Office of the Chief Accountant:
Application of the Commission’s Rules on Auditor Independence
Frequently Asked Questions
The answers to these frequently asked questions represent the views of the Office of the Chief Accountant. They are not rules, regulations or statements of the Securities and Exchange Commission. Further, the Commission has neither approved nor disapproved them.
Note: The SEC staff has received questions regarding the implementation and interpretation of the Commission’s Rules on Auditor Independence, most recently relating to the Commission's Rules on Strengthening the Commission's Requirements Regarding Auditor Independence (Release No. 33-8183, January 28, 2003). We encourage these questions and related correspondence regarding auditor independence. Additional questions on auditor independence issues should be directed to Ed Bailey (baileye@sec.gov) or Dan Dodson (dodsond@sec.gov) in the Office of the Chief Accountant, Mail Stop 1103, 450 Fifth Street, NW, Washington, DC 20549; telephone: (202) 942-4400. Questions regarding disclosure in proxy statements should be directed to the Office of Chief Counsel in the Division of Corporation Finance at (202) 942-2900. Questions related to investment companies should be directed to Adeel Jivraj (jivraja@sec.gov) in the Division of Investment Management at (202) 942-0590.
Partner Rotation-Transition Questions
Question 1 (issued August 13, 2003)
Q: The 2003 audit of a calendar year client will be the last audit of that client for the person currently serving as the "lead" partner. The Commission's rules specify that, as of the beginning of the next year (e.g., January 1, 2004), the firm is not independent when the "lead" partner has served for more than five years. How does the staff believe that the transition should be applied?
A: The intention of the transition rules is to allow a "lead" partner to finish the current audit (e.g., the calendar 2003 audit). The "lead" partner could complete the current audit even though work would extend beyond January 1, 2004, without impairing the firm's independence. However, care must be taken to ensure that the partner is not involved in work that may be performed with respect to the first quarter of the 2004 reporting period. Since some of this work may be performed simultaneously with the audit, firms will need to carefully monitor the transition to ensure compliance with the rotation requirements.
Question 2 (issued August 13, 2003)
Q: A "lead" partner served for seven years and was off for two years prior to the effective date of the new independence rules. For example, for a calendar-year client, the "lead" partner completed his or her seventh year of service on the engagement for the 2001 audit. He or she subsequently did not participate in the audit for either 2002 or 2003 in accordance with the then-existing "lead" partner rotation rules. Can the partner return to the engagement in 2004, and, if so, for how long?
A: The partner can serve five years as "lead" partner beginning with the 2004 audit. Under the previous rotation rules, the partner would have been able to return to the 2004 engagement with a fresh clock. Therefore, the staff believes that he or she can begin fresh since he or she was out for the requisite period under the old rules.
Question 3 (issued August 13, 2003)
Q: Assume that in the previous situation, the "lead" partner had only been out one year (e.g., the 2003 audit) before the new rules became effective. Can the partner return to the engagement in 2004, and, if so, for how long?
A: In Question 2, the partner would have been able to return to the engagement in 2004 under the old rules. In Question 3, however, the partner would not have been able to return to the engagement in 2004 under the old rules. Accordingly, the partner would have to complete the requisite time out period specified under the new rules since, under the Commission's transition provisions, prior service as the "lead" partner counts for purposes of determining the "lead" partner's service on the engagement. Since the partner has been out for only one year, he or she would have to be out for an additional four years before returning to the engagement.
Question 4 (issued August 13, 2003)
Q: Assume that a "lead" partner had completed three years in the role of "lead" partner prior to the effective date of the new rules. For how many years would he or she be permitted to continue in the role of "lead" partner after the effective date of the new rules?
A: He or she could serve for two additional years as either "concurring" or "lead" partner, since prior service counts in determining the rotation requirements for "lead" partners.
Question 5 (issued August 13, 2003)
Q: Assume that a "lead" partner had completed five or more years in the role of "lead" partner prior to the effective date of the new rules. Could he or she be permitted to continue in the role of "lead" partner for the current year's audit after the effective date of the new rules?
A: The rules relating to partner rotation became effective for fiscal years beginning on or after May 6, 2003. If the audit engagement of the first year ending on or after that date is the fifth, sixth, or seventh year that a partner serves in the capacity of "lead" partner, he or she could complete such audit before being required to rotate off the engagement. He or she could not participate as the "lead" partner in the audit for the first year beginning on or after May 6, 2003.
Question 6 (issued August 13, 2003)
Q: A "concurring" partner served for seven years and was off for two years prior to the effective date of the adoption. For example, for a calendar-year client, the "concurring" partner completed his or her seventh year of service on the engagement for the 2001 audit. He or she subsequently did not participate in the audit for either 2002 or 2003. Can the partner return to the engagement in 2004, and, if so, for how long?
A: In this situation, the partner would be allowed to start the engagement in 2004 as an "audit" partner with a fresh clock. Therefore, he or she could serve for five years as either the "lead" or "concurring" partner before rotation or as an "other audit" partner for seven years before rotation.
Question 7 (issued August 13, 2003)
Q: Assume that in the previous situation, the "concurring" partner had only been out one year (e.g., the 2003 audit) before the new rules became effective. Can the partner return to the engagement in 2004, and, if so, for how long?
A: The partner would be allowed to return to the engagement in 2004 with a fresh clock. It should be noted that this is different for the "concurring" partner than it is for the "lead" partner (see response to Question 3). These situations are different because the "concurring" partner previously did not have a rotation requirement and, therefore, did not have a stated "time out" period. Therefore, the staff believes that it would be inappropriate to impose the two-year time out period (which previously applied only to the "lead" partner) to the "concurring" partner.
Question 8 (issued August 13, 2003)
Q: Assume that a "concurring" partner had completed three years in the role of "concurring" partner prior to the effective date of the new rules. For how many years would he or she be permitted to continue in the role of "concurring" partner after the effective date of the new rules?
A: He or she could serve for two additional years as either "concurring" or "lead" partner since prior service counts in determining the rotation requirements for "concurring" partners.
Question 9 (issued August 13, 2003)
Q: Assume that a "concurring" partner had completed five or more years in the role of "concurring" partner prior to the effective date of the new rules. Could he or she be permitted to continue in the role of "concurring" partner after the effective date of the new rules?
A: The transition provisions of the rules relating to rotation of a "concurring" partner provide for one additional year of transition more than is provided for the "lead" partner. Thus, if the current year's engagement was the fifth year (or more) of service as a "concurring" partner, he or she could continue to serve as the "concurring" partner for audits of fiscal years ending on or before May 6, 2005 before being required to rotate off the engagement.
Audit Partner and Partner Rotation
For purposes of the following questions assume that the situations are for time periods after the transition period established in the release has elapsed.
Question 1 (issued August 13, 2003)
Q: Generally, a tax or other specialty partner is not included within the definition of "audit partner." Are there circumstances where a tax or other specialty partner would be included within the definition of "audit partner"? If so, what are the consequences?
A: The term "audit partner" is significant in that it establishes the partners who are subject to the partner rotation requirements and the partner compensation requirements. The discussion of "audit partner" in the release text states: "the term audit partner would include the 'lead' and 'concurring' partners, partners such as 'relationship' partners who serve the client at the issuer or parent level." "Relationship" partners have a high level of contact with management and the audit committee of the issuer. Therefore, a tax or other specialty partner who serves as the "relationship" partner would be included within the scope of the definition of "audit partner."
Question 2 (issued August 13, 2003)
Q: What are the rotation requirements for the "relationship" partner who is not the "lead" or "concurring" partner?
A: As discussed in question 1, the "relationship" partner meets the definition of an "audit partner" and, therefore, is subject to the partner rotation requirements. "Lead" and "concurring" partners are required to rotate off an engagement after a maximum of five years in either capacity
1 and, upon rotation, must be off the engagement for five years. Other "audit partners" are subject to rotation after seven years on the engagement and must be off the engagement for two years. A "relationship" partner who is not the "lead" or "concurring" partner would, therefore, be subject to the seven years of service, two years time out rotation requirement.
Question 3 (issued August 13, 2003)
Q: An accounting firm has served as the auditor of a non-public company for more than three years using the same partners. The non-public client is now going through an IPO. What are the rotation requirements for the "lead" and "concurring" partners?
A: Since the company has become an issuer
2 through the IPO process, the partners are now subject to the rotation requirements. The question is whether some or all of the service time prior to the IPO should count towards the rotation requirements. The rotation requirements would be established by the number of years of audited financial statements that are included in the filing. Some filings would include three years of audited financial statements while others (e.g., filers that use Small Business forms) would include two years of audited financial statements. Those prior years now would count as prior service in determining the rotation requirements. Accordingly, both the "lead" and "concurring" partners would have either two or three additional years before having to rotate off the engagement, depending on the number of years of audited financial statements that are included in the filing. The same conclusion would apply for determining the service time under the rotation requirements for partners other than the "lead" and "concurring" partners.
The same analysis also would apply to foreign companies that become issuers. As above, some foreign registrant filings include three years of audited financial statements while others may include two years of audited financial statements. The same conclusions regarding the partner rotation requirements would apply to these foreign companies at the time they become foreign private issuers.
Question 4 (issued August 13, 2003)
Q: A CPA firm accepts a new audit client that had previously been audited by another firm. In the course of auditing the current period's financial statements, it was determined that the prior two periods should be re-audited by the newly-engaged firm. For purposes of the partner rotation provisions of the independence rules, does this engagement constitute one year or three years of service by the audit partners?
A: This constitutes one year for purposes of determining when the partners would need to rotate. This is a different situation from the IPO situation (see Question 3). In the IPO situation, the firm and its partners had an established relationship with the client for more than three years before the company became a registrant. In this situation, there is no previous relationship with the client. As noted in the independence release, one of the objectives of partner rotation is for the firm to have a "fresh look" at the company. In this situation, there has not been an ongoing relationship with management or the company. Therefore, the fact that multiple periods were audited does not create a need to accelerate the "fresh look." The same would be true for a company preparing its IPO where it had never had its previous financial statements audited and the auditor concurrently audited all three periods included in the IPO.
Question 5 (issued August 13, 2003)
Q: Assume that Partner A is an audit partner with Audit Firm Z. Partner A has served as the "lead" partner on the audit of Company E for three years. Partner A leaves Audit Firm Z to join Audit Firm Y. In doing so, Partner A takes Company E with him or her to Audit Firm Y. After joining Audit Firm Y, how many additional years may Partner A serve as the "lead" or "concurring" partner for Company E before he or she must rotate off the engagement?
A: As discussed earlier, the rotation requirement is, in part, directed towards the need to have a fresh look with respect to the audit client. Since Partner A has a continuing relationship with Company E, the prior service would count in the determination of the partner rotation requirement. As a consequence, Partner A would be able to serve as the "lead" or "concurring" partner on Company E's audit for two additional years (thus, serving the client for five consecutive years) upon joining Audit Firm Y. At that point, Partner A would be required to rotate off the engagement for the required five-year time-out period.
Question 6 (issued August 13, 2003)
Q: Assume that a client changes its fiscal year-end. As a consequence, in the year of the change, its "annual" financial statements would cover less than 12 months. How would this "short" period be counted in determining when the "audit partners" should rotate?
A: The rules state that a "lead" or "concurring" partner cannot serve for more than five consecutive years and that other "audit partners" cannot serve for more than seven consecutive years. The question relates to what constitutes a "year" for purposes of the rule. Under the SEC's current rules, a domestic company is not required to file a separate 10-K for the "stub" period if that period is less than 6 months. If, however, the "stub" period is six months or longer, then a separate 10-K is required for that "stub" period. If the issuer is required to file a separate periodic annual report for the "stub" period, then that period constitutes a "year" for purposes of the partner rotation requirements. If, however, the issuer is not required to file a separate periodic annual report for the "stub" period, then the "stub" period does not constitute a "year" for purposes of the partner rotation requirements.
Question 7 (issued December 13, 2004)
Q: When a registered public accounting firm accepts its fifth audit client that is an issuer (as defined in section 10A (f) of the Securities Exchange Act of 1934) or its tenth partner, the exemption to the partner rotation rules as described in Regulation S-X, Section 210.2-01 (c) (6) (ii) no longer applies. After the exemption no longer applies, is there a transition period before the lead, concurring, and other partners are required to rotate? In this situation, how do you determine the years of service for the lead, concurring and other partners as defined in rule 2-01 (f) (7) (ii) for purposes of partner rotation?
A: Rule 2-01 (e) (1) (v) of Regulation S-X provides a transition period with respect to the auditor rotation rules for the lead, concurring, and other partners. In a similar manner, a transition period is appropriate when a firm no longer qualifies for the small firm exemption. A firm should determine annually whether the firm qualifies for the small firm exemption; this determination should be made each year as of the end of the calendar year. Once a determination has been made that the exemption no longer applies the lead partner may continue to serve a client through the first annual audit period ending after the exemption is no longer applicable, regardless of whether that partner has served the client for more than five consecutive years; the concurring review partner may continue to serve a client through two annual audit periods ending after the exemption is no longer applicable, regardless of whether that partner has served the client for more than five consecutive years; audit partners, other than the “lead’ and “concurring” partner, receive a “fresh clock” and may continue to serve a client through seven annual audit periods ending after the exemption is no longer applicable.
Question 8 (issued December 13, 2004)
Q: After a lead or concurring partner rotates off an audit engagement may that partner provide services to the issuer in a specialty partner capacity (i.e., providing tax services or national office/technical services) and still have this period continue to be considered part of the partner’s rotation-off the audit engagement?
A: Any time audit partners spend time providing services which continue their direct relationship with the issuer such time would not be considered as time off the audit engagement. However, limited discussions solely between the audit engagement team and a rotated-off partner generally would be considered as time off the audit engagement.
Question 9 (issued December 13, 2004)
Q: A principal auditor’s report on an issuer’s financial statement refers to and places reliance on the auditor of a subsidiary or equity method investee of the registrant and the audit report of the subsidiary or investee auditor is required to be included in the SEC filing. In many cases these entities are not issuers as defined by the Sarbanes Oxley Act of 2002. Are the audit partner rotation requirements applicable to the auditors of these entities?
A: Yes. The entire audit of an issuer must be conducted by independent auditors. For the principal auditor to rely on and make reference to the auditor of a subsidiary or equity method investee, such auditor must be independent under the SEC independence rules. The principal auditor is primarily responsible for determining and confirming compliance with those rules.
Question 10 (issued December 13, 2004)
Q: In an integrated audit of the financial statements and internal controls over financial reporting, how would the rotation requirements affect a partner who is primarily responsible for the audit of internal control over financial reporting? Does that person meet the definition of audit partner?
A: Yes. Such a person meets the definition of audit partner.
Prohibited and Non-audit Services
Question 1 (issued January 16, 2001)
Q: Does the restriction on the independent accountant providing legal services to an audit client apply only to litigation services?
A: No. The Commission's rule provides that an auditor's and firm's independence would be impaired if an auditor provides to its audit client a service for which the person providing the service must be admitted to practice before the courts of a U.S. jurisdiction. This standard includes all legal services. The rule does not apply only to appearance in court or solely to litigators. The only circumstances excluded by the rule are those in which local U.S. law allows certain limited activities without admission to the bar (generally confined to advice concerning the law of foreign jurisdictions). Additionally, as discussed in the adopting release, some firms may be providing legal services outside of the United States to registrants when those services are not precluded by local law and are routine and ministerial or relate to matters that are not material to the consolidated financial statements. Such services raise serious independence concerns under circumstances other than those meeting at least those minimum criteria.
Question 2 (issued January 16, 2001)
Q: Does Rule 2-01(c) (4) (i) (bookkeeping services) preclude an auditor from assisting an audit client in preparing its financial statements?
A: "Assistance" can take many forms. As a general matter, Rule 2-01(c) (4) (i) sets forth in rule form the Commission's previous guidance on this subject. In particular, the Codification of Financial Reporting Policies provides that: "It is the Commission's position that an accounting firm cannot be deemed independent with regard to auditing financial statements of a client if it has participated closely, either manually or through its computer services, in maintenance of basic accounting records and preparation of financial statements, or if the firm performs other accounting services through which it participates with management in operational decisions."
Question 3 (issued August 13, 2003)
Q: A firm was not independent with respect to Company A for Year 1 because the firm performed bookkeeping or other prohibited services for Company A during the audit and professional engagement period of Year 1. For Year 2, however, the firm is independent with respect to Company A. The firm is auditing the Year 2 financial statements. In the course of conducting the audit for Year 2, the firm becomes aware that there will be restatements of prior year's financial statements. Can the accounting firm re-audit the prior period financial statements?
A: Rule 2-01 does contain a specific "cure" if the independence issue related to the prior period is a financial interest. However, if the independence problem is caused by something else (e.g., having provided prohibited non-audit services in that prior period), there is no cure and the firm's independence would continue to be impaired. Since the accounting firm would need to be independent with respect to that prior period in order to issue an opinion on that period, the accounting firm would be precluded from re-auditing the prior period financial statements.
Question 4 (issued August 13, 2003)
Q: For five of the prohibited services (bookkeeping, internal audit outsourcing, valuation services, actuarial services, information system design and implementation), the rules contain the modifier that allows the audit firm to provide these services to an audit client when "it is reasonable to conclude that the results of these services will not be subject to audit procedures during an audit of the audit client's financial statements." The release text discussion indicates that there is a presumption that the services will be subject to audit procedures. Is materiality a basis for determining that it is reasonable to conclude that the services will not be subject to audit procedures (e.g., could the audit firm provide bookkeeping services for a subsidiary that is immaterial to the consolidated financial statements)?
A: No. There is a rebuttable presumption that the prohibited services will be subject to audit procedures. Determining whether a subsidiary, division, or other unit of the consolidated entity is material is a matter of audit judgment. Thus, the determination of whether to apply detailed audit procedures to a unit of the consolidated entity is, in and of itself, an audit procedure. Therefore, materiality is not an appropriate basis upon which to overcome the presumption in making a determination that it is reasonable to conclude that the results of the services will not be subject to audit procedures.
Question 5 (issued August 13, 2003)
Q: Some accounting firms have developed their own proprietary income tax preparation software. The software is used to facilitate the preparation of company income tax returns for various tax jurisdictions. Can an accounting firm license or sell its proprietary income tax preparation software to an audit client?
A: Licensing or selling income tax preparation software to an audit client would be subject to audit committee pre-approval requirements for permissible tax services. To the extent that the audit client's audit committee pre-approves the acquisition of the income tax preparation software from the accounting firm, it would be permissible for the accounting firm to license or sell its income tax preparation software to an audit client, so long as the functionality is, indeed, limited to preparation of returns for filing of tax returns. If the software performs additional functions, each function should be evaluated for its potential effect on the auditor's independence (see Question 4).
Question 6 (issued August 13, 2003)
Q: Some accounting firms have developed software modules which extend the functionality of the proprietary income tax preparation software. One of the additional software modules that has been developed by some firms takes the information used in preparing the tax return and generates some or all of the information needed to prepare the tax accrual and disclosures related to income taxes that will appear in the company's financial statements. Can the accounting firm license or sell this type of module to an audit client either concurrently with or subsequent to the licensing or sale of its income tax preparation software?
A: No. Since the purpose of the module is to develop the information needed to prepare a significant element of the company's financial statements, licensing or selling the module to an audit client would constitute the design and implementation of a financial information system, which is a prohibited non-audit service. It should be noted that the prohibition exists whether or not the module is integrated with, linked to, feeds the company's general ledger system, or otherwise prepares entries on behalf of the audit client (even if those entries are required to be manually recorded by client personnel). The output of the module aggregates source data or generates information that can be significant to the company's financial statements taken as a whole.
Other Matters
Question 1 (issued January 16, 2001, revised 2004)
Q: The rules do not define an affiliate of an accounting firm. What is the Staff’s approach to this issue?
A: The definition of an "accounting firm" includes the accounting firm's "associated entities." The Commission uses this phrase to reflect the staff's current practice of addressing these questions in light of all relevant facts and circumstances, and by looking to the factors identified in our previous guidance on this subject. Much of this guidance was cited in footnotes 489 and 491 of the January 16, 2001 adopting release (“Revision of the Commission’s Auditor Independence Requirements”). The staff is available for consultations on this issue.
Question 2 (issued January 16, 2001, revised 2004)
Q: What is the Commission's guidance with respect to business relationships?
A: The basic standard of the Commission's guidance is codified in the rules. Much of the Commission's previous guidance was retained and continues to apply. For example, joint ventures, limited partnerships, investments in supplier or customer companies, certain leasing interest and sales by the accountant of items other than professional services are examples of business relationships that may impair an accountant's independence. In a 1989 letter to Arthur Andersen, the Commission stated:
The Commission has recognized that certain situations, including those in which accountants and their audit clients have joined together in a profit-sharing venture, create a unity of interest between the accountant and client. In such cases, both the revenue accruing to each party ...and the existence of the relationship itself create a situation in which to some degree the auditor's interest is wedded to that of its client. That interdependence impairs the auditor's independence, irrespective of whether the audit was in fact performed in an objective, critical fashion. Where such a unity of interests exists, there is an appearance that the auditor has lost the objectivity and skepticism necessary to take a critical second look at management's representations in the financial statements. The consequence is a loss of confidence in the integrity of the financial statements.
Question 3 (issued December 13, 2004)
Q: Do the Commission’s independence rules apply to auditors whose reports are filed with the Commission on financial statements of entities other than those of the issuer?
A: The Commission’s independence rules apply to audits of financial statements required by SEC rules, except for those required by Rule 3-05 and 3-14 of Regulation S-X and Item 310(c) and (e) of Regulation S-B.
Question 4 (issued December 13, 2004)
Q: Has there been any change in the Commission’s long standing view (Financial Reporting Policies – Section 600 – 602.02.f.i. “Indemnification by Client”) that when an accountant enters into an indemnity agreement with the registrant, his or her independence would come into question?
A: No. When an accountant and his or her client, directly or through an affiliate, enter into an agreement of indemnity which seeks to provide the accountant immunity from liability for his or her own negligent acts, whether of omission or commission, the accountant is not independent. Further, including in engagement letters a clause that a registrant would release, indemnify or hold harmless from any liability and costs resulting from knowing misrepresentations by management would also impair the firm’s independence.
Audit Committee Pre-approval
Question 1 (issued August 13, 2003)
Q: An issuer has wholly-owned subsidiaries that also are issuers. The parent company has an audit committee. The wholly-owned subsidiaries do not have audit committees. Can the audit committee of the parent company function as the audit committee of the wholly-owned subsidiaries for purposes of satisfying the pre-approval requirements?
A: Yes. It is appropriate for the audit committee of the parent company to, in effect, serve as the audit committee of the parent company and the wholly-owned subsidiaries. In this situation, the subsidiary's disclosure should include the pre-approval policies and procedures of the subsidiary and, also should include the pre-approval policies and procedures of the parent company. It should be noted that this view does not extend to the fund industry in a manner that would permit an adviser's audit committee to pre-approve non-audit work on behalf of the funds. For more information, see Release No. 33-8220, "Standards Related to Listed Company Audit Committees."
Question 2 (issued August 13, 2003)
Q: An issuer that is a listed company has foreign subsidiaries that are consolidated. The issuer's "principal" auditor is a member firm of a network of international accounting firms. Some of the foreign subsidiaries have statutory audits performed and, in some cases (depending upon location, size, etc.) the statutory auditor may be a firm outside the member firm's network. Any statutory audits performed by member firms are subject to audit committee pre-approval requirements. Do the issuer's pre-approval requirements run to the statutory non-network auditors for the foreign subsidiaries or should the issuer's pre-approval requirements run just to the "principal" audit firm?
A: The Commission's rules relating to listed company audit committees (see Release No. 33-8220, "Standards Related to Listed Company Audit Committees") require audit committees to approve all audit services provided to the company, whether provided by the principal auditor or other firms. Therefore, the issuer's pre-approval requirements run to the statutory auditors for the foreign subsidiaries. However, failure of the audit committee to pre-approve audit services to be provided by another firm would not affect the independence of the principal auditor.
Question 3 (issued August 13, 2003)
Q: The Commission's rules require the audit committee to pre-approve all services provided by the independent auditor. In doing so, the audit committee can pre-approve services using pre-approval policies and procedures. Can the audit committee use monetary limits as the basis for establishing its pre-approval policies and procedures?
A: The Commission's rules include three requirements that must be followed in the audit committee's use of pre-approval through policies and procedures. First, the policies and procedures must be detailed as to the particular services to be provided. Second, the audit committee must be informed about each service. Third, the policies and procedures cannot result in the delegation of the audit committee's authority to management. Pre-approval policies and procedures that do not comply with all three of these requirements are in contravention of the Commission's rules. Therefore, monetary limits cannot be the only basis for the pre-approval policies and procedures. The establishment of monetary limits would not, alone, constitute policies that are detailed as to the particular services to be provided and would not, alone, ensure that the audit committee would be informed about each service.
Question 4 (issued August 13, 2003)
Q: Can the audit committee's pre-approval policies and procedures provide for broad, categorical approvals (e.g., tax compliance services)?
A: No. The Commission's rules require that the pre-approval policies be detailed as to the particular services to be provided. Use of broad, categorical approvals would not meet the requirement that the policies must be detailed as to the particular services to be provided.
Question 5 (issued August 13, 2003)
Q: How detailed do the pre-approval policies need to be?
A: The determination of the appropriate level of detail for the pre-approval policies will differ depending upon the facts and circumstances of the issuer. However, a key requirement is that the policies cannot result in a delegation of the audit committee's responsibility to management. As such, if a member of management is called upon to make a judgment as to whether a proposed service fits within the pre-approved services, then the pre-approval policy would not be sufficiently detailed as to the particular services to be provided. Similarly, pre-approval policies must be designed to ensure that the audit committee knows precisely what services it is being asked to pre-approve so that it can make a well-reasoned assessment of the impact of the service on the auditor's independence. For example, if the audit committee is presented with a schedule or cover sheet describing services to be pre-approved, that schedule or cover sheet must be accompanied by detailed back-up documentation regarding the specific services to be provided.
Audit Committee Communications
Question 1 (issued January 16, 2001)
Q: Does Item 9(e) (5) of Schedule 14A require disclosure of a conclusion by the audit committee or of factors considered by the audit committee in the assessment of independence?
A: No. Voluntary disclosures describing conclusions reached and factors considered are permitted.
Question 2 (issued August 13, 2003)
Q: The release text and rules text are silent with regard to effective date and transition requirements for Rule 2-07, "Communications With Audit Committees." Auditing standards presently require certain communications with audit committees. What is the effective date for the required communications with audit committees?
A: Because there are no specific transition provisions in the final release, the communication requirements under Rule 2-07 are effective for audit reports filed on or after May 6, 2003, the effective date of the new rules.
Question 3 (issued August 13, 2003)
Q: Would the requirement to communicate with audit committees apply to situations where the auditor is providing a consent (e.g., related to a 1933 Act filing)? If so, what information should be communicated to the audit committee?
A: Yes. In that situation, the audit report is deemed to be filed. As a result, the auditor would be required to communicate the relevant information to the audit committee. Since the auditor would have communicated the relevant information when the audit report was originally filed, this communication at the time of the consent may properly be restricted to updating the audit committee. However, if in the process of applying audit procedures required by AU �1, matters come to the auditor's attention that would or could have affected the financial statements or the auditor's report that was previously filed, all relevant information should be communicated to the audit committee.
Question 4 (issued August 13, 2003)
Q: The rules require that auditors communicate to the audit committee alternative applications of GAAP relating to material items that have been discussed with management. Does this require that auditors discuss with audit committees transactions where there are alternative applications of GAAP that occurred subsequent to the balance sheet date that are not reflected in the financial statements (including the related notes) subject to audit?
A: Because the rules require the auditor to communicate alternative applications of GAAP that are material and that the communications occur before the audit opinion is filed with the Commission, the rules relate to items that are material to the financial statements on which the auditor is expressing an opinion. Therefore, such transactions that have occurred subsequent to the balance sheet date and which are not required to be reflected in the financial statements or the related notes are not required to be communicated to the audit committee until the period in which the transactions affect the financial statements. It should be noted, however, that the release text indicates that over time these communications should occur on a "real time" basis and, thus, the auditor is strongly advised to consider communicating the matters to the audit committee at the first opportunity after the matters arise.
Question 5 (issued August 13, 2003)
Q: Assume that the issuer's filing contains the report of a successor audit firm and a predecessor audit firm. Each of the audit firms will be required to provide a consent. Must each of the audit firms provide the communications with the audit committee?
A: No. When there is a predecessor-successor auditor relationship, only the successor auditor is required to communicate with the audit committee. Prior to providing its consent, however, the predecessor is required to perform the audit procedures specified in AU �1.
Question 6 (issued August 13, 2003)
Q: Assume that a portion of the company's consolidated financial statements were audited by a firm other than the principal accountant. Due to the significance of the portion audited by the other firm, the principal accountant decides to make reference to the other accountant. Because reference will be made to the other firm's report, both the audit opinions of the principal accountant and the other accountant must be filed. Is the other accountant required to make the specified communications with the issuer's audit committee?
A: Yes. The Commission's rules require that the auditor communicate with the audit committee before the audit report is filed with the Commission. Because, in this situation, the other auditor's report will be filed, the other auditor also is required to provide the required communications with the audit committee.
Fee Disclosures
Question 1 (issued January 16, 2001)
Q: Should "out-of-pocket" costs incurred in connection with providing the professional service and billed to the registrant be included in the fee disclosures required by Items 9(e)(1) – (e)(4) of Schedule 14A?
A: Yes. These costs should be included as part of the aggregate fee for the service to which they apply.
Question 2 (issued January 16, 2001 revised 2004)
Q: In determining fees that are disclosed pursuant to Items 9(e) (1) – (e) (4) of Schedule 14A, should the disclosure be based on when the service was performed, the period to which the service applies, or when the bill for the service is received?
A: Fees to be disclosed in response to Item 9(e)(1) of Schedule 14A should be those billed or expected to be billed for the audit of the registrant's financial statements for the two most recently completed fiscal years and the review of financial statements for any interim periods within those years. If the registrant has not received the bill for such audit services prior to filing with the Commission its definitive proxy statement, then the registrant should ask the auditor for the amount that will be billed for such services, and include that amount in the disclosure. Amounts disclosed pursuant to Items 9(e) (2) - (e) (4) should include amounts billed for services that were rendered during the most recent fiscal year, even if the auditor did not bill the registrant for those services until after year-end.
Question 3 (issued January 16, 2001)
Q: In situations where other auditors are involved in the delivery of services, to what extent should the fees from the other auditors be included in the required fee disclosures?
A: Only the fees billed by the principal accountant need to be disclosed. See Question 4 regarding the definition of "principal accountant." If the principal accountant's billings or expected billings include fees for the work performed by others (such as where the principal accountant hires someone else to perform part of the work), then such fees should be included in the fees disclosed for the principal accountant.
In some foreign jurisdictions a registrant may be required to have a joint audit requiring both accountants to issue an audit report for the same fiscal year. In these circumstances, fees for each accountant should be separately disclosed as they are both "principal accountants."
Question 4 (issued January 16, 2001)
Q: Does the term "principal accountant" in Item 9(e) of Schedule 14A include associated or affiliated organizations?
A: Yes. "Principal accountant" has the meaning given to it in the auditing literature. In determining what services rendered by the principal accountant must be disclosed, all entities that comprise the accountant, as defined in Rule 2-01(f) (1) of Regulation S-X, should be included. This term includes not only the person or entity that furnishes reports or other documents that the registrant files with the Commission, but also all of the person's or entity's departments, divisions, parents, subsidiaries, and associated entities, including those located outside of the United States.
Question 5 (issued January 16, 2001, revised 2004)
Q: Where in the proxy materials should the disclosures required pursuant to Item 9(e) of Schedule 14A appear? For example, can registrants include the disclosures in the audit committee report?
A: Like other Items in Schedule 14A, Item 9(e) does not specify where in the proxy statement the disclosures must appear. We think it is certainly appropriate for the disclosures to accompany the disclosures required by Item 7(d) and Items 9(a)-(d) of Schedule 14A. Registrants can include the disclosures in the audit committee report, but we remind registrants that the safe harbor in Item 7(d)(3)(v) of Schedule 14A applies only to information required to be disclosed under Item 7(d)(3) and the safe harbor in Item 306(c) of Regulation S-K applies only to information required to be disclosed by Items 306(a) and (b) of Regulation S-K and, therefore, neither safe harbor would cover disclosures required by Item 9(e) but included in the audit committee report. The 2003 rules require disclosure of Item 9 (a) – (d) be included in a company’s annual report. However, domestic companies are able to incorporate the required disclosure from the proxy or information statement into the annual report. Registrant that do not issue proxy statements are required to include disclosures in their annual filings.
Question 6 (issued January 16, 2001, revised 2004)
Q: When there has been a change in accountants during the year, should fees paid to both the predecessor and successor auditor be disclosed pursuant to Item 9(e) of Schedule 14A?
A: No. The fee disclosure should only be made for the accountant who renders an audit opinion on that year's financial statements.
Question 7 (issued August 13, 2003)
Q: What fee disclosure category is appropriate for professional fees in connection with an audit of the financial statements of a carve-out entity in anticipation of a subsequent divestiture?
A: The release establishes a new category, "Audit-Related Fees," which enables 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 (e.g., due diligence services) that traditionally are 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 consultations and audits in connection with acquisitions, internal control reviews, attest services related to financial reporting that are not required by statute or regulation and consultation concerning financial accounting and reporting standards. Fees for the above services would be disclosed under "Audit-Related Fees."
Question 8 (issued August 13, 2003)
Q: Would fees paid to the audit firm for operational audit services be included in "Audit-Related Fees"?
A: No. "Audit-Related Fees" are fees for assurance and related services by the principal accountant that are traditionally performed by the principal accountant and which are "reasonably related to the performance of the audit or review of the registrant's financial statements." Operational audits would not be related to the audit or review of the financial statements and, therefore, the fees for these services should be included in "All Other Fees." As required by the rules, the registrant would need to include a narrative description of the services included in the "All Other Fees" category.
Question 9 (issued August 13, 2003)
Q: The Commission's new independence rules require companies to disclose fees paid to the principal auditor in four categories ("audit", "audit-related", "tax", and "all other") for the two most recent years. Previously, companies were required to disclose fees paid to the principal auditor in three categories and only for the most recent year. When are the new fee disclosure requirements effective?
A: The release text indicates that the new disclosure requirements are effective for periodic annual filings and proxy or information statement filings for the first fiscal year ending after December 15, 2003. Thus, the new disclosure requirements are not mandatory until the calendar-year 2003 periodic annual filings are made in 2004. However, the release text also indicates that "we encourage issuers . . . to adopt these disclosure provisions earlier." Thus, companies may, but are not required, to provide the new disclosures for proxies and other periodic annual filings that are made prior to the effective date for the new disclosures.
"Cooling Off" Period
Question 1 (issued August 13, 2003)
Q: The "cooling off" period states that the accounting firm is no longer independent when a member of the audit engagement team commences employment with the issuer in a financial reporting oversight role within the one-year period preceding the date of the commencement of audit procedures. For purposes of applying this provision, is the term "issuer" restricted to the legal entity (typically the parent company) that issues the securities?
A: No. The rule prohibits a member of the audit engagement team from commencing employment in a "financial reporting oversight role" with the issuer if the auditor is to remain independent. The Commission's rules define a financial reporting oversight roles as "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 . . ." The issuer is required to prepare consolidated financial statements to include in filings with the Commission. Therefore, a financial reporting oversight role can extend to the issuer and its subsidiaries. In determining whether an individual is in a financial reporting oversight role with the issuer, consideration should be given to the role the individual is playing, his or her involvement in the financial reporting process of the issuer, and the impact of his or her role on the consolidated financial statements.
Question 2 (issued August 13, 2003)
Q: Assume that an accounting firm has been providing audit services to a non-public client. The company now wishes to file an IPO and, in doing so, will become an issuer. Included in the IPO filing will be three years of audited financial statements. Do the "cooling off" rules apply to all audited periods included in the filing or just to the periods after the company becomes an issuer?
A: The Commission's rules on auditor independence require that the auditor is independent in each period for which an audit report will be issued. Thus, just as is the case for prohibited non-audit services, accounting firms will need to consider their relationship with the client both prior to and after the time that the client becomes an issuer. Since the IPO will contain an audit report for three years, the "cooling off" rules, likewise, would apply to all years. In applying the cooling off period rules for time periods prior to the IPO filing, the day after the audit report is dated (rather than the day after the periodic report is filed with the Commission) is deemed to constitute the commencement of audit procedures.
Broker-Dealer and Investment Advisers
Question 1 (issued August 13, 2003)
Q: Do the partner rotation and compensation requirements apply to auditors of non-issuer brokers and dealers or investment advisers that are non-issuers?
A: The term "audit partner" is intended to apply to an issuer as defined by the Sarbanes-Oxley Act of 2002. Therefore, for brokers and dealers or investment advisers which are not issuers as defined by the Act, the auditors would not be subject to the rotation requirements or the compensation requirements of the Commission's independence rules. However, since the prohibition on non-audit services applies to audit clients, those provisions would apply to auditors of non-issuer brokers and dealers or investment advisers.
Endnotes
1 For example, if a partner served as the "concurring" partner for two years and then began serving as the "lead" partner, he or she could serve for three years as the "lead" partner before reaching the maximum five year period as either the "lead" or "concurring" partner.
2 An issuer is an entity whose securities are registered under section 12 of the Exchange Act or that is required to file reports under section 15(d) or that files or has filed a registration statement that has not yet become effective under the Securities Act and that it has not withdrawn. Therefore, these conclusions would be applicable whether or not the filing has gone effective.
http://www.sec.gov/info/accountants/ocafaqaudind121304.htm
