Non-Audit Services And Financial Relationships
[Current as of March 9, 2004]
14:1.1 General Auditor Independence Principles
The touchstone of the SEC's auditor independence rules is the integrity of financial statements and the resultant investor confidence in those financial statements. The SEC has stated: "It is the auditor's opinion that furnishes investors with critical assurance that the financial statements have been subjected to a rigorous examination by an objective, impartial, and skilled professional, and that investors, therefore, can rely on them."1
The SEC independence rules set forth the general standard of independence: an accountant's independence is impaired if the accountant is not, or a reasonable investor with knowledge of all relevant facts and circumstances would conclude that the accountant is not, capable of exercising objective and impartial judgment on all issues encompassed within the accountant's judgment. The rules describe four factors the SEC considers in evaluating auditor independence questions: (1) whether there is a mutual or conflicting interest between the accountant and the audit client; (2) whether the accountant is in the position of auditing his or her own work; (3) whether the accountant acts as management or an employee of the audit client; and (4) whether the accountant is in a position of being an advocate for the audit client.2
The SEC independence rules set forth a non-exclusive list of circumstances that are inconsistent with the concept of auditor independence. This list covers, among other things: (1) prohibited non-audit services; (2) required audit committee pre-approval of engagements of the accountant; (3) independence-impairing financial, business and payment relationships with the audit client; (4) audit partner rotation; (5) independence-impairing employment relationships between the accountant and the audit client; and (6) prohibition on audit partner compensation for cross-selling non-audit services. The first three items are discussed in this chapter and the latter three are discussed in chapter 15.
14:1.2 Evolution Of Current Independence Rules
In 2000, the SEC issued an overhaul of its auditor independence rules. The revised rules addressed many areas with much greater specificity than before, and reflected a general tightening of the requirements. The 2000 revisions, which became effective on February 5, 2001, with significant transition relief, had engendered some controversy when proposed as being too strict. The rules tightened the prohibitions on security ownership and other financial interests by audit professionals in audit clients and established a list of prohibited services, including substantially limiting the amount of financial information systems consulting audit firms could perform for audit clients. The rules also prohibited business and employment relationships with audit clients and contingent fees, and required former audit professionals to sever financial and other ties with the accounting firm when becoming employed by an audit client. The final revisions reflected compromises resulting from discussions between the Big Five accounting firms and the SEC following the initial proposal in early 2000.
In 2002, the SOA eliminated many of the exceptions to the list of prohibited non-audit services in the 2000 independence rules and added "expert services" as a newly prohibited service. The SOA also added requirements for audit committee pre-approval of all services performed by the accounting firm, audit partner rotation and a one-year cooling-off period before audit engagement team members may accept employment at an audit client. The SEC amended its auditor independence rules in 2003 to reflect these new requirements, as required by the SOA. The SEC also added a prohibition, not required by the SOA, on the accounting firm's compensating audit partners for cross-selling non-audit services.
Thus, while the SOA significantly expanded the scope of the auditor independence rules, many of the requirements have been in effect since early 2001. Prior to the SOA, issuers may have been more inclined to defer to their accounting firms for compliance with those rules. Given the new audit committee pre-approval requirements and the generally greater focus on governance and financial reporting matters following enactment of the SOA, issuers and their inside and external counsel are becoming increasingly involved in matters of auditor independence.
14:1.3 Prohibited Non-Audit Services
The prohibitions on specified non-audit services, described further in section 14:1, are, according to the January 2003 adopting release, "largely predicated" on three basic principles. In particular, an accountant cannot: (1) audit its own work; (2) function in the role of management; or (3) serve in an advocacy role for its client. The ten enumerated prohibited non-audit services generally invoke one or more of those three concepts:
(1) bookkeeping and related services;
(2) financial information systems design and implementation;
(3) appraisal or valuation services, fairness opinions or contribution-in-kind reports;
(4) actuarial services;
(5) internal audit outsourcing;
(6) management functions;
(7) human resources;
(8) broker-dealer, investment adviser or investment banking services;
(9) legal services; and
(10) expert services.
14:1.4 Audit Committee Pre-Approval
In connection with the revisions to the prohibited non-audit services, and as required under the SOA, the SEC also adopted a rule in 2003 requiring audit committees to pre-approve all audit and non-audit services performed by the outside auditor. As an alternative to "direct" pre-approval by the audit committee, audit committees may develop pre-approval policies and procedures so long as the criteria set forth in the rule are met. However, as discussed in section 14:2, this alternative may be limited due to the lack of SEC guidance in this area.
14:1.5 Financial, Business And Payment Relationships
The independence rules also set forth a number of financial, business and payment relationships that would impair independence. Many of these rules, which are discussed in section 14:3 and were not amended or affected by the SOA, are designed to protect against situations in which the accountant has an interest in the continued success of the audit client and as a result may be hesitant to perform rigorous audit procedures or present a qualified opinion on the audit client's financial statements in situations in which such an opinion is so warranted. The independence rules prohibit an accountant and certain related parties from investing or having other financial interests in the accountant's audit clients. Other prohibited financial interests include loans to or from an audit client, savings and checking accounts with an audit client, broker-dealer or futures commission merchant accounts with an audit client, credit card balances owed to an audit client and insurance products issued by an audit client. The independence rules also prohibit common investments with audit clients and investments by audit clients in the accounting firm.
14:1.6 Audit Partner Rotation
Under a 2003 SEC rule required by the SOA, lead and concurring audit partners are subject to a five-year rotation and a five-year time-out requirement. Other "audit partners" (as defined) are required to rotate every seven years and observe a two-year time-out period. The rule provides a limited exemption for small accounting firms. The rule is discussed in section 15:1.
14:1.7 Employment Relationships
Another 2003 SEC rule implementing the SOA requires a one-year cooling-off period before an audit client may employ former members of the audit engagement team. The rule applies to those former partners, principals, shareholders or professional employees of an accounting firm who seek employment in a "financial reporting oversight role" (as defined) at an audit client of the accounting firm.
The former auditor independence rules also contained prohibitions on employment relationships, and these prohibitions were continued in the revised rules. Under these rules, former partners, principals, shareholders and professional employees must sever certain financial ties to the accounting firm before they can become audit client employees, whether or not employed in a financial reporting oversight role. The rule also prohibits an audit client from employing a current accountant and certain relatives of the accountant. Conversely, the rule prohibits the accounting firm from employing former employees of the audit client in capacities where they could influence the audit of financial statements covering any period during which they were employed at the audit client. These requirements are discussed in sections 15:2 and 15:3.
14:1.8 Prohibition On Audit Partner Compensation For Cross-Selling Non-Audit Services
Under the 2003 rule relating to audit partner compensation for cross-selling non-audit services, an accountant is not independent of an audit client if, at any point during the audit and professional engagement period, any audit partner earns or receives compensation based on the audit partner procuring engagements with that audit client to provide any products or services other than audit, review or attest services. This rule is discussed in section 15:4.
14:1.9 Enhanced Disclosure
In addition to modifying the rules relating to auditor independence, the SEC has enhanced the annual report and proxy statement disclosure requirements as they relate to services provided by outside auditors. Under these rules, issuers are required to disclose the fees paid to auditors for services in four categories for each of the past two fiscal years: audit, audit-related, tax and other. Issuers must also disclose pre-approval policies and procedures adopted by the audit committee. These disclosure requirements are discussed in section 14:4.
14:1.10 Consequences Of Impaired Auditor Independence
The auditor independence rules are complex, relatively strict, in many cases do not apply materiality thresholds and do not provide a means of retroactive cure for violations. Although a violation of many of these rules will impair independence and therefore have a direct impact on accountants (indeed, as discussed in section 14:5, certain violations may constitute violations of the Exchange Act on the part of the auditor), a violation of the independence rules will impact companies as well. A violation of the independence rules could result in a company having to change auditors (if the impairment is limited to the current year) or even to obtain a re-audit of its financial statements (if the impairment relates to a year covered by those financial statements and relief is unavailable) and could preclude it from accessing the capital markets until the re-audit is complete. Thus, audit committees considering independence issues can be expected to apply the rules conservatively. Section 14:6 includes suggested actions for companies in complying with these rules.1 See Final Rule: Revision of the Commission's Auditor Independence Requirements, Rel. Nos. 33-7919, 34-43602, 35-27279, IC-24744, IA-1911, and FR-56 (Nov. 21, 2000); 65 Fed. Reg. 76,008 (Dec. 5, 2000), available at , at paragraph referencing n.9.
2 See Preliminary Note to Rule 2-01 of Reg. S-X.