and
available?
I. Transition Period
While much of the current proposal implements title II of the Act,
we are also proposing changes which go beyond the provisions of the
Act. In those areas, we are proposing that the provisions would be
effective upon adoption of final rules. However, for those situations,
we are considering the appropriate timing for the implementation of
final rules and how best to allow for an orderly transition as a result
of the new requirements imposed by the proposals. We are considering
whether the application of some of these provisions should be delayed
to a later date. For example, we are considering transition provisions
related to the rules concerning audit partner rotation, audit committee
communications, disclosures of fees paid to auditors, and partner
compensation.
[sbull] Would a period of time beyond the adoption date of the
final rules be necessary or appropriate for compliance with the final
rules by smaller companies or companies with whose securities currently
are not listed or quoted? If so, which rules should we consider a
delayed effective date?
[sbull] How should an effective date be determined with respect to
each amendment?
[sbull] Are there special considerations that we should take into
account in providing a transition period for foreign private issuers?
III. General Request for Comments
[sbull] We invite any interested person wishing to submit written
comments on the proposals or any matters that may impact the proposals,
to do so. We specifically request comments from investors, issuers, and
accounting firms.
[sbull] We solicit comment on each component of the proposals.
[sbull] Would the proposals related to audit committees and partner
compensation help alleviate the pressure that clients may place on
engagement partners or accounting firms to acquiesce to the clients'
views on accounting issues? What are some of the other scenarios where
such pressures might exist?
IV. Paperwork Reduction Act
Certain provisions of the proposed amendments to Regulation S-X,
schedule 14A and forms 10-K, 10-KSB, 20-F, 40-F and proposed form N-CSR
contain ``collection of information'' requirements within the meaning
of the Paperwork Reduction Act of 1995 (``PRA'') (44 U.S.C. 3501 et
seq.), and the Commission has submitted them to the Office of
Management and Budget (``OMB'') for review in accordance with 44 U.S.C.
3507(d) and 5 CFR 1320.11. An agency may not conduct or sponsor, and a
person is not required to respond to, a collection of information
unless it displays a currently valid control number. Compliance with
the proposed requirements would be mandatory. There would be no
mandatory retention period for the information disclosed under the
rules being proposed in this release. Responses to the disclosure
requirements would not be kept confidential.
The titles for the collections of information are: ``Regulation S-
X''; ``Proxy Statements--Regulation 14A and Schedule 14A''; ``Form 10-
K''; ``Form 10-KSB''; ``Form 20-F''; ``Form 40-F''; and ``Form N-CSR
under the Investment Company Act of 1940 and Securities Exchange Act of
1934, Certified Shareholder Report.''
Regulation S-X (OMB Control No. 3235-0009) is the central
repository for rules related to the form and content of financial
statements filed with the Commission. Regulation S-X, however, does not
direct registrants to file financial statements or to collect financial
data. Regulation S-X indicates
[[Page 76801]]
what should be in the financial statements and how financial statements
should be presented when they are required to be filed by other rules
or forms under the securities laws. Because Regulation S-X does not
require any information to be filed with the Commission, only one
burden hour is assigned to cover a reading of the regulation. Burden
hours and costs associated with the preparation of financial statements
in accordance with Regulation S-X are allocated to the rules or forms
that require the financial statements to be filed.
A. Communication With Audit Committees
As required by section 204 of the Sarbanes-Oxley Act, 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 to the issuer's audit
committee (1) all critical accounting policies and practices used by
the issuer, (2) alternative accounting treatments within GAAP that have
been discussed with management, including the ramifications of the use
of the alternative treatments and the treatment preferred by the
accounting firm, and (3) other material written communications between
the accounting firm and management of the issuer such as any management
letter or schedule of ``unadjusted differences.'' The required reports
need not be in writing but the report would be required to be presented
to the audit committee before the auditor's report on the financial
statements is filed with the Commission.\107\
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\107\ Release No. 33-8040 (Dec. 12, 2001) (66 FR 65013). In May
of this year, we proposed rules to require disclosures that would
enhance investors' understanding of the application of companies'
critical accounting policies. The proposed disclosures would focus
on accounting estimates a company makes in applying its accounting
policies and the initial adoption by a company of an accounting
policy that has a material impact on its financial presentation.
Release No. 33-8098 (May 10, 2002) (67 FR 35620).
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We believe that auditing standards currently require discussions
between the auditors and the audit committee of significant unusual,
controversial, or emerging accounting policies, of the process used by
management to select certain estimates, and of disagreements over
certain accounting matters.\108\ We further believe that audit
committees generally are aware of management's letter making
representations to the auditors, which the auditor uses in conducting
the audit of the issuer's financial statements. Audit committees also
should be aware of ``unadjusted differences,'' if any, as a result of
the enactment of section 401 of the Sarbanes-Oxley Act, which added
section 13(i) to the Securities Exchange Act of 1934 (``Exchange
Act'').\109\ Under new section 13(i) of the Exchange Act, therefore,
there should be no material ``unadjusted differences.''
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\108\ See SAS 61, AUSec. 380, ``Communication with Audit
Committees or Others with Equivalent Authority and Responsibility.''
\109\ Each financial report that contains financial statements,
and that is required to be prepared in accordance with (or
reconciled to) generally accepted accounting principles under this
title and filed with the Commission shall reflect all material
correcting adjustments that have been identified by a registered
public accounting firm in accordance with generally accepted
accounting principles and the rules and regulations of the
Commission.
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Because of these GAAS and legal provisions, we believe that
adoption of the proposed rules regarding auditor reports to audit
committees would not increase significantly the burden hours on
accounting firms or registrants.
B. Disclosures of Audit and Non-Audit Services
1. Proxy and Information Statements
Schedule 14A \110\ (OMB Control No. 3235-0059) prescribes the
information that a company must include in its proxy statement to
ensure that shareholders are provided material information relating to
voting decisions. The Commission currently estimates that 7,661
registrants annually file schedule 14A. Schedule 14C \111\ (OMB Control
No. 3235-0057) prescribes the information that a company that is
registered under section 12 of the Exchange Act must include in its
information statement in advance of a security holders' meeting when it
is not soliciting proxies from its security holders. The Commission
currently estimates that 464 registrants annually file schedule 14C.
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\110\ 17 CFR 240.14a-101.
\111\ 17 CFR 240.14c-101.
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Item 9 of schedule 14A requires the disclosure of certain
information regarding the registrant's relationship with the
independent auditor of the company's financial statements when there is
a solicitation relating to (1) a meeting at which directors to the
company's board of directors are to be elected (or the solicitation of
consents or authorizations in lieu of such a meeting) or (2) the
election of the auditor, or the approval or ratification of the
company's selection of the auditor. We are proposing to amend paragraph
(e) of item 9 to provide more detailed information regarding the
categories of fees paid by the registrant to the auditor and to inform
investors about the critical role that audit committees play in
assuring the auditor's independence. We believe that the proposed
disclosure would allow investors to better assess an auditor's
independence and the certain activities of an audit committee.
Item 9(e) currently requires disclosure of fees billed by the
auditor in the last fiscal year, with the fees broken down into three
categories: Audit fees, financial information systems design and
implementation fees, and all other fees. The proposals would add
disclosure of two categories (tax fees and audit-related fees), while
eliminating one category (financial information systems design and
implementation), and require disclosure of one more past year of each
of these fees. Because these fees are already being disclosed,
repeating the prior year's disclosures for comparison purposes should
not increase significantly a registrant's compliance burden. In
addition, breaking tax fees and audit-related fees out of the ``all
other'' category of fees currently being disclosed should not result in
any significant incremental burden.
Under the proposals, registrants also would be required to disclose
any policies and procedures adopted by an audit committee to be
followed for auditor engagements for services other than audit, review
and attest services in the event that the audit committee does not
expressly pre-approve the particular engagements. In addition, the
proposals would require registrants to disclose what percentage of fees
in each of the categories noted above (audit, audit-related, tax, and
other) relate to engagements that were pre-approved by the audit
committee.
We estimate that the incremental disclosure of fees, the audit
committee's policies and procedures for approval of audit engagements,
and the percentage of fees pre-approved by the audit committee, would
impose, on average, two additional burden hours on each of the 7,661
filers of schedule 14A, or an aggregate 15,322 additional burden hours.
We estimate that most of this time would relate to consideration and
review of the disclosures of the audit committee's policies and
procedures. We further estimate that approximately 75% of the extra
burden hours, or approximately 11,492 hours, would be expended by
internal staff and the remaining 25%, or 3,830 hours, would be for
outside legal costs associated with reviewing the proposed disclosures.
Assuming that outside legal costs would be an average of $300 per hour,
the aggregate annual legal costs would be $1,149,000. Similarly, we
estimate that these proposed disclosures would
[[Page 76802]]
impose, on average, two additional burden hours on each of the 464
filers of schedule 14C, or an aggregate 928 additional burden hours.
Using the same allocation of hours and cost estimate of legal fees as
for schedule 14A, we estimate that 696 hours would be expended by
internal staff and the remaining 232 hours would be for outside legal
assistance, producing an outside legal cost of $69,600.
2. Annual Reports on Form 10-K
The proposed disclosure generally should be presented in a
company's proxy statement in accordance with item 9(e) of schedule 14A,
and incorporated by reference into the form 10-K (OMB Control No. 3235-
0063). Some companies that file forms 10-K, however, are not subject to
the proxy disclosure requirements. These companies would, therefore,
now be required to present the required disclosures in the form 10-K.
We do not believe, however, that the disclosures would be burdensome to
these companies because the information to be disclosed (fees billed to
the company by the auditor in the last fiscal year, with the fees
broken down into certain categories) should be readily available to the
company.
We estimate that the incremental disclosure of fees, the audit
committee's olicies and procedures for approval of audit engagements,
and the percentage of fees pre-approved by the audit committee, would
impose, on average, two additional burden hours per year on each of the
8,484 filers of form 10-K. Six thousand six hundred and seventy-six
(6,676) of those filers, however, would provide the information under
schedule 14A and 209 of those filers would provide the information
under schedule 14C.\112\ The burden hours for the disclosure by these
filers therefore has been assigned to schedule 14A and schedule 14C,
respectively. The burden imposed on the remaining 1,599 filers is being
assigned to form 10-K. This results in 3,198 (2 hours x 1,599 filers)
additional burden hours. We estimate that most of this time would
relate to consideration and review of the disclosures of the audit
committee's policies and procedures. We further estimate that
approximately 75% of the extra burden hours, or approximately 2,399
hours, would be expended by internal staff and the remaining 25%, or
799 hours, would be for outside legal costs associated with reviewing
the proposed disclosures. Assuming that outside legal costs would be an
average of $300 per hour, the aggregate annual legal costs would be
$239,700.
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\112\ These numbers are obtained by reviewing the number of
filers that filed a form 10-K and schedule 14A or schedule 14C,
respectively, between October 1, 2001, and September 30, 2002.
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3. Annual Reports on Form 10-KSB
Form 10-KSB (OMB Control No. 3235-0420) is the annual report filed
with the Commission by ``small businesses issuers.'' A ``small business
issuer'' is an entity that (1) has revenues of less than $25,000,000,
(2) is a U.S. or Canadian issuer, (3) is not an investment company, and
(4) if a majority owned subsidiary, the parent corporation is also a
small business issuer. An entity is not a ``small business issuer,''
however, if the aggregate market value of its outstanding voting and
non-voting common stock held by non-affiliates is $25,000,000 or
more.\113\ We do not believe, however, that these disclosures would be
burdensome to these companies because the information to be disclosed
(fees billed to the company by the auditor in the last fiscal year,
with the fees broken down into certain categories) should be readily
available to the company.
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\113\ 17 CFR 240.12b-2.
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We estimate that the incremental disclosure of fees, the audit
committee's policies and procedures for approval of audit engagements,
and the percentage of fees pre-approved by the audit committee, would
impose, on average, two additional burden hours per year on each of the
3,820 filers of form 10-KSB. Nine hundred and eighty-five (985) of
those filers, however, would provide the information under schedule 14A
and 255 of those filers would provide the information under schedule
14C. The burden hours for the disclosure by these filers has been
assigned to schedule 14A and schedule 14C, respectively. The burden
imposed on the remaining 2,580 filers is being assigned to form 10-KSB.
This results in 5,160 (2 hours x 2,580 filers) additional burden hours.
We estimate that most of this time would relate to consideration and
review of the disclosures of the audit committee's policies and
procedures. We further estimate that approximately 75% of the extra
burden hours, or approximately 3,870 hours, would be expended by
internal staff and the remaining 25%, or 1,290 hours, would be for
outside legal costs associated with reviewing the proposed disclosures.
Assuming that outside legal costs would be an average of $300 per hour,
the aggregate annual legal costs would be $387,000.
4. Annual Reports by Foreign Private Issuers on Form 20-F
Form 20-F (OMB Control No. 3235-0288) is used for the registration
of securities of foreign private issuers pursuant to sections 12(b) or
12(g) of the Exchange Act and annual and transition reports filed with
the Commission pursuant to sections 13(a) or 15(d) of the Exchange
Act.\114\
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\114\ 17 CFR 249.220f.
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Foreign private issuers generally are not subject to the proxy
disclosure requirements and, therefore, would be required to present
the required disclosures on form 20-F. We do not believe, however, that
these disclosures would be burdensome to these companies because the
information to be disclosed (fees billed to the company by the auditor
in the last fiscal year, with the fees broken down into certain
categories) should be readily available to the company.
We estimate that the incremental disclosure of fees, the audit
committee's policies and procedures for approval of audit engagements,
and the percentage of fees pre-approved by the audit committee, would
impose, on average, two additional burden hours per year on each of the
1,194 filers of form 20-F, or 2,388 additional burden hours. We
estimate that most of this time would relate to consideration and
review of the disclosures of the audit committee's policies and
procedures. We further estimate that approximately 25% of the extra
burden hours, or approximately 597 hours, would be expended by internal
staff and the remaining 75%, or 1,791 hours, would be for outside legal
costs associated with reviewing the proposed disclosures because this
form is prepared by foreign private issuers who rely more heavily on
outside counsel for assistance. Assuming that outside legal costs would
be an average of $300 per hour, the aggregate annual legal costs would
be $537,300.
5. Reports by Certain Canadian Issuers on Form 40-F
Form 40-F is used by certain Canadian issuers to register
securities with the Commission pursuant to section 12(b) or section
12(g) and for reports pursuant to section 15(d) of the Exchange Act. A
Canadian issuer may use the form if it is subject to the reporting
requirements solely by reason of having filed a registration statement
on form F-7, F-8, F-9, F-10, or F-80 under the Securities Act of 1933.
A Canadian issuer also may use the form if it has a reporting
obligation under the Exchange Act and (1) the issuer is incorporated
under the laws of Canada or any Canadian province or territory, (2) the
issuer is a foreign private issuer
[[Page 76803]]
or a crown corporation, (3) the issuer has been subject to periodic
reporting requirements of any securities commission or equivalent
regulatory authority in Canada for a period of at least 12 calendar
months immediately preceding the filing of the form and currently is in
compliance with such obligations, and (4) the aggregate market value of
the public float of the issuer's outstanding equity shares is $75
million or more (no market value threshold needs to be satisfied,
however, in connection with non-convertible securities eligible for
registration on form F-9).\115\
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\115\ 17 CFR 249.240f.
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Canadian companies that file form 40-F generally are not subject to
the proxy disclosure requirements and, therefore, would be required to
present the required disclosures on form 40-F. We do not believe,
however, that these disclosures would be burdensome to these companies
because the information to be disclosed (fees billed to the company by
the auditor in the last fiscal year, with the fees broken down into
certain categories) should be readily available to the company.
We estimate that the incremental disclosure of fees, the audit
committee's policies and procedures for approval of audit engagements,
and the percentage of fees pre-approved by the audit committee, would
impose, on average, two additional burden hours per year on each of the
134 filers of form 40-F, or 268 additional burden hours. We estimate
that most of this time would relate to consideration and review of the
disclosures of the audit committee's policies and procedures.
Consistent with our treatment of foreign private issuers filing form
20-F, we further estimate that approximately 25% of the extra burden
hours, or approximately 67 hours, would be expended by internal staff
and the remaining 75%, or 201 hours, would be for outside legal costs
associated with reviewing the proposed disclosures. Assuming that
outside legal costs would be an average of $300 per hour, the aggregate
annual legal costs would be $60,300.
6. Proposed Form N-CSR
We issued a release proposing form N-CSR on August 30, 2002,
pursuant to section 30 of the Investment Company Act (15 U.S.C. 80a-29)
and sections 13 and 15(d) of the Exchange Act (15 U.S.C. 78m and
78o(d)). The proposed disclosure would be required in a registered
management investment company's annual report on proposed form N-CSR.
We estimate that the additional disclosure of fees, the audit
committee's policies and procedures for approval of audit engagements,
and the percentage of fees pre-approved by the audit committee, would
impose, on average, 1.5 additional burden hours per year on each of the
anticipated 3,700 filers of proposed form N-CSR. This results in 5,550
(1.5 hours x 3,700 filers) additional burden hours. We estimate that
most of this time would relate to consideration and review of the
disclosures of the audit committee's policies and procedures. We
estimate that the cost of these burden hours would $81 per hour,
resulting in aggregate internal costs of $449,550.\116\ Further, we
estimate that this additional disclosure would require 0.5 hours in
legal review by outside counsel at an average rate of $300 per hour,
resulting in aggregate annual outside legal costs of $555,000.
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\116\ See Securities Industry Association, Report on Management
& Professional Earnings in the Securities Industry 2002 (2002).
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Pursuant to 44 U.S.C. 3506(c)(2)(B), we solicit comments to: (1)
Evaluate whether the proposed collections of information are necessary
for the proper performance of the functions of the agency, including
whether the information will have practical utility; (2) evaluate the
accuracy of the Commission's estimates of the burden of the proposed
collections of information; (3) determine whether there are ways to
enhance the quality, utility, and clarity of the information to be
collected; and (4) evaluate whether there are ways to minimize the
burden of the collections of information on those who are to respond,
including through the use of automated collection techniques or other
forms of information technology.
Persons submitting comments on the collection of information
requirements should direct the comments to the Office of Management and
Budget, Attention: Desk Officer for the Securities and Exchange
Commission, Office of Information and Regulatory Affairs, Washington,
DC 20503, and should send a copy to Jonathan G. Katz, Secretary,
Securities and Exchange Commission, 450 Fifth Street, NW., Washington,
DC 20549-0609, with reference to File No. S7-49-02. Requests for
materials submitted to OMB by the Commission with regard to these
collections of information should be in writing, refer to File No.S7-
49-02, and be submitted to the Securities and Exchange Commission,
Records Management, Office of Filings and Information Services. OMB is
required to make a decision concerning the collection of information
between 30 and 60 days after publication of this release. Consequently,
a comment to OMB is assured of having its full effect if OMB receives
it within 30 days of publication.
V. Cost--Benefit Analysis
We are sensitive to the costs and benefits imposed by our rules,
and we have identified certain costs and benefits of these proposals.
Additionally, certain of these costs are imposed by Congressional
mandate through the enactment of the Sarbanes-Oxley Act. We request
comments on all aspects of this cost-benefit analysis, including the
identification of any additional costs or benefits. We encourage
commenters to identify and supply relevant data concerning the costs or
benefits of the proposed amendments.
A. Background
The Sarbanes-Oxley Act was enacted on July 30, 2002. Title II to
that Act adds sections 10A(g) through 10A(l) to the Securities Exchange
Act of 1934 (``Exchange Act'') and requires that the Commission, within
180 days of enactment, adopt rules to carry out each of those
sections.\117\
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\117\ Section 208(a) of the Sarbanes-Oxley Act of 2002.
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The proposed rules, in general, would:
[sbull] Revise the Commission's regulations related to the non-
audit services that, if provided to an audit client, would impair an
accounting firm's independence \118\;
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\118\ See section 201 of the Sarbanes-Oxley Act.
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[sbull] Require that an issuer's audit committee pre-approve all
audit and non-audit services provided to the issuer by the auditor of
an issuer's financial statements \119\;
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\119\ See section 202 of the Sarbanes-Oxley Act.
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[sbull] Prohibit any partner on the audit engagement team from
providing audit services to the issuer for more than five consecutive
years \120\;
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\120\ See section 203 of the Sarbanes-Oxley Act.
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[sbull] Prohibit an accounting firm from auditing an issuer's
financial statements if certain members of management of that issuer
had been members of the accounting firm's audit engagement team within
the one-year period preceding the commencement of audit procedures
\121\;
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\121\ See section 206 of the Sarbanes-Oxley Act.
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[sbull] Require that the auditor of an issuer's financial
statements report certain matters to the issuer's audit committee,
including ``critical'' accounting policies used by the issuer \122\;
and
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\122\ See section 204 of the Sarbanes-Oxley Act.
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[[Page 76804]]
[sbull] Require 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.\123\
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\123\ See generally, section 202 of the Sarbanes-Oxley Act;
section 10A(i)(2) of the Exchange Act, 15 U.S.C. 78j-1(i)(2).
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In addition, under the proposed rules, an accountant would not be
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 directly on any service provided or
sold to that client other than audit, review and attest services. We
believe that accounting firms should discontinue compensating these
individuals for ``cross-selling'' services. While many of these
proposed rules would respond directly to the provisions of title II of
the Sarbanes-Oxley Act, certain of these proposals would go beyond the
specific provisions of the Act to more fully address what we believe to
be the Congressional intent. These provisions include:
[sbull] Our proposal requiring any partner on the audit engagement
team be subject to the rotation requirements;
[sbull] Requiring a one-year cooling-off period for all audit
client's employment of engagement team personnel; and
[sbull] Our proposal to limit an audit partner from receiving
compensation for recommending non-audit services to an audit client.
B. Potential Benefits of the Proposed Rules
Potential benefits resulting from the proposed amendments include
increased investor confidence in the independence of auditors, in the
audit process, and in the reliability of reported financial
information. As discussed below, clearer auditor independence
regulations should provide investors with comfort that auditors are
placing the interests of investors over financial or personal
incentives. Proposed rules mandating that auditors communicate certain
matters to audit committees should benefit investors by enhancing the
opportunities for meaningful audit committee oversight of the financial
reporting process. Investors also would benefit from the enhanced
disclosure of the non-audit services provided by, and fees paid to, the
accounting firm that audits and reviews the company's financial
statements, and from better disclosure of the audit committee's role in
approving the provision of non-audit services by the accounting firm
that audits the company's financial statements. We believe that these
factors could improve the efficiency of the markets and result in a
lower cost of capital.
1. Auditor Independence
The amendments would facilitate the independence of the auditor
from management in the following ways.
[sbull] Providing clearer definition of the lines of non-audit
services that would impair an auditor's independence;
[sbull] Requiring that each engagement of the auditor to perform
audit or non-audit services for the company be pre-approved by the
audit committee, which serves as the representative of investors;
[sbull] Requiring the ``rotation'' of partners on the audit
engagement to assure a periodic fresh look at the accounting and
auditing issues presented in the engagement;
[sbull] Providing that the auditor's independence would be impaired
if revenues to the accounting firm from the sale of non-audit services
or products to a company were directly paid to any partner, principal,
or shareholder of the firm who works on the audit of that company's
financial statements. This provision should decrease the appearance of
any pressure on the audit engagement partner to appease management
during the audit process in order to facilitate sales of non-audit
services and increase the appearance and reality of auditor
independence; and
[sbull] Requiring a ``cooling off'' period between working on the
audit engagement team and joining the client as a member of management
in order to assure that personal relationships and the new member of
management's knowledge of the audit plan do not negatively impact the
audit process.
Strengthening auditor independence should provide investors with
more comfort that the auditors would play their ``gatekeeper'' role in
companies'' financial reporting and provide further assurance that the
true financial condition of companies is reflected in their financial
reporting thereby allowing public companies less costly access to the
capital markets.
2. Auditor Reports to Audit Committees
The proposed rules would require that each public accounting firm
registered with the Public Company Accounting Oversight Board that
audits an issuer's financial statements report to the issuer's audit
committee (1) All critical accounting policies and practices used by
the issuer, (2) alternative accounting treatments within GAAP that have
been discussed with management, including the ramifications of the use
of the alternative treatments and the treatment preferred by the
accounting firm, and (3) other material written communications between
the accounting firm and management of the issuer such as any management
letter or schedule of ``unadjusted differences.''
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 the need for such reports from the auditor to
the audit committee, 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.\124\
\124\ Report of the Senate Committee on Banking, Housing, and
Urban Affairs, ``Public Company Accounting Reform and Investor
Protection Act of 2002,'' Senate Report 107-205, 107th Cong., 2d
Sess., at 21 (July 3, 2002).
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Almost eight months before passage of the Sarbanes-Oxley Act, in
December 2001, we issued cautionary advice regarding each issuer
disclosing in the Management Discussion and Analysis \125\ section of
its annual report those accounting policies that management believes
are most critical to the preparation of the issuer's financial
statements.\126\ 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.\127\ As part of that cautionary advice, we
stated:
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\125\ Item 303 of Regulation S-K (17 CFR 229.303), which
requires disclosure about, among other things, trends, events or
uncertainties known to management that would have a material impact
on reported financial information.
\126\ Release No. 33-8040 (Dec. 12, 2001) (66 FR 65013).
\127\ Id.
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
[[Page 76805]]
management and auditor about critical accounting policies are
appropriate.\128\
---------------------------------------------------------------------------
\128\ Id. (footnotes omitted).
We continue to believe that such communications are appropriate and
facilitate the audit committee's oversight of the financial reporting
process. Investors should benefit by the audit committee being in a
position to challenge what it may view as novel or aggressive use of
GAAP to enhance reports of the company's financial results or financial
condition.
The rules proposed in May 2002 provide additional information about
the application of critical accounting policies, including ``critical
accounting estimates'' and the initial adoption of material accounting
policies. Auditors may want to refer to these proposed rules,\129\ as
well as the December 2001 cautionary advice, in determining the types
of matters to be communicated to the audit committee.
---------------------------------------------------------------------------
\129\ Release Nos. 33-8098 (May 10, 2002) (67 FR 35620).
---------------------------------------------------------------------------
3. Enhanced Disclosures About the Services Provided by Auditors to
Registrants
Investors would receive more detailed information about:
[sbull] Any policies and procedures adopted by an audit committee
that are designed to assure that the provision of non-audit services
and products by the auditor do not impair the auditor's independence,
[sbull] The fees paid by the registrant to the auditor in each of
the last two years for audit, audit-related, tax, and all other
services, and
[sbull] The percentage of fees in each of those categories that
were pre-approved by the audit committee.
The proposed disclosures will afford investors greater visibility
into those aspects of the auditor-client relationship. Providing
better, more complete information in cases where non-audit services
occur allows investors to determine for themselves whether there are
concerns related to the auditor's independence. It also may allow
investors to ask more direct and useful questions of management and
directors regarding their decisions to engage the auditors for such
services.
4. Compensation
The proposed rules specify that audit partners that are compensated
for cross-selling non-audit services are not independent. This would
further enhance the independence of the audit function since the audit
partner's focus would be on the conduct of the audit rather than on
efforts to sell other services to management. The danger inherent in
compensation to audit partners for cross-selling non-audit services is
that it might create a temptation for auditors to compromise the
quality of the audit in order to maintain their relationship with
clients to whom they hope to cross-sell such services.\130\
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\130\ Moreover, such compensation might increase the effect of
any conflict of interest inherent in the provision of non-audit
services. It would do this by inadvertently providing a mechanism by
which an issuer may influence an audit partner short of the threat
to change auditors. That is, if issuers are not pleased with the
results of an audit, such a compensation structure gives them the
option to ``punish'' the audit partner by discontinuing the purchase
of (or by not purchasing) the non-audit services and thereby causing
the audit partner's compensation to be directly reduced. Since this
punitive action is apt to be less costly to the issuer than would be
a change in auditors, it represents a more credible threat to the
audit partner than does the threat to change auditors. As a
consequence, issuers may be more willing to employ this avenue of
improper influence than to actually change auditors, and, indeed,
audit partners may be more responsive to such pressure, given its
enhanced credibility.
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C. Potential Costs of the Proposals
1. Auditor Independence
Changes in our auditor independence regulations may impose costs on
accounting firms and on any issuers that engage, or would like to
consider engaging, the auditor of an issuer's financial statements to
perform non-audit services.
(a) Non-audit services. According to the information available to
the staff in 2000, approximately 12,600 registrants did not purchase
any consulting services from the auditor of their financial statements,
and 4,100 registrants reported purchasing such services.\131\ Based on
the scrutiny that these services have received over the past year, the
Commission staff believes that the number of companies purchasing non-
audit services from their auditor might have decreased significantly.
---------------------------------------------------------------------------
\131\ Id.; 65 FR at 43185.
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The current auditor independence rules state that the performance
of certain non-audit services will impair an auditor's independence.
The proposed rules, in some cases, would redefine the limits of those
services and would add one more item, ``expert services,'' to the list
of prohibited services. These changes could impact the competitive
markets for these services. Issuers would be precluded from engaging
auditors to perform certain services in the categories of internal
audit services, financial systems design and implementation services,
appraisal and valuation services, actuarial services, and others, that
may be performed under the current rules. These companies may incur
costs from having to use a separate vendor for such services resulting
in the possible loss of any synergistic benefits of having a single
provider for both audit and non-audit services. In particular, the loss
of company-specific information that might flow from the non-audit team
to the audit engagement team, or vice versa, could in some instances
lower the quality of either service. Issuers also may incur costs
locating a new vendor and developing a business relationship with that
vendor. In addition, issuers may incur costs from not being able to
retain their preferred provider of non-audit services, if that
preferred provider happens to also be their auditor. The difference in
value between a preferred provider and a second choice may be
substantial, particularly if the preferred provider has relatively
unique service offerings or service offerings that are particularly
well suited to the needs of the issuer.
Accounting firms may lose one or more sources of revenue if the
proposed rules are adopted because they would no longer be able to sell
certain non-audit services to their audit clients. We believe, however,
that in view of the statements by the largest four accounting firms,
and others, that they would no longer provide internal audit
outsourcing services and financial system design and implementation
services to audit clients,\132\ costs associated with the proposed
rules may be limited. Also, to the extent non-audit services are merely
redistributed among the firms, there would be no net loss of revenue to
public accounting firms as a whole.
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\132\ Report of the Senate Committee on Banking, Housing, and
Urban Affairs, ``Public Company Accounting Reform and Investor
Protection Act of 2002,'' Senate Report 107-205, 107th Cong., 2d
Sess., at 18 (July 3, 2002).
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(b) Audit Committee Pre-approval of Services. Under the proposed
rules, all auditing and non-audit services to be provided by the
auditor of an issuer's financial statements must be pre-approved by the
issuer's audit committee.\133\ There may be incremental
[[Page 76806]]
costs associated with audit committees performing this function. Such
costs might include more frequent committee meetings, an increased
workload on audit committee members, and having legal counsel review
the audit committee's draft policies and procedures for engaging the
auditors for non-audit services. The increased burden on audit
committee members might result in the need to increase their
compensation, resulting in additional costs to issuers. Some of these
costs may be mitigated by the provisions in the Act and in the proposed
rules that would allow the audit committee to delegate to one or more
audit committee members the authority to grant pre-approvals of these
services.\134\
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\133\ Section 301 of the Sarbanes-Oxley Act of 2002 requires the
Commission to direct the national securities exchanges and national
securities associations to prohibit the listing of any security of
an issuer that does not meet certain criteria, including having an
audit committee that performs certain functions. See section 10A(m)
of the Exchange Act, 15 U.S.C. 78j-1(m). The Sarbanes-Oxley Act
defines ``audit committee'' to be ``(A) a committee (or equivalent
body) established by and amongst the board of directors of an issuer
for the purpose of overseeing the accounting and financial reporting
processes of the issuer and audits of the financial statements of
the issuer; and (B) if no such committee exists with respect to an
issuer, the entire board of directors of the issuer.'' Section
205(a) of the Sarbanes-Oxley Act, which, among other things, adds
section 3(a)(58) to the Exchange Act.
\134\ Section 202 of the Sarbanes-Oxley Act; section 10A(i)(3)
of the Exchange Act, 15 U.S.C. 78j-1(i)(3).
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Inadvertent violations of the Act and the proposed rules that would
add to the costs of the rules also may be mitigated by the de minimus
exception to the pre-approval requirement.\135\ Under this exception,
the pre-approval requirement is waived if: (1) The aggregate amount of
the non-audit services is not more than five percent of the total
amount of revenues paid by the issuer to the auditor during the fiscal
year in which the non-audit services were provided, (2) at the time of
the engagement the issuer did not recognize the services to be non-
audit services, and (3) the services are approved by the audit
committee prior to the completion of the audit.\136\
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\135\ Section 202 of the Sarbanes-Oxley Act; section
10A(i)(1)(B) of the Exchange Act, 15 U.S.C. 78j-1(i)(1)(B).
\136\ Id.
---------------------------------------------------------------------------
We also believe that as a result of the Commission's audit
committee disclosure requirements adopted in 1999,\137\ prior
disclosures related to the involvement of the audit committee in
recommending or approving changes in auditors and the resolution of
disagreements between management and the auditors,\138\ and
professional standards that require communications between the auditor
and audit committees on auditor independence issues,\139\ many
companies currently have audit committees that closely monitor issues
related to the auditor's independence and the engagement of auditors to
perform non-audit services. Accordingly, we believe that the
incremental costs associated with the proposals would not be
significant.
---------------------------------------------------------------------------
\137\ Item 306 of Regulation S-K (17 CFR 229.306), and item 306
of Regulation S-B (17 CFR 228.306); see generally, Release No. 34-
42266 (Dec. 22, 1999) (64 FR 73389). These disclosure requirements
are discussed supra, in section II.C. of this release.
\138\ Item 4 of form 8-K, 17 CFR 249.308 and item 304 of
Regulation S-K, 17 CFR 229.304, which require disclosure of
``whether the decision to change accountants was recommended or
approved by: (A) Any audit or similar committee of the board of
directors, if the issuer has such a committee; or (B) the board of
directors, if the issuer has no such committee'' and ``whether any
audit or similar committee of the board of directors, or the board
of directors, discussed the subject matter of each of such
disagreements with the former accountant* * *.'' Item
304(a)(1)(iii)(A), (iii)(B), and (iv)(B). 17 CFR
229.304(a)(1)(iii)(A), (iii)(B) and (iv)(B). For small business
issuers, item 304(a)(1)(iii) of Regulation S-B, 17 CFR
228.304(a)(1)(iii) requires disclosure of ``whether the decision to
change accountants was recommended or approved by the board of
directors or an audit or similar committee of the board of
directors.''
\139\ See, e.g., American Institute of Certified Public
Accountants (``AICPA''), ``Communications With Audit Committees,''
Statements on Auditing Standards No. (``SAS'') 61, as amended by SAS
89 and 90; AICPA, Codification of Statements on Auditing Standards
(``AU'') Sec. 380; Independence Standards Board, ``Independence
Discussions with Audit Committees,'' Independence Standard No. 1
(Jan. 1999).
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(c) Rotation of Partners on the Audit Engagement. Under the
proposed rules, no partner would serve on an audit engagement team for
more than five years.\140\ Current professional requirements state that
the partner in charge of an audit engagement should be replaced at
least once every seven years.\141\ The proposals, therefore, would
require more partners to be rotated and the engagement partner to be
rotated more often.
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\140\ See generally, section 203 of the Sarbanes-Oxley Act.
\141\ See American Institute of Certified Public Accountants,
SEC Practice Section, Requirements of Members, at item e. The
membership requirements are available online at http://www.aicpa.org/members/div/secps/require.htm
.
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Costs associated with the periodic replacement of partners might
include more frequent company-specific training, conducted by both the
accounting firm and the company, as new partners join the team auditing
that company's financial statements. For example, the new partners
would need to learn the company's accounting and financial reporting
procedures, controls and personnel. The proposed rules also might
result in incremental costs related to some partners being required to
relocate from one part of the country to another.
The costs related to these proposed rules would vary based on the
proximity of an accounting firm's audit clients, the concentration of
the firm's practice within an industry, and the availability of
partners to whom the work may be redistributed, and similar factors.
Smaller firms that do not have sufficient partners to replace the
partners on an audit engagement team may be particularly affected by
the proposed rules in that they would have to accept more partners into
the firm or lose the audit engagement.
It is difficult to calculate the costs associated with this portion
of the proposed rules. However, it is likely that these costs may be
passed on to issuers in the form of higher audit fees. As noted below,
we request comments on the anticipated costs associated with all
aspects of the proposed rules.
(d) One-Year Cooling Off Period. The proposed rules would indicate
that an accounting firm is not independent with respect to an audit
client if a former partner, principal, shareholder, or professional
employee of an accounting firm is in a ``financial reporting oversight
role'' at that client, unless the individual had not been a member of
the audit engagement team for that client's financial statements during
the one year period preceding the initiation of the audit.\142\ A
``financial reporting oversight role'' is a role in which a person is
in a position to or does influence the contents of financial statements
or anyone who prepares them.\143\ Such persons would include directors,
chief executive officers, chief financial officers, chief accounting
officers, controllers, and others.\144\
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\142\ See section 206 of the Sarbanes-Oxley Act.
\143\ See 17 CFR 210.2-01(f)(3) and proposed rule 2-01(f)(3)(B).
\144\ Id.
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Currently, when a former professional employee of an accounting
firm joins an audit client within one year of leaving the firm, and the
individual has significant interaction with the accounting firm's audit
engagement team, professional standards require the accounting firm to
perform procedures to assure that the individual's knowledge of, or
relationships with, the accounting firm do not adversely influence the
quality of the audit.\145\ These procedures include modifying the audit
plan to adjust for the risk that the individual would be able to
circumvent key aspects of the audit, and assuring that the people on
the audit engagement team have the stature and objectivity not to be
influenced by their former partner or co-employee and to be have the
appropriate level of skepticism when evaluating the individual's
representations and views. Because the proposed rules would limit the
situations in which this situation could occur, accounting firms and
audit
[[Page 76807]]
clients would not have to pay for the performance of these procedures.
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\145\ Independence Standards Board, ``Independence Standard No.
3: Employment with Audit Clients'' (July 2000).
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Costs might occur, however, from the company being required to
delay the hiring, or not being able to hire, the individual that it
believes is the most qualified person to perform a ``financial
reporting oversight role'' at the company. This may add to recruitment
costs or less efficient operations. Such costs are difficult to
estimate and would vary from one company to another.
(e) Compensation. The proposed rules would provide that an auditor
is not independent with respect to an audit client if a partner,
principal or shareholder of an accounting firm, who is a member of the
audit engagement team conducting an audit of that client's financial
statements, earns or receives compensation based on the performance of,
or in consideration of procuring, engagements to provide any services
to that client other than audit, review, or attest services. This
provision might affect the compensation plans of those firms that
currently reward partners, principals, and shareholders of the firm for
generating sales of non-audit services to their respective audit
clients. If the proposed rules were adopted, those revenues would be
allocated to other persons within the accounting firm. Absent this
incentive, auditors may be less inclined to inform issuers of ways to
improve their performance or condition through non-audit services. We
do not expect, however, that there would be any incremental costs to
the firm or to the client.
2. Auditor Reports to Audit Committees
Under the proposed rules, each public accounting firm registered
with the Public Company Accounting Oversight Board that audits an
issuer's financial statements must report to the issuer's audit
committee (1) all critical accounting policies and practices used by
the issuer, (2) alternative accounting treatments within GAAP that have
been discussed with management, including the ramifications of the use
of the alternative treatments and the treatment preferred by the
accounting firm, and (3) other material written communications between
the accounting firm and management of the issuer such as any management
letter or schedule of ``unadjusted differences.'' \146\ The required
reports need not be in writing but the report would be required to be
presented to the audit committee before the auditor's report is filed
with the Commission.
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\146\ See section 204 of the Sarbanes-Oxley Act.
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Because of existing GAAS and legal provisions,\147\ we believe that
adoption of the proposed rules regarding auditor reports to audit
committees will not significantly increase costs for accounting firms
or registrants. Any such costs may arise from the timing of the
communications, which, under the proposed rules, must occur before the
auditor's report is filed with the Commission.
---------------------------------------------------------------------------
\147\ See item 303 of Regulation S-K, 17 CFR 229.303; Release
No. 33-8040 (Dec. 12, 2001); and SAS 61, AU Sec. 380,
``Communication with Audit Committees or Others with Equivalent
Authority and Responsibility.''
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3. Enhanced Disclosures About the Services Provided by Auditors to
Registrants
The existing proxy disclosure rules require disclosure of all
professional fees billed by the principal auditor in the last fiscal
year, with the fees broken down into three categories: audit fees,
financial information systems design and implementation fees, and all
other fees. The proposals would divide the disclosure into two more
categories--tax fees and audit-related fees--and add disclosure of one
more year of these fees while eliminating separate disclosure of fees
related to financial information systems design and implementation. The
proposals also would require companies that do not file proxy
statements to file this information with the Commission in their annual
reports on forms 10-K and 10-KSB, foreign private issuers to file the
information on form 20-F, certain Canadian issuers to file the
information on form 40-F, and registered management investment
companies to file the information on proposed form N-CSR.\148\
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\148\ Form 10-K is the annual report that registrants file with
the Commission pursuant to section 13 or 15(d) of the Exchange Act,
if no other annual reporting form has been prescribed. Small
business issuers may use abbreviated form 10-KSB. A ``small business
issuer'' is an entity that (1) has revenues of less than
$25,000,000, (2) is a U.S. or Canadian issuer, (3) is not an
investment company, and (4) if a majority owned subsidiary, the
parent corporation is also a small business issuer. An entity is not
a ``small business issuer,'' however, if the aggregate market value
of its outstanding voting and non-voting common stock held by non-
affiliates is $25,000,000 or more. See 17 CFR 240.12b-2. Registered
management investment companies would use proposed form N-CSR to
file certified shareholder reports with the Commission under the
Sarbanes-Oxley Act of 2002. See Investment Company Act Release No.
25723 (Aug. 30, 2002) (67 FR 57298 (Sept. 9, 2002)).
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Registrants also would be required to disclose the audit
committee's policies and procedures for approval of auditor
engagements, and the percentage of fees in each of the four categories
noted above (audit, audit-related, tax, and all other) that were pre-
approved by the audit committee during each of the last two fiscal
years.
Based on the staff's experience, we believe that the additional
disclosure contemplated by the proposed rules would require, on
average, approximately one-half of a page in a company's proxy
statement or annual report. A financial printing company informed the
staff that adding one-half of a page in the proxy statement would not
be likely to increase the printing cost to the company because that
much more text normally can be incorporated without increasing the page
length by reformatting the document.\149\ Accordingly, based on our
preliminary estimates, there should be little, if any, additional
printing costs from these additional disclosures.
---------------------------------------------------------------------------
\149\ See Release No. 34-41987 (Oct. 7, 1999) (64 FR 55648, at
55658).
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For the purposes of the Paperwork Reduction Act, we have estimated
that the incremental disclosure of fees, the disclosure of the audit
committees policies and procedures for approval of audit engagements,
and the percentage of fees pre-approved by the audit committee would
impose, on average, two additional burden hours for each of the 7,661
filers of schedule 14A, or an aggregate annual burden of 15,322
additional burden hours. We estimate that most of this time would
relate to consideration and review of the disclosures of the audit
committee's policies and procedures. We further estimate that
approximately 75% of the extra burden hours, or approximately 11,492
hours, would be expended by internal staff and the remaining 25%, or
3,830 hours, would be for outside legal costs associated with reviewing
the proposed disclosures. Assuming that the internal staff costs the
company an average of $125 per hour,\150\ the aggregate annual cost for
internal staff assistance would be approximately $1,436,500. If we
assume that outside legal costs would be an average of $300 per hour,
the aggregate annual legal costs would be $1,149,000. The total annual
paperwork costs associated with the proposed disclosures, therefore,
would be approximately $2,585,500. Similarly, we estimated that the 464
filers of schedule 14C would incur an additional annual burden of 928
hours, or which 696 hours would be imposed on the company itself and
232 would represent a cost for outside legal assistance. Based on these
numbers, we estimate that the annual internal cost would be $87,000
(696 hours x $125 per
[[Page 76808]]
hour) and the annual external cost would be $69,600 (232 hours x $300
per hour), for a total annual cost of $156,600.
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\150\ This cost estimate is based on data obtained from The SIA
Report on Management and Professional Earnings in the Securities
Industry (Oct. 2001).
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For those registrants who would be providing the information on
form 10-K, we estimated for the purposes of the Paperwork Reduction Act
that the incremental disclosure of fees, the audit committee's policies
and procedures for approval of audit engagements, and the percentage of
fees pre-approved by the audit committee, would impose, on average, two
additional burden hours per year on each of the 8,484 filers of form
10-K.\151\ Six thousand six hundred and seventy-six (6,676) of those
filers, however, would provide the information under schedule 14A and
209 of those filers would provide the information under schedule 14C.
The burden hours for the disclosure by these filers therefore has been
assigned to schedule 14A and schedule 14C, respectively. The burden
imposed on the remaining 1,599 filers is being assigned to form 10-K.
This results in 3,198 (2 hours x 1,599 filers) additional burden hours.
We estimate that most of this time would relate to consideration and
review of the disclosures of the audit committee's policies and
procedures. We further estimate that approximately 75% of the extra
burden hours, or approximately 2,399 hours, would be expended by
internal staff and the remaining 25%, or 799 hours, would be for
outside legal costs associated with reviewing the proposed disclosures.
Assuming a cost of $125 per hour for internal costs results in
aggregate internal costs of $299,875. Assuming that outside legal costs
would be an average of $300 per hour, the aggregate annual legal costs
would be $239,700. The total annual paperwork costs associated with the
proposed disclosures, therefore, would be approximately $539,575.
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\151\ As noted previously, the proposed rules also would amend
forms 20-F and 40-F. However, because the number of registrants
which use these forms is very small, it is not expected to have a
significant burden increase.
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For smaller companies that file forms 10-KSB \152\ we estimated for
the purposes of the Paperwork Reduction Act that the incremental
disclosure of fees, the audit committee's policies and procedures for
approval of audit engagements, and the percentage of fees pre-approved
by the audit committee, would impose, on average, two additional burden
hours per year on each of the 2,590 filers of form 10-KSB that do not
file either schedule 14A or schedule 14C, or 5,180 additional burden
hours. We estimate that most of this time would relate to consideration
and review of the disclosures of the audit committee's policies and
procedures. We further estimate that internal staff would expend
approximately 75% of the extra burden hours, or approximately 3,885
hours. Assuming a cost $125 per hour for internal staff, the aggregate
internal costs would be approximately $485,625. The remaining 25%, or
1,295 hours, would be for outside legal costs associated with reviewing
the proposed disclosures. Assuming that outside legal costs would be an
average of $300 per hour, the aggregate annual legal costs would be
$388,500. The total annual paperwork costs associated with the proposed
disclosures, therefore, would be approximately $874,125.
---------------------------------------------------------------------------
\152\ 17 CFR 240.12b-2.
---------------------------------------------------------------------------
Using a similar analysis, we estimated an increase of 2,388 burden
hours and $537,300 in annual legal costs (2,388 x .75 x $300) for form
20-F. This produces an estimate of $298,500 (2,388 hours x $125 per
hour) for internal costs, or a total cost of $835,800 ($537,300 +
$298,500) for such filers. For form 40-F filers, we estimated an
increase of 268 burden hours and $60,300 in annual legal costs (200 x
.25 x $300). This produces an estimate of $33,500 (268 hours x $125 per
hour) for internal costs, or a total cost of $93,800 ($60,300 +
$33,500).
Proposed form N-CSR. We issued a release proposing form N-CSR on
August 30, 2002, pursuant to section 30 of the Investment Company Act
(15 U.S.C. 80a-29) and sections 13 and 15(d) of the Exchange Act (15
U.S.C. 78m and 78o(d)). For registered management investment companies
that would be providing the information on proposed form N-CSR, we
estimate that the incremental disclosure of fees, the audit committee's
policies and procedures for approval of audit engagements, and the
percentage of fees pre-approved by the audit committee, would impose,
on average, two additional burden hours per year on each of the
estimated 3,700 filers of proposed form N-CSR. This results in 7,400 (2
hours x 3,700 filers) additional burden hours. We estimate that most of
this time would relate to consideration and review of the disclosures
of the audit committee's policies and procedures. We further estimate
that approximately 75% of the extra burden hours, or approximately
5,550 hours, would be expended by internal staff and the remaining 25%,
or 1,850 hours, would be for outside legal costs associated with
reviewing the proposed disclosures. We estimate a cost of $40 per hour
for internal staff review, resulting in aggregate internal costs of
$222,000. Further, we estimate that outside legal costs would be an
average of $300 per hour, resulting in aggregate annual legal costs of
$555,000. The total annual paperwork costs associated with the proposed
disclosures, therefore, would be approximately $1,004,550.
D. Request for Comments
As noted above, we request comments on all aspects of this cost-
benefit analysis, including the identification of any additional costs
or benefits. We encourage commenters to identify and supply relevant
data concerning the costs or benefits of the proposed amendments. We
request comments, including supporting data, on the magnitude of the
costs and benefits mentioned in this section.
[sbull] Are there any other costs or benefits that we have not
identified? For example, would the additional duties on audit
committees increase the cost of maintaining those committees? Would the
amount of compensation demanded by audit committee members increase?
Would there be a shortage of potential audit committee members that
would lead to higher costs related to finding and retaining such
members? Would the cost of officer/director liability insurance
increase? Please describe any such costs and provide relevant data.
[sbull] Are there additional costs related to the proposed
disclosures? If there are, please identify them and provide supporting
data.
[sbull] We request comments on the reasonableness of the burden
hour, cost estimates, and underlying assumptions related to the
proposed disclosures.
[sbull] Will the prohibition of certain non-audit services impose
greater costs on companies? If so, what will those costs be and how
significant will those costs be?
[sbull] How much cost will issuers incur from not being able to
retain their preferred providers of non-audit service, when that
preferred provider happens to also be their auditor?
[sbull] What will be the impact, if any, on audit fees from the
proposal to prohibit certain non-audit services?
[sbull] Are there any economies of scope that will be lost due to
implementation of the auditor independence rules?
[sbull] Are there any economies of scale that will be lost due to
implementation of the auditor independence rules?
VI. Consideration of Impact on the Economy, Burden on Competition, and
Promotion of Efficiency, Competition, and Capital Formation
For purposes of the Small Business Regulatory Enforcement Fairness
Act of
[[Page 76809]]
1996,\153\ the Commission is requesting information regarding the
potential impact of the proposals on the economy on an annual basis.
Commentators should provide empirical data to support their views.
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\153\ Pub. L. 104-121, tit. II, 110 Stat. 857 (1996).
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Section 23(a)(2) of the Exchange Act \154\ requires the Commission,
when adopting rules under the Exchange Act, to consider the anti-
competitive effects of any rule it adopts. In this regard, we note that
it may be possible that some small accounting firms would not have
professionals, other than those working on the audit of a client's
financial statements, with the expertise to provide non-audit services
to that client. Because, under the proposed rules, receipt of fees by
that professional from the provision of non-audit services would impair
the auditor's independence, the accounting firm might not be in a
position to provide non-audit services to that client. This proposal,
therefore, could result in some companies seeking new providers of non-
audit services. In addition, some companies that engage accounting
firms for non-audit services permitted under the current rules, but not
allowed under the Sarbanes-Oxley Act and the proposed rules, would be
required to switch vendors for those services. This may have an impact
on competition for those services, although to the extent the new
vendor is another accounting firm, the result may a redistribution of
services among firms rather than an increase or decrease in services.
Small accounting firms also may be disadvantaged by the prohibition on
partners providing auditing services to the issuer for more than five
consecutive years, since they may not have other partners available to
retain the client.
---------------------------------------------------------------------------
\154\ 15 U.S.C 78w(a)(2).
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[sbull] Given that only larger clients have more than two partners
as part of the audit process, would this provision impose higher costs
on mid-tier firms?
In addition, section 2(b) of the Securities Act of 1933,\155\
section 3(f) of the Exchange Act,\156\ and section 2(c) of the
Investment Company Act \157\ require the Commission, when engaging in
rulemaking that requires it to consider or determine whether an action
is necessary or appropriate in the public interest, to consider whether
the action will promote efficiency, competition, and capital formation.
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\155\ 15 U.S.C. 77b(b).
\156\ 15 U.S.C. 78c(f).
\157\ 15 U.S.C. 80a-2(c).
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One possible adverse impact on capital formation may come from
additional costs related to audit committees. Although the proposed
rules do not require companies to have audit committees, many companies
may choose to establish such committees to facilitate application of
the rules. Additional costs may be associated with forming such
committees and, if necessary, recruiting and retaining independent
directors to serve on those committees.
We believe, however, that investors need to have confidence in the
independence of auditors and in the integrity of the financial
information that fuels our securities markets. The proposals are
designed to bolster investor confidence in the securities markets by
strengthening auditor independence, improving the transparency of the
role of corporate audit committees, and enhancing the reliability and
credibility of financial statements of public companies. Accordingly,
on the whole, the proposals should promote capital formation and market
efficiency.
[sbull] We request comment on the anti-competitive effects of the
proposals.
[sbull] The possible effects of our rule proposals on efficiency,
competition, and capital formation are difficult to quantify. We
request comment on these matters in connection with our proposed rules.
VII. Initial Regulatory Flexibility Act Analysis
This Initial Regulatory Flexibility Act Analysis has been prepared
in accordance with 5 U.S.C. 603. It relates to proposed revisions to
Regulation S-X and to item 9 of schedule 14A, and to forms 10-K, 10-
KSB, 20-F, 40-F and proposed form N-CSR. The proposals would strengthen
the Commission's requirements regarding the independence of auditors
and related disclosures.
A. Reasons for the Proposed Action
The proposed rules generally implement a congressional mandate.
Some of the proposals, although not specifically required by the
statute, are designed to implement the intent of the Sarbanes-Oxley Act
and to assure investors that independent auditors critically are
examining reported financial information. The proposed rules should
provide greater assurance to investors that independent auditors are
performing their public responsibilities and that the financial
information published by registrants and issuers is reliable.
The proposed rules, in general, would:
[sbull] Revise the Commission's regulations related to the non-
audit services that, if provided to an audit client, would impair an
accounting firm's independence;\158\
---------------------------------------------------------------------------
\158\ See section 201 of the Sarbanes-Oxley Act.
---------------------------------------------------------------------------
[sbull] Require that an issuer's audit committee pre-approve all
audit and non-audit services provided to the issuer by the auditor of
an issuer's financial statements;\159\
---------------------------------------------------------------------------
\159\ See section 202 of the Sarbanes-Oxley Act.
---------------------------------------------------------------------------
[sbull] Prohibit any partner on the audit engagement team from
providing audit services to the issuer for more than five consecutive
years;\160\
---------------------------------------------------------------------------
\160\ See section 203 of the Sarbanes-Oxley Act.
---------------------------------------------------------------------------
[sbull] Prohibit an accounting firm from auditing an issuer's
financial statements if certain members of management of that issuer
had been members of the accounting firm's audit engagement team within
the one-year period preceding the commencement of audit
procedures;\161\
---------------------------------------------------------------------------
\161\ See section 206 of the Sarbanes-Oxley Act.
---------------------------------------------------------------------------
[sbull] Require that the auditor of an issuer's financial
statements report certain matters to the issuer's audit committee,
including ``critical'' accounting policies used by the issuer;\162\ and
---------------------------------------------------------------------------
\162\ See section 204 of the Sarbanes-Oxley Act.
---------------------------------------------------------------------------
[sbull] Require 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.\163\
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\163\ See generally, section 202 of the Sarbanes-Oxley Act;
section 10A(i)(2) of the Exchange Act, 15 U.S.C. 78j-1(i)(2).
---------------------------------------------------------------------------
In addition, under the proposed rules, an accountant would not be
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.
B. Objectives
Our objectives are to implement title II of the Sarbanes-Oxley Act
in order to increase investor confidence in the independence of
auditors, in the audit process, and in the reliability of reported
financial information.\164\ This would be accomplished by having: (1)
Clearer auditor independence regulations that would provide investors
with comfort that auditors are placing the interests of investors over
financial or personal incentives, (2) rules mandating that auditors
communicate certain matters to audit committees, which should enhance
the opportunities for meaningful audit committee oversight of the
financial reporting process, and (3) enhanced disclosure of
[[Page 76810]]
the non-audit services provided by, and fees paid to, the accounting
firm that audits and reviews the company's financial statements, and
from better disclosure of the audit committee's role in approving the
provision of non-audit services by the accounting firm that audits the
company's financial statements. We believe that these factors may
improve the efficiency of the markets and result in a lower cost of
capital.
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\164\ See section 208 of the Sarbanes-Oxley Act.
---------------------------------------------------------------------------
C. Legal Basis
We are proposing amendments to Regulation S-X and item 9 of
schedule 14A and to forms 10-K, 10-KSB, 20-F, 40-F and proposed form N-
CSR under the authority set forth in sections 3(a) and 208 of the
Sarbanes-Oxley Act; schedule A and sections 7, 8, 10, 19 and 28 of the
Securities Act, sections 3, 10A, 12, 13, 14, 17, 23 and 36 of the
Exchange Act, sections 5, 10, 14 and 20 of the Public Utility Holding
Company Act of 1935, sections 8, 30, 31 and 38 of the Investment
Company Act of 1940, and sections 203 and 211 of the Investment
Advisers Act of 1940.
D. Small Entities Subject to the Proposed Rules
The proposals would affect small registrants and small accounting
firms that are small entities. Exchange Act rule 0-10(a) \165\ and
Securities Act rule 157 \166\ define a company to be a ``small
business'' or ``small organization'' if it had total assets of $5
million or less on the last day of its most recent fiscal year. We
estimate that approximately 2,500 companies were small entities, other
than investment companies.
---------------------------------------------------------------------------
\165\ 17 CFR 240.0-10(a).
\166\ 17 CFR 230.157.
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For purposes of the Investment Company Act, rule 0-10 \167\ defines
``small business'' to be an investment company with net assets of $50
million or less as of the end of its most recent fiscal year. We
estimate that approximately 225 investment companies met this
definition.
---------------------------------------------------------------------------
\167\ 17 CFR 270.0-10.
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Our rules do not define ``small business'' or ``small
organization'' for purposes of accounting firms. The Small Business
Administration defines small business, for purposes of accounting
firms, as those with under $6 million in annual revenues.\168\ We have
only limited data indicating revenues for accounting firms, and we
cannot estimate the number of firms with less than $6 million in
revenues that practice before the Commission. We request comment on the
number of accounting firms with revenue under $6 million.
---------------------------------------------------------------------------
\168\ 13 CFR 121.201.
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E. Reporting, Recordkeeping and Other Compliance Requirements
1. Auditor Independence
The vast majority of registrants are audited by one of the four
largest accounting firms, which clearly are not small entities.
Nonetheless, changes in the auditor independence regulations may impose
compliance requirements, recordkeeping and reporting requirements on
small accounting firms and on any small registrant that engages, or
would like to consider engaging, the auditor of an issuer's financial
statements to perform non-audit services.
(a) Non-audit services. The current auditor independence rules
state that the performance of certain non-audit services will impair an
auditor's independence. The proposed rules, in some cases, would
redefine the limits of those services and would add one more item,
``expert services,'' to the list of prohibited services. These changes
could impact the competitive markets for these services. In particular,
the Commission is considering withdrawing the specific exemption in the
current rules that allows audit clients with less than $200 million in
total assets to engage the auditors of their financial statements to
perform internal audit services.\169\ Under the proposed rules, small
issuers also would be precluded from engaging auditors to perform
certain services in the categories of financial systems design and
implementation services, appraisal and valuation services, actuarial
services, and others, that may be performed under the current rules.
Small registrants, therefore, may have to use a separate vendor for
such services. Small accounting firms may lose one or more sources of
revenue if the proposed rules are adopted because they would no longer
be able to sell certain non-audit services to their audit clients.
---------------------------------------------------------------------------
\169\ 17 CFR 210.2-01(c)(4)(v)(A).
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According to the information available to the staff in 2000,
however, approximately 12,600 registrants did not purchase any
consulting services from the auditor of their financial statements, and
4,100 registrants reported purchasing such services.\170\ Based on the
attention that has been drawn to this area over the past year, the
Commission staff believes that the number of small registrants
purchasing non-audit services from their auditor, and the amount of
small accounting firms providing services to audit clients that are
Commission registrants, might have decreased significantly. Also, to
the extent non-audit services are merely redistributed among the firms,
there would be no net loss of revenue to public accounting firms as a
whole.
---------------------------------------------------------------------------
\170\ Id.; 65 FR at 43185.
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(b) Audit Committee Pre-approval of Services. Under the proposed
rules, all auditing and non-audit services to be provided by the
auditor of an issuer's financial statements must be pre-approved by the
issuer's audit committee.\171\ The definition of audit committee in the
Sarbanes-Oxley Act, which is cited in the proposed rules, however,
indicates that if no such committee exists, the entire board of
directors of the issuer may perform this function.\172\ The rules,
therefore, would not require a small company to form an audit
committee.
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\171\ Section 301 of the Sarbanes-Oxley Act of 2002 requires the
Commission to direct the national securities exchanges and national
securities associations to prohibit the listing of any security of
an issuer that does not meet certain criteria, including having an
audit committee that performs certain functions. See section 10A(m)
of the Exchange Act, 15 U.S.C. 78j-1(m). The Sarbanes-Oxley Act
defines ``audit committee'' to be ``(A) a committee (or equivalent
body) established by and amongst the board of directors of an issuer
for the purpose of overseeing the accounting and financial reporting
processes of the issuer and audits of the financial statements of
the issuer; and (B) if no such committee exists with respect to an
issuer, the entire board of directors of the issuer.'' Section
205(a) of the Sarbanes-Oxley Act, which, among other things, adds
section 3(a)(58) to the Exchange Act.
\172\ Id.
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There are reasons to believe that many small entities currently
have audit committees.\173\ Any small entity that does not have such a
committee and would form one to facilitate operation of the proposed
rules, however, would incur costs to establish such a committee and, if
necessary, to recruit and retain the required number of independent
directors. Small entities also might spend time and incur costs to
document the audit committee's activities in the areas covered by the
proposed rules, including drafting and maintaining the audit
committee's policies and procedures related to engaging the auditor to
perform non-audit services. Small entities also might incur costs in
seeking the help of outside experts, particularly outside legal
counsel, in drafting the audit committee's policies and procedures.
---------------------------------------------------------------------------
\173\ See, e.g., NACD, 2001-2002 Public Company Governance
Survey (Nov. 2001).
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(c) Rotation of Partners on the Audit Engagement. Under the
proposed rules, no partner would serve on an audit engagement team for
more than five
[[Page 76811]]
years.\174\ Current professional requirements state that the partner in
charge of an audit engagement should be replaced at least once every
seven years.\175\ The proposals, therefore, would require more partners
to be rotated and the engagement partner to be rotated more often.
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\174\ See generally, section 203 of the Sarbanes-Oxley Act.
\175\ See American Institute of Certified Public Accountants,
SEC Practice Section, Requirements of Members, at item e. The
membership requirements are available online at http://www.aicpa.org/members/div/secps/require.htm
.
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Costs associated with the periodic replacement of partners might
include more frequent company-specific training because new partners
joining the audit engagement team would need to learn the company's
accounting and financial reporting procedures, controls and personnel.
The proposed rules also might result in incremental costs related to
some partners being required to relocate from one part of the country
to another.
Smaller firms that do not have sufficient partners to make the
required replacements of the partners on an audit engagement team may
be particularly affected by the proposed rules. These small accounting
firms might have to accept more qualified partners into the firm or
lose the audit engagement.
(d) One-Year Cooling Off Period. The proposed rules would deem an
accounting firm as not independent with respect to an audit client if a
former partner, principal, shareholder, or professional employee of an
accounting firm is in a ``financial reporting oversight role'' at that
client, unless the individual had not been a member of the audit
engagement team for that client's financial statements during the one
year period preceding the initiation of the audit.\176\ A ``financial
reporting oversight role'' is a role in which a person is in a position
to or does influence the contents of financial statements or anyone who
prepares them.\177\ Such persons would include directors, chief
executive officers, chief financial officers, chief accounting
officers, controllers, and others.\178\ A small registrant might incur
costs from a delay in hiring, or not being able to hire, the individual
that it believes is the most qualified person to perform a ``financial
reporting oversight role'' at the company. This may add to recruitment
costs or less efficient operations. We have solicited comment and are
considering alternatives to minimize the impact of this proposed rule
on small entities.
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\176\ See section 206 of the Sarbanes-Oxley Act.
\177\ See 17 CFR 210.2-01(f)(3) and proposed rule 2-01(f)(3)(B).
\178\ Id.
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(e) Compensation. Under the proposed rules, an accounting firm's
independence would be impaired if any partner, principal or shareholder
of the firm, who is a member of an engagement team auditing a client's
financial statements, receives any compensation directly based on any
service provided or sold to that client other than audit, review and
attest services. Thus, accounting firms would have to discontinue
compensating these individuals for ``cross-selling'' services.
Some small accounting firms might have a relatively small number of
partners, principals or shareholders of the firm available to serve
each client. Such firms might not have personnel, other than the
partner in charge of the audit of a small company's financial
statements, with sufficient expertise to market and provide non-audit
services to that company. In such cases, the proposed rule might result
in a small company being forced to find another provider for those
services. This might result in increased costs related to small
entities locating and engaging additional service providers, and might
decrease revenues to small accounting firms.
2. Auditor Reports to Audit Committees
Under the proposed rules, each public accounting firm registered
with the Public Company Accounting Oversight Board that audits an
issuer's financial statements must report to the issuer's audit
committee (1) all critical accounting policies and practices used by
the issuer, (2) alternative accounting treatments within GAAP that have
been discussed with management, including the ramifications of the use
of the alternative treatments and the treatment preferred by the
accounting firm, and (3) other material written communications between
the accounting firm and management of the issuer such as any management
letter or schedule of ``unadjusted differences.'' \179\ The required
reports need not be in writing, but must be provided to the audit
committee before the auditor's report on the financial statements if
filed with the Commission.
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\179\ See section 204 of the Sarbanes-Oxley Act.
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Auditing standards currently require discussions between the
auditors and the audit committee of significant unusual, controversial,
or emerging accounting policies, of the process used by management to
select certain estimates, and of disagreements over certain accounting
matters. Further, audit committees generally are aware of management's
letter making representations to the auditors, which the auditor uses
in conducting the audit of the issuer's financial statements, and the
auditors' letters to management on reportable conditions in internal
controls and other matters. Also, due to enactment of section 401 of
the Sarbanes-Oxley Act, all material adjustments identified by the
auditor should be reflected in the issue's financial statements and,
therefore, there should be no material ``unadjusted differences.''
Because of these GAAS and legal provisions, we believe that
adoption of the proposed rules regarding auditor reports to audit
committees will not significantly increase costs, including costs for
small accounting firms and small registrants. Some costs may be
incurred, however, to the extent communications would be required
before the auditor's report is filed with the Commission.
3. Enhanced Disclosures About the Services Provided by Auditors to
Registrants
Currently, disclosure is required in proxy and information
statements of the fees billed in the most recent fiscal year under the
categories of audit fees, information systems design and implementation
fees, and all other fees. The proposals would require disclosure of the
fees billed in each of the two most recent years, instead of the
current requirement for disclosure of only the most recent year's fees.
The proposals also would add the categories of tax fees and audit-
related fees but eliminate separate disclosure of information systems
design and implementation form the current list of audit fees,
information systems design and implementation fees, and all other fees.
The proposed rules also would require disclosure of the percentage of
fees in each category that were pre-approved by the audit committee as
opposed to being entered into under the audit committee's policies and
procedures. Finally, the proposals would extend the disclosure
requirements to all entities filing forms 10-K, 10-KSB, 20-F, 40-F and
proposed form N-CSR.\180\
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\180\ Form 10-K is the annual report that registrants file with
the Commission pursuant to section 13 or 15(d) of the Exchange Act,
if no other annual reporting form has been prescribed. Small
business issuers may use abbreviated form 10-KSB. A ``small business
issuer'' is an entity that (1) has revenues of less than
$25,000,000, (2) is a U.S. or Canadian issuer, (3) is not an
investment company, and (4) if a majority owned subsidiary, the
parent corporation is also a small business issuer. An entity is not
a ``small business issuer,'' however, if the aggregate market value
of its outstanding voting and non-voting common stock held by non-
affiliates is $25,000,000 or more. See 17 CFR 240.12b-2. Registered
management investment companies would use proposed form N-CSR to
file certified shareholder reports with the Commission under the
Sarbanes-Oxley Act of 2002. See Investment Company Act Release No.
25723 (Aug. 30, 2002) (67 FR 57298 (Sept. 9, 2002)).
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[[Page 76812]]
The proposed rules would require all entities filing forms 10-K,
10-KSB, 20-F, 40-F and proposed form N-CSR to include the disclosure
either in the proxy or information statement or, if the company does
not issue a proxy or information statement, in forms 10-K, 10-KSB, 20-
F, 40-F or proposed form N-CSR. The proposed rules, therefore, might
require small entities to spend additional time and incur additional
costs in preparing disclosures. Small entities also might incur costs
to set up procedures to monitor the activities of the audit committee
in order to collect and record the information to be disclosed under
the proposed rules.
F. Duplicative, Overlapping or Conflicting Federal Rules
The Commission is not aware of any rules that duplicate, overlap,
or conflict with the proposed rules.
G. Significant Alternatives
The Regulatory Flexibility Act directs us to consider significant
alternatives that would accomplish the stated objective, while
minimizing any significant adverse impact on small entities. In
connection with the proposed amendments, we considered the following
alternatives:
1. The establishment of differing compliance or reporting
requirements or timetables that take into account the resources of
small entities;
2. The clarification, consolidation, or simplification of
compliance and reporting requirements under the rule for small
entities;
3. The use of performance rather than design standards; and
4. An exemption from coverage of the proposed amendments, or any
part thereof, for small entities.
We do not propose to exempt small business issuers from the
proposals because Congress indicated that any exemptions should be on a
case-by-case basis and not by categories. We, nevertheless, are
considering whether any exception or classifications for small
businesses would be appropriate and consistent with the Sarbanes-Oxley
Act. We believe investors in small companies, however, just as
investors in large companies, would want and benefit from the proposed
revisions in the auditor independence rules and enhanced communications
between the auditor and the audit committee.
The proposed rules are designed to enhance auditors' independence
and the reliability and credibility of financial statements for all
public companies. Currently, we do not believe that it is feasible to
further clarify, consolidate, or simplify the proposed rules for small
entities. We are particularly mindful of the implications of our
proposed rules on the provision of bookkeeping and internal controls
services, as well as auditor rotation and cooling-off period
requirements for small firms. We invite comments on these and all other
issues.
H. Solicitation of Comments
We encourage the submission of comments with respect to any aspect
of this Initial Regulatory Flexibility Analysis. Specifically, we
request comments regarding the number of small entities that may be
affected by the proposed rules, and the existence or nature of the
potential impact on those small entities. We also seek comments on how
to quantify the number of small accounting firms that would be affected
by the proposals, and how to quantify the impact of the proposed rules
on those firms.
Commenters are requested to describe the nature of any impact and
provide empirical data supporting the extent of the impact. Such
comments will be considered in the preparation of the Final Regulatory
Flexibility Analysis, if the proposed rules are adopted, and will be
placed in the same public file as comments on the proposed rules.
VIII. Codification Update
The Commission proposes to amend the ``Codification of Financial
Reporting Policies'' announced in Financial Reporting Release No. 1
(April 15, 1982):
By amending section 602 to add a new discussion at the end of that
section under the Financial Reporting Release Number (FR-64) assigned
to the adopting release and including the text in the adopting release
that discusses the final rules, which, if the proposals are adopted,
would be substantially similar to section III of this release.
The Codification is a separate publication of the Commission. It
will not be published in the Code of Federal Regulations.
IX. Statutory Bases and Text of Amendments
We are proposing amendments to rules 2-01 and 2-07 of Regulation S-
X, item 9 of schedule 14A, forms 10-K, 10-KSB, 20-F and 40-F, and
proposed form N-CSR under the authority set forth in schedule A and
sections 7, 8, 10, 19 and 28 of the Securities Act, sections 3, 10A,
12, 13, 14, 17, 23 and 36 of the Exchange Act, sections 5, 10, 14 and
20 of the Public Utility Holding Company Act of 1935, sections 8, 30,
31 and 38 of the Investment Company Act of 1940, and sections 203 and
211 of the Investment Advisers Act of 1940 and sections 3(a) and 208 of
the Sarbanes-Oxley Act.
List of Subjects
17 CFR Part 210
Accountants, Accounting.
17 CFR Part 240
Broker-dealers, Issuers, Securities.
17 CFR Part 249
Reporting and recordkeeping requirements, Securities.
17 CFR Part 274
Investment companies, Reporting and recordkeeping requirements,
Securities.
Text of Proposed Amendments
In accordance with the foregoing, title 17, chapter II of the Code
of Federal Regulations is proposed to be amended as follows:
PART 210--FORM AND CONTENT OF AND REQUIREMENTS FOR FINANCIAL
STATEMENTS, SECURITIES ACT OF 1933, SECURITIES EXCHANGE ACT OF
1934, PUBLIC UTILITY HOLDING COMPANY ACT OF 1935, INVESTMENT
COMPANY ACT OF 1940, INVESTMENT ADVISERS ACT OF 1940 AND ENERGY
POLICY AND CONSERVATION ACT OF 1975
1. The authority citation for part 210 continues to read as
follows:
Authority: 15 U.S.C. 77f, 77g, 77h, 77j, 77s, 77z-2, 77z-3,
77aa(25), 77aa(26), 78c, 78j-1, 78l, 78m, 78n, 78o(d), 78q, 78u-5,
78w(a), 78ll, 78mm, 79e(b), 79j(a), 79n, 79t(a), 80a-8, 80a-20, 80a-
29, 80a-30, 80a-37(a), 80b-3, 80b-11 unless otherwise noted.
2. Section 210.2-01 is amended by:
a. Revising paragraph (c)(2)(iii);
b. Revising paragraph (c)(4);
c. Adding paragraph (c)(6);
d. Adding paragraph (c)(7);
e. Adding paragraph (c)(8);
f. Revising paragraph (f)(1);
g. Revising paragraph (f)(3); and
h. Adding paragraph (f)(17).
The revisions and additions read as follows:
Sec. 210.2-01 Qualifications of accountants.
* * * * *
(c) * * *
(2) * * *
(iii) Employment at audit client of former employee of accounting
firm.
(A) A former partner, principal, shareholder, or professional
employee
[[Page 76813]]
of an accounting firm is in an accounting role or financial reporting
oversight role at an audit client, unless the individual:
(1) Does not influence the accounting firm's operations or
financial policies;
(2) Has no capital balances in the accounting firm; and
(3) Has no financial arrangement with the accounting firm other
than one providing for regular payment of a fixed dollar amount (which
is not dependent on the revenues, profits, or earnings of the
accounting firm):
(i) Pursuant to a fully funded retirement plan, rabbi trust, or, in
jurisdictions in which a rabbi trust does not exist, a similar vehicle;
or
(ii) In the case of a former professional employee who was not a
partner, principal, or shareholder of the accounting firm and who has
been disassociated from the accounting firm for more than five years,
that is immaterial to the former professional employee.
(B) A former partner, principal, shareholder, or professional
employee of an accounting firm is in a financial reporting oversight
role at an audit client, unless the individual:
(1) Was not a member of the audit engagement team of the audit
client during the one year period preceding the date that audit
procedures commenced. Audit procedures are deemed to have commenced at
the earlier of:
(i) The date that the accountant commenced the audit for the period
covered by the financial statements that included the date of the
initial employment of the audit engagement team member by the audit
client; or
(ii) The date that the accountant commenced review procedures for
the period covered by the financial statements that included the
initial employment of the audit engagement team member by the audit
client.
* * * * *
(4) Non-audit services. An accountant is not independent if, at any
point during the audit and professional engagement period, the
accountant provides the following non-audit services to an audit
client:
(i) Bookkeeping or other services related to the accounting records
or financial statements of the audit client. Any service, 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, including:
(A) Maintaining or preparing the audit client's accounting records;
(B) Preparing the audit client's financial statements that are
filed with the Commission or form the basis of financial statements
filed with the Commission; or
(C) Preparing or originating source data underlying the audit
client's financial statements.
(ii) Financial information systems design and implementation. (A)
Directly or indirectly, operating, or supervising the operation of, the
audit client's information system or managing the audit client's local
area network.
(B) Designing or implementing 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 or other financial information systems taken as a whole.
(iii) Appraisal or valuation services, fairness opinions, or
contribution-in-kind reports. Any appraisal service, valuation service
or any service involving a fairness opinion or contribution-in-kind
report for an 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.
(iv) Actuarial services. Any actuarially-oriented advisory service
involving the determination of 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.
(v) Internal audit outsourcing services. Any internal audit
services related to the internal accounting controls, financial
systems, or financial statements, for an audit client.
(vi) Management functions. 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.
(vii) Human resources. (A) Searching for or seeking out prospective
candidates for managerial, executive, or director positions;
(B) Engaging in psychological testing, or other formal testing or
evaluation programs;
(C) Undertaking reference checks of prospective candidates for an
executive or director position;
(D) Acting as a negotiator on the audit client's behalf, such as
determining position, status or title, compensation, fringe benefits,
or other conditions of employment; or
(E) Recommending, or advising the audit client to hire, a specific
candidate for a specific job (except that an accounting firm may, upon
request by the audit client, interview candidates and advise the audit
client on the candidate's competence for financial accounting,
administrative, or control positions).
(viii) Broker-dealer, investment adviser, or investment banking
services. Acting as a broker-dealer (registered or unregistered),
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.
(ix) Legal services. Providing any service to an 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.
(x) Expert services unrelated to the audit. Providing expert
opinions for an audit client in connection with legal, administrative,
or regulatory proceedings or acting as an advocate for an audit client
in such proceedings.
* * * * *
(6) Partner rotation. An accountant is not independent of an audit
client that is:
(i) An issuer as defined in section 10A(f) of the Securities
Exchange Act of 1934 (15 U.S.C. 78j-1(f)) when an audit engagement team
partner, principal or shareholder performs audit, review or attest
services for that issuer or any significant subsidiaries as defined in
17 CFR 210.1-02(w), as a partner, principal or shareholder in each of
the five previous fiscal years of the issuer or any significant
subsidiaries and continues to serve as a partner, principal or
shareholder on the audit engagement team. Following five consecutive
years where audit, review or attest services have not been provided to
that issuer or any significant subsidiaries by the aforementioned
partners, principals or shareholders such partners, principals or
shareholders again may perform audit, review or attest services for the
audit client.
(ii) An entity that is part of an investment company complex as
defined in 17 CFR 210.2-01(f)(14) when any audit engagement team
partner, principal or shareholder performs audit, review or attest
services for any entity in the investment company complex, as a
partner, principal or shareholder in
[[Page 76814]]
each of the five previous fiscal years of the entity and continues to
serve as a partner, principal or shareholder on the audit engagement
team. Following five consecutive years where audit, review or attest
services have not been provided to any entity in the investment company
complex by the aforementioned partners, principals or shareholders such
partners, principals or shareholders again may perform audit, review or
attest services for the audit client.
(7) Audit committee administration of the engagement. An accountant
is not independent of an issuer (as defined in section 10A(f) of the
Securities Exchange Act of 1934 (15 U.S.C. 78j-1(f))), other than an
issuer that is an Asset-Backed Issuer as defined in Sec. 240.13a-14(g)
and Sec. 240.15d-14(g) of this chapter, or an investment company
registered under section 8 of the Investment Company Act of 1940 (15
U.S.C. 80a-8), other than a unit investment trust as defined by section
4(2) of the Investment Company Act of 1940 (15 U.S.C. 80a-4(2)),
unless:
(i) In connection with audit, review and attest reports required
under the securities laws, the issuer's or registered investment
company's audit committee pre-approves all such engagements;
(ii) For engagements other than those specified in paragraph
(c)(7)(i) of this section, in accordance with section 10A(i) of the
Securities Exchange Act of 1934, either:
(A) Before the accountant is engaged by the issuer or its
subsidiaries, or the registered investment company or its subsidiaries,
to render the service, the engagement is approved by the issuer's or
registered investment company's audit committee; or
(B) The engagement to render the service is entered into pursuant
to pre-approval policies and procedures established by the audit
committee of the issuer or registered investment company, provided the
audit committee is informed of each service.
(C) Notwithstanding paragraphs (c)(7)(ii)(A) and (B) of this
section, the pre-approval requirement is waived with respect to the
provision of services covered under paragraph (c)(7)(ii) of this
section provided:
(1) The aggregate amount of all such services provided constitutes
no more than five percent of the total amount of revenues paid by the
audit client to its accountant during the fiscal year in which the
services are provided;
(2) Such services were not recognized by the issuer or registered
investment company at the time of the engagement to be non-audit
services; and
(3) Such services are promptly brought to the attention of the
audit committee of the issuer or registered investment company and
approved prior to the completion of the audit by the audit committee or
by one or more members of the audit committee who are members of the
board of directors to whom authority to grant such approvals has been
delegated by the audit committee;
(iii) In addition, a registered investment company's audit
committee pre-approves its accountant's engagements under paragraph
(c)(7)(ii) of this section with the registered investment company's
investment adviser (not including a sub-adviser whose role is primarily
portfolio management and is sub-contracted or overseen by another
investment adviser) and any entity controlling, controlled by, or under
common control with the investment adviser that provides services to
the registered investment company in accordance with paragraphs
(c)(7)(ii)(A) through (C) of this section, except that with respect to
paragraph (c)(7)(ii)(C)(1) of this section, the aggregate amount of all
services provided constitutes no more than five percent of the total
amount of revenues paid to the registered investment company's
accountant by the registered investment company, its investment adviser
and any entity controlling, controlled by, or under common control with
the investment adviser that provides services to the registered
investment company during the fiscal year in which the services are
provided.
(8) Compensation. An accountant is not independent of an audit
client if, at any point during the audit and professional engagement
period, any partner, principal or shareholder 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 products or services other than audit, review or attest
services.
* * * * *
(f)(1) Accountant, as used in paragraphs (b) through (e) of this
section, means a registered public accounting firm, certified public
accountant or public accountant performing services in connection with
an engagement for which independence is required. References to the
accountant include any accounting firm with which the certified public
accountant or public accountant is affiliated.
* * * * *
(3)(i) Accounting role means a role in which a person is in a
position to or does exercise more than minimal influence over the
contents of the accounting records or anyone who prepares them.
(ii) Financial reporting oversight role means a role in which a
person is in a position to or does exercise influence over the contents
of the financial statements or anyone who prepares them, such as when
the person is a member of the board of directors or similar management
or governing body, chief executive officer, president, chief financial
officer, chief operating officer, general counsel, chief accounting
officer, controller, director of internal audit, director of financial
reporting, treasurer, or any equivalent position.
* * * * *
(17) Audit committee means a committee (or equivalent body) as
defined in section 3(a)(58) of the Securities Exchange Act of 1934 (15
U.S.C. 78c(a)(58)).
3. By adding Sec. 210.2-07 to read as follows:
Sec. 210.2-07 Communication with audit committees.
(a) Each registered public accounting firm that performs for an
audit client that is an issuer (as defined in section 10A(f) of the
Securities Exchange Act of 1934 (15 U.S.C. 78j-1(f))), other than an
issuer that is an Asset-Backed Issuer as defined in Sec. 240.13a-14(g)
and Sec. 240.15d-14(g) of this chapter, or an investment company
registered under section 8 of the Investment Company Act of 1940 (15
U.S.C. 80a-8), other than a unit investment trust as defined by section
4(2) of the Investment Company Act of 1940 (15 U.S.C. 80a-4(2)), any
audit required under the securities laws shall report, prior to the
filing of such audit report with the Commission, to the audit committee
of the issuer or registered investment company:
(1) All critical accounting policies and practices to be used;
(2) All alternative treatments of financial information within
Generally Accepted Accounting Principles that have been discussed with
management of the issuer or registered investment company, including:
(i) Ramifications of the use of such alternative disclosures and
treatments; and
(ii) The treatment preferred by the registered public accounting
firm;
(3) Other material written communications between the registered
public accounting firm and the management of the issuer or registered
investment company, such as any management letter or schedule of
unadjusted differences.
(b) [Reserved]
[[Page 76815]]
PART 240--GENERAL RULES AND REGULATIONS, SECURITIES EXCHANGE ACT OF
1934
4. The authority citation for part 240 continues to read as
follows:
Authority: 15 U.S.C. 77c, 77d, 77g, 77j, 77s, 77z-2, 77z-3,
77eee, 77ggg, 77nnn, 77sss, 77ttt, 78c, 78d, 78e, 78f, 78g, 78i,
78j, 78j-1, 78k, 78k-1, 78l, 78m, 78n, 78o, 78p, 78q, 78s, 78u-5,
78w, 78x, 78ll, 78mm, 79q, 79j, 79n, 79t(a), 80a-8, 80a-20, 80a-29,
80a-30, 80a-37(a), 80b-4, 80b-11, unless otherwise noted.
* * * * *
5. Section 240.10A-2 is added to read as follows:
Sec. 240.10A-2 Auditor independence.
It shall be unlawful for an auditor not to be independent under
Sec. 210.2-01(c)(2)(iii)(B), 2-01(c)(4), 2-01(c)(6), 2-01(c)(7) and 2-
07.
6. Section 240.14a-101 is amended by revising paragraph (e) of item
9 to read as follows:
Sec. 240.14a-101 Schedule 14A. Information required in proxy
statement.
* * * * *
Item 9. Independent public accountants. * * *
* * * * *
(e)(1) Disclose, under the caption Audit Fees, the aggregate
fees billed for each of the last two fiscal years for professional
services rendered by the principal accountant for the audit of the
registrant's annual financial statements and review of financial
statements included in the registrant's form 10-Q (17 CFR 249.308a)
or 10-QSB (17 CFR 249.308b) for those fiscal years.
(2) Disclose, under the caption Audit-Related Fees, the
aggregate fees billed in each of the last two fiscal years for
assurance and related services by the principal accountant that are
reasonably related to the performance of the audit or review of the
registrant's financial statements and are not reported under
paragraph (e)(1) of this section. Registrants shall describe each
subcategory of services comprising the fees disclosed under this
category.
(3) Disclose, under the caption Tax Fees, the aggregate fees
billed in each of the last two fiscal years for professional
services rendered by the principal accountant for tax compliance,
tax consulting, and tax planning.
(4) Disclose, under the caption All Other Fees, the aggregate
fees billed in each of the last two fiscal years for products and
services provided by the principal accountant, other than the
services reported in paragraphs (e)(1) through (e)(3) of this
section. Registrants shall describe each subcategory of services
comprising the fees disclosed under this category.
(5)(i) Disclose the audit committee's pre-approval policies and
procedures described in paragraph (c)(7)(ii) of Regulation S-X (17
CFR 210.2-01(c)(7)(ii)).
(ii) Disclose the percentage of fees described in each of
paragraphs (e)(2) through (e)(4) of this section that were approved
by the audit committee pursuant to each of the paragraphs
(c)(7)(ii)(A), (c)(7)(ii)(B) and, (c)(7)(ii)(C), of rule 2-01 of
Regulation S-X (17 CFR 210.2-01(c)(7)(ii)(A), (B) and (C)).
(6) If greater than 50 percent, disclose the percentage of hours
expended on the principal accountant's engagement to audit the
registrant's financial statements for the most recent fiscal year
that were attributed to work performed by persons other than the
principal accountant's full-time, permanent employees.
Instruction to Item 9(e).
For purposes of item 9(e)(2), (3), (4), and (5)(ii) registrants
that are investment companies must disclose fees billed for services
rendered to the registrant, the registrant's investment adviser (not
including any sub-adviser whose role is primarily portfolio
management and is subcontracted with or overseen by another
investment adviser), and any entity controlling, controlled by, or
under common control with the adviser that provides services to the
registrant.
* * * * *
PART 249--FORMS, SECURITIES EXCHANGE ACT OF 1934
7. The authority citation for part 249 is amended by revising the
citations, Sec. 249.220f, Sec. 249.240f, Sec. 249.310 and Sec.
249.310b and a citation for Sec. 249.331 is added in numerical order
to read as follows:
Authority: 15 U.S.C. 78a et seq., unless otherwise noted.
* * * * *
Section 249.220f is also issued under secs. 3(a), 202, 302, 404 and
407, Pub. L. No. 107-204, 116 Stat. 745.
Section 249.240f is also issued under secs. 3(a), 202, 302, 404 and
407, Pub. L. No. 107-204, 116 Stat. 745.
* * * * *
Section 249.310 is also issued under 15 U.S.C. 78m, 78o(d) and
78w(a) and secs. 3(a), 202 and 302, Pub. L. No. 107-204, 116 Stat. 745.
Section 249.310b is also issued under secs. 3(a), 202 and 302, Pub.
L. No. 107-204, 116 Stat. 745.
* * * * *
Section 249.331 is also issued under secs. 3(a), 202, and 302, Pub.
L. No. 107-204, 116 Stat. 745.
8. Amend form 20-F (referenced in Sec. 249.220f) by adding
paragraph (d) to item 15 to read as follows:
Note: The text of form 20-F does not, and this amendment will
not, appear in the Code of Federal Regulations.
Form 20-F
* * * * *
Item 15. Certain Disclosures.
* * * * *
(d) Principal Accountant Fees and Services.
(1) Disclose, under the caption Audit Fees, the aggregate fees
billed for each of the last two fiscal years for professional
services rendered by the principal accountant for the audit of the
registrant's annual financial statements and review of financial
statements included in the registrant's form 10-Q (17 CFR 249.308a)
or 10-QSB (17 CFR 249.308b) for those fiscal years.
(2) Disclose, under the caption Audit-Related Fees, the
aggregate fees billed in each of the last two fiscal years for
assurance and related services by the principal accountant that are
reasonably related to the performance of the audit or review of the
registrant's financial statements and are not reported under
paragraph (e)(1) of this section. Registrants shall describe each
subcategory of services comprising the fees disclosed under this
category.
(3) Disclose, under the caption Tax Fees, the aggregate fees
billed in each of the last two fiscal years for professional
services rendered by the principal accountant for tax compliance,
tax consulting, and tax planning.
(4) Disclose, under the caption All Other Fees, the aggregate
fees billed in each of the last two fiscal years for products and
services provided by the principal accountant, other than the
services reported in paragraphs (e)(1) through (e)(3) of this
section. Registrants shall describe each subcategory of services
comprising the fees disclosed under this category.
(5)(i) Disclose the audit committee's pre-approval policies and
procedures described in paragraph (c)(7)(ii) of rule 2-01 of
Regulation S-X (17 CFR 210.2-01(c)(7)(ii)).
(ii) Disclose the percentage of fees described in each of
paragraphs (e)(2) through (e)(4) of this section that were approved
by the audit committee pursuant to each of the paragraphs
(c)(7)(ii)(A), (c)(7)(ii)(B), and (c)(7)(ii)(C), of rule 2-01 of
Regulation S-X (17 CFR 210.2-01(c)(7)(ii)(A), (B) and (C)).
(6) If greater than 50 percent, disclose the percentage of hours
expended on the principal accountant's engagement to audit the
registrant's financial statements for the most recent fiscal year
that were attributed to work performed by persons other than the
principal accountant's full-time, permanent employees.
Instructions to Item 15(d).
1. You do not need to provide the information called for by this
item 15(d) unless you are using this form as an annual report.
2. A registrant that is an Asset-Backed Issuer (as defined in
Sec. 240.13a-14(g) and Sec. 240.15d-14(g) of this chapter) is not
required to disclose the information required by this item.
* * * * *
9. Amend form 40-F (referenced in Sec. 249.240f) by adding
paragraph (10) to general instruction B to read as follows:
Note: The text of form 40-F does not, and this amendment will
not, appear in the Code of Federal Regulations.
Form 40-F
* * * * *
[[Page 76816]]
General Instructions
* * * * *
B. Information To Be Filed on This Form.
* * * * *
(10) Principal Accountant Fees and Services.
(1) Disclose, under the caption Audit Fees, the aggregate fees
billed for each of the last two fiscal years for professional
services rendered by the principal accountant for the audit of the
registrant's annual financial statements and review of financial
statements included in the registrant's form 10-Q (17 CFR 249.308a)
or 10-QSB (17 CFR 249.308b) for those fiscal years.
(2) Disclose, under the caption Audit-Related Fees, the
aggregate fees billed in each of the last two fiscal years for
assurance and related services by the principal accountant that are
reasonably related to the performance of the audit or review of the
registrant's financial statements and are not reported under
paragraph (e)(1) of this section. Registrants shall describe each
subcategory of services comprising the fees disclosed under this
category.
(3) Disclose, under the caption Tax Fees, the aggregate fees
billed in each of the last two fiscal years for professional
services rendered by the principal accountant for tax compliance,
tax consulting, and tax planning.
(4) Disclose, under the caption All Other Fees, the aggregate
fees billed in each of the last two fiscal years for products and
services provided by the principal accountant, other than the
services reported in paragraphs (e)(1) through (e)(3) of this
section. Registrants shall describe each subcategory of services
comprising the fees disclosed under this category.
(5)(i) Disclose the audit committee's pre-approval policies and
procedures described in paragraph (c)(7)(ii) of rule 2-01 of
Regulation S-X (17 CFR 210.2-01(c)(7)(ii)).
(ii) Disclose the percentage of fees described in each of
paragraphs (e)(2) through (e)(4) of this section that were approved
by the audit committee pursuant to each of the paragraphs
(c)(7)(ii)(A), (c)(7)(ii)(B), and (c)(7)(ii)(C), of rule 2-01 of
Regulation S-X (17 CFR 210.2-01(c)(7)(ii)(A), (B) and (C)).
(6) If greater than 50 percent, disclose the percentage of hours
expended on the principal accountant's engagement to audit the
registrant's financial statements for the most recent fiscal year
that were attributed to work performed by persons other than the
principal accountant's full-time, permanent employees.
Notes to Instruction B.(10).
1. You do not need to provide the information called for by this
instruction B.(10) unless you are using this form as an annual
report.
2. A registrant that is an Asset-Backed Issuer (as defined in
Sec. 240.13a-14(g) and Sec. 240.15d-14(g) of this chapter) is not
required to disclose the information required by this instruction
B.(10).
* * * * *
10. Amend form 10-K (referenced in Sec. 249.310) by:
a. Redesignating item 16 of part IV as item 17 of part IV, and
b. Adding new item 16 to part III.
The addition reads as follows:
Note: The text of form 10-K does not, and this amendment will
not, appear in the Code of Federal Regulations.
Form 10-K
* * * * *
General Instructions
* * * * *
Annual Report Pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
* * * * *
Part III
* * * * *
Item 16. Principal Accountant Fees and Services.
Furnish the information required by item 9(e) of schedule 14A
(Sec. 240.14a-101 of this chapter).
(1) Disclose, under the caption Audit Fees, the aggregate fees
billed for each of the last two fiscal years for professional
services rendered by the principal accountant for the audit of the
registrant's annual financial statements and review of financial
statements included in the registrant's form 10-Q (17 CFR 249.308a)
or 10-QSB (17 CFR 249.308b) for those fiscal years.
(2) Disclose, under the caption Audit-Related Fees, the
aggregate fees billed in each of the last two fiscal years for
assurance and related services by the principal accountant that are
reasonably related to the performance of the audit or review of the
registrant's financial statements and are not reported under
paragraph (e)(1) of this section. Registrants shall describe each
subcategory of services comprising the fees disclosed under this
category.
(3) Disclose, under the caption Tax Fees, the aggregate fees
billed in each of the last two fiscal years for professional
services rendered by the principal accountant for tax compliance,
tax consulting, and tax planning.
(4) Disclose, under the caption All Other Fees, the aggregate
fees billed in each of the last two fiscal years for products and
services provided by the principal accountant, other than the
services reported in paragraphs (e)(1) through (e)(3) of this
section. Registrants shall describe each subcategory of services
comprising the fees disclosed under this category.
(5)(i) Disclose the audit committee's pre-approval policies and
procedures described in paragraph (c)(7)(ii) of rule 2-01 of
Regulation S-X (17 CFR 210.2-01(c)(7)(ii)).
(ii) Disclose the percentage of fees described in each of
paragraphs (e)(2) through (e)(4) of this section that were approved
by the audit committee pursuant to each of the paragraphs
(c)(7)(ii)(A), (c)(7)(ii)(B), and (c)(7)(ii)(C), of rule 2-01 of
Regulation S-X (17 CFR 210.2-01(c)(7)(ii)(A), (B) and (C)).
(6) If greater than 50 percent, disclose the percentage of hours
expended on the principal accountant's engagement to audit the
registrant's financial statements for the most recent fiscal year
that were attributed to work performed by persons other than the
principal accountant's full-time, permanent employees.
Instruction to Item 16.
A registrant that is an Asset-Backed Issuer (as defined in Sec.
240.13a-14(g) and Sec. 240.15d-14(g) of this chapter) is not
required to disclose the information required by this item.
* * * * *
11. Amend form 10-KSB (referenced in Sec. 249.310b) by adding item
16 to part III to read as follows:
Note: The text of form 10-KSB does not, and this amendment will
not, appear in the Code of Federal Regulations.
Form 10-KSB
* * * * *
Part III
* * * * *
Item 16. Principal Accountant Fees and Services.
Furnish the information required by item 9(e) of schedule 14A
(Sec. 240.14a-101 of this chapter).
(1) Disclose, under the caption Audit Fees, the aggregate fees
billed for each of the last two fiscal years for professional
services rendered by the principal accountant for the audit of the
registrant's annual financial statements and review of financial
statements included in the registrant's form 10-Q (17 CFR 249.308a)
or 10-QSB (17 CFR 249.308b) for those fiscal years.
(2) Disclose, under the caption Audit-Related Fees, the
aggregate fees billed in each of the last two fiscal years for
assurance and related services by the principal accountant that are
reasonably related to the performance of the audit or review of the
registrant's financial statements and are not reported under
paragraph (e)(1) of this section. Registrants shall describe each
subcategory of services comprising the fees disclosed under this
category.
(3) Disclose, under the caption Tax Fees, the aggregate fees
billed in each of the last two fiscal years for professional
services rendered by the principal accountant for tax compliance,
tax consulting, and tax planning.
(4) Disclose, under the caption All Other Fees, the aggregate
fees billed in each of the last two fiscal years for products and
services provided by the principal accountant, other than the
services reported in paragraphs (e)(1) through (e)(3) of this
section. Registrants shall describe each subcategory of services
comprising the fees disclosed under this category.
(5)(i) Disclose the audit committee's pre-approval policies and
procedures described in paragraph (c)(7)(ii) of rule 2-01 of
Regulation S-X (17 CFR 210.2-01(c)(7)(ii)).
(ii) Disclose the percentage of fees described in each of
paragraphs (e)(2) through (e)(4) of this section that were approved
by the audit committee pursuant to each of the paragraphs
(c)(7)(ii)(A), (c)(7)(ii)(B), and (c)(7)(ii)(C), of rule 2-01 of
Regulation S-X (17 CFR 210.2-01(c)(7)(ii)(A), (B) and (C)).
(6) If greater than 50 percent, disclose the percentage of hours
expended on the
[[Page 76817]]
principal accountant's engagement to audit the registrant's
financial statements for the most recent fiscal year that were
attributed to work performed by persons other than the principal
accountant's full-time, permanent employees.
Instruction to Item 16.
A registrant that is an Asset-Backed Issuer (as defined in Sec.
240.13a-14(g) and Sec. 240.15d-14(g) of this chapter) is not
required to disclose the information required by this item.
* * * * *
PART 274--FORMS PRESCRIBED UNDER THE INVESTMENT COMPANY ACT OF 1940
12. The authority citation for part 274 is revised to read as
follows:
Authority: 15 U.S.C. 77f, 77g, 77h, 77j, 77s, 78c(b), 78l, 78m,
78n, 78o(d), 80a-8, 80a-24, 80a-26, and 80a-29, unless otherwise
noted.
Section 274.128 is also issued under secs. 3(a), 202, and 302, Pub.
L. 107-204, 116 Stat. 745.
PART 249--FORMS, SECURITIES EXCHANGE ACT OF 1934
PART 274--FORMS PRESCRIBED UNDER THE INVESTMENT COMPANY ACT OF 1940
13. By amending form N-CSR (referenced in Sec. Sec. 249.331 and
274.128).
a. By revising general instruction D;
b. By redesignating items 5 and 6 as items 6 and 7; and
c. By adding a new item 5.
The revisions and additions read as follows:
Note: The text of form N-CSR does not, and this amendment will
not, appear in the Code of Federal Regulations.
Form N-CSR
* * * * *
General Instructions
* * * * *
D. Incorporation by Reference.
A registrant may incorporate by reference information required
by items 5 and 7(b). No other items of the form shall be answered by
incorporating any information by reference. The information required
by item 5 may be incorporated by reference from the registrant's
definitive proxy statement (filed or required to be filed pursuant
to Regulation 14A (17 CFR 240.14a-1 et seq.)) or definitive
information statement (filed or to be filed pursuant to Regulation
14C (17 CFR 240.14c-1 et seq.)) which involves the election of
directors, if such definitive proxy statement or information
statement is filed with the Commission not later than 120 days after
the end of the fiscal year covered by an annual report on this form.
All incorporation by reference must comply with the requirements of
this form and the following rules on incorporation by reference:
Rule 10(d) of Regulation S-K under the Securities Act of 1933 (17
CFR 229.10(d)) (general rules on incorporation by reference, which,
among other things, prohibit, unless specifically required by this
form, incorporating by reference a document that includes
incorporation by reference to another document, and limits
incorporation to documents filed within the last 5 years, with
certain exceptions); rule 303 of Regulation S-T (17 CFR 232.303)
(specific requirements for electronically filed documents); rules
12b-23 and 12b-32 under the Securities Exchange Act of 1934
(additional rules on incorporation by reference for reports filed
pursuant to sections 13 and 15(d) of the Securities Exchange Act of
1934); and rules 0-4, 8b-23, and 8b-32 under the Investment Company
Act of 1940 (17 CFR 270.0-4, 270.8b-23, and 270.8b-32) (additional
rules on incorporation by reference for investment companies).
* * * * *
Item 5. Principal Accountant Fees and Services.
(a) Disclose, under the caption Audit Fees, the aggregate fees
billed for each of the last two fiscal years for professional
services rendered by the principal accountant for the audit of the
registrant's annual financial statements for those fiscal years.
(b) Disclose, under the caption Audit-Related Fees, the
aggregate fees billed in each of the last two fiscal years for
assurance and related services by the principal accountant that are
reasonably related to the performance of the audit of the
registrant's financial statements and are not reported under
paragraph (a) of this item. Registrants shall describe each
subcategory of services comprising the fees disclosed under this
category.
(c) Disclose, under the caption Tax Fees, the aggregate fees
billed in each of the last two fiscal years for professional
services rendered by the principal accountant for tax compliance,
tax consulting, and tax planning.
(d) Disclose, under the caption All Other Fees, the aggregate
fees billed in each of the last two fiscal years for products and
services provided by the principal accountant, other than the
services reported in paragraphs (a) through (c) of this item.
Registrants shall describe each subcategory of services comprising
the fees disclosed under this category.
(e)(1) Disclose the audit committee's pre-approval policies and
procedures described in paragraph (c)(7)(ii) of rule 2-01 of
Regulation S-X (17 CFR 210.2-01(c)(7)(ii)).
(2) Disclose the percentage of fees described in each of
paragraphs (b) through (d) of this item that were approved by the
audit committee pursuant to each of the paragraphs (c)(7)(ii)(A),
(B), and (C) of rule 2-01 of Regulation S-X (17 CFR 210.2-
01(c)(7)(ii)(A), (B), and (C)).
(f) If greater than 50 percent, disclose the percentage of hours
expended on the principal accountant's engagement to audit the
registrant's financial statements for the most recent fiscal year
that were attributed to work performed by persons other than the
principal accountant's full-time, permanent employees.
Instructions
1. The information required by this item 5 is only required in a
report on this form N-CSR that is required by item 7(a) to include a
copy of an annual report transmitted to stockholders.
2. For purposes of paragraphs (b), (c), (d) and (e)(2) of this
item, registrants must disclose fees billed for services rendered to
the registrant, the registrant's investment adviser (not including
any sub-adviser whose role is primarily portfolio management and is
subcontracted with or overseen by another investment adviser), and
any entity controlling, controlled by, or under common control with
the adviser that provides services to the registrant.
* * * * *
By the Commission.
Dated: December 2, 2002.
Jill M. Peterson,
Assistant Secretary.
[FR Doc. 02-30884 Filed 12-12-02; 8:45 am]
BILLING CODE 8010-01-P