SEC AUDITOR INDEPENDENCE REQUIREMENTS
On November 15, 2000 the SEC adopted the first changes in its independence rules
since 1983. The following discussion addresses the underlying drivers that caused the
SEC to amend its independence rules, the scope of audits that are affected by the new
rules, and an explanation of the new rules as they relate to family relationships,
employment relationships, non-audit services, quality controls, and disclosure rules.
DRIVERS OF CHANGE FOR NEW INDEPENDENCE RULES
The accounting industry is in the midst of a dramatic transformation. Accounting
firms are increasingly global and they offer a wide range of multi-disciplinary services.
As a result of these trends, many CPA firms have partners and other family members that
have not influence on the audit that need to be concerned about independence issues.
Further, the growth of non-audit services raise questions about the ability of CPA firms to
remain independent while providing other services that may represent a revenue stream
that is larger than that provided by the independent audit. Each of these issues are
explored further below.
Family Relationships
The SEC’s previous independence rules on financial and employment relationships of
auditors were developed during an era when accounting firms were small, less
diversified, and there were few dual career families. As accounting firms have expanded
internationally, most SEC registrants now have their financial statements audited by firms
that have officers and professionals all over the globe. Most of the professionals in those
offices have no connection to, or influence over, the registrant’s audit.
The size of auditing firms, the increase in the number of professionals employed by
these firms, and the increase in dual career families has greatly increased the number of
employees who potentially would have independence problems. For example, the spouse
of an accounting firm partner could not hold certain positions at an audit client or stock in
the audit client, even though an employee stock compensation or 401K plan and the
partner had not connection to the audit. The new SEC rules allow accounting firm
employees to maximize the opportunities available to them , while promoting the public
interest and protecting investor confidence.
Non-audit Services
In 1993 four of the Big Six accounting firms earned more than 50% of their revenues
from accounting and auditing fees. According to Figure 1-6 the most that any of the Big
Five firms earns from accounting and auditing fees is 35% of total firm revenues.
According to the SEC, in 1999 4.6% of Big Five SEC audit clients paid consulting fees in
excess of audit fees. The SEC is concerned that the more the auditor has at stake in its
dealings with the audit client, the greater the cost to the auditor should he or she displease
the client, particularly when the non-audit service relationship has the potential to
generate significant revenues on top of the audit relationship. Further, certain types of
non-audit services, when provided by the auditor, create inherent conflicts that in
incompatible with objectivity.
The accounting profession, however, disagreed about whether non-audit services
impaired or facilitated the performance of the audit and the financial reporting process,
and served the public interest. On one hand, many auditor’s believe that if they
understand the factors that influence and improve the entity’s performance, that they also
focus the audit on the most critical audit issues. On the other hand, the SEC wanted to
ensure that auditors approach each audit with an appropriate level of professional
skepticism, and that auditor’s would be willing to take positions that might be against the
interests of management or against the interests of the accounting firm. The issues that
might impair an auditor’s objectivity are subtle, and the SEC final rules represent steps to
minimize the possibility that external factors will influence the auditor’s judgment.
SCOPE OF RULES
The final rules apply only to public companies and other entities registered with the
SEC or otherwise required to file audited financial statements with the SEC. The AICPA
and the accounting profession were concerned that State Boards of Accountancy might
adopt similar rules, particularly as they relate to non-audit services offered by CPAs. The
accounting profession was also concerned that the GAO might adopt similar rules for
governmental audits (see Chapter 23), which might restrict the services offered to small
governmental entities. However, at present, these rules apply only to companies that file
financial statements with the SEC.
FINANCIAL RELATIONSHIPS
The new SEC rule addresses the direct or material indirect investments that impair
independence. It also addresses a variety of other financial relationships that impair
independence, such as loan relationships, credit cards, and other similar financial
relationships. Investments in audit clients and other financial relationships are discussed
below.
Investments in Audit Clients
The goal of the new rule regarding investments in clients is to allow worldwide
partners or employees of an accounting firm that have no influence on the audit to be able
to invest directly in an audit client without violating the independence rules. Under the
new rule the following individuals in an accounting firm would be prohibited from
investing directly in an audit client through stocks, bonds, notes, options or other
securities, in order for the firm to remain independent.
 The accounting firm including its pension, retirement, investment or similar plans.
 Any covered persons in the firm which means the following partners, principals,
shareholders, and employees of an accounting firm:
 The audit engagement team.
 The chain of command including all persons who (1) supervise or have direct
management responsibility for the audit, including all successively senior
levels through the accounting firm's chief executive; (2) evaluate the
performance or recommend the compensation of the audit engagement
partner; or (3) provide quality control or other oversight of the audit.
Any other partner, principal, shareholder, or managerial employee of the
accounting firm who has provided ten or more hours of non-audit services to
the client for the period.
 The immediate family members (a person’s spouse, spousal equivalent and
dependents) of a covered person.
A direct investment also includes investing through an intermediary unless it is a
diversified management investment company as defined by Section 5(b) (1) of the Invest
Company Act of 1940.
The scope of the independence rule increases to any partner, shareholder, or
professional employee of the accounting firm, or immediate family member, or any group
of the above persons that has beneficial ownership of more than 5% of an audit client’s
equity securities or controls an audit client.
Independence would also be violated if the accounting firm, any covered person in the
firm, or his or her immediate family member serves as voting trustee of a trust, or
executor of an estate, containing the securities of an audit client, along with the authority
to make investment decisions for the trust or estate.
Independence problems also surface through material indirect investment. Hence, if
an accounting firm, a covered person, or his or her immediate family members owned
more than 5% of a diversified management investment company that invests in and audit
client, the firm would no longer be independent with respect to the audit client.

Other Financial Relationships
The SEC has also established rules related to a variety of financial relationships that
relate to the accounting firm, covered persons, and his or her immediate family members.
Such financial relationships with an audit client includes:
 Lending and debtor – creditor relationships.
 Savings and checking accounts.
 Broker-dealer accounts.
 Futures commission merchant accounts.
 Credit cards.
 Insurance products.
 Investment companies.
For example, a covered person or his or her immediate family member may not have a
saving or checking account with an audit client with a balance that exceed the amount
insured by the FDIC or similar insurer. In another example, the accounting firm, covered
persons, and his or her immediate family members cannot have a broker-dealer account
with an audit client if the account includes any asset other than cash or securities that are
covered by the Securities Investor Protection Act of 1970. The full list of all rules is too
numerous to cover here, but students should be aware of the general categories outlined
above.
Exceptions
The new SEC rules provide three exceptions that address common situations that
might cause an audit firm, covered person, or immediate family member not to be
independent. The first exception relates to inheritance and gifts. Independence rules are
not violated if any person acquires an unsolicited financial interest, such as through an
unsolicited gift or inheritance, that would cause an accountant to be not independent and
the financial interest is disposed of as soon as practicable. In any case the financial
interest must be disposed of within 30 days after the person has knowledge of, and the
right to dispose of, the financial interest.
The second exception relates to new audit engagements. Independence would not be
violated if a accounting firm, covered person, or his or her immediate family member has
a financial interest in a new audit client and
 The accountant did not audit the client’s financial statements for the immediate
preceding fiscal year, and
 The accountant is independent before the earlier of
 Signing an initial engagement letter, or
 Commencing audit, review, or attest procedures.
The final exception relates to employee compensation and benefit plans. Immediate
family members of covered persons are allowed to participate in employee compensation
and benefit plans provided that the financial interest, other than unexercised employee
stock options, are disposed of as soon as practicable, but no later than 30 days after the
person has the right to dispose of the financial interest.
EMPLOYMENT RELATIONSHIPS
The SEC adopted new rules on employment relationships in light of the increased
mobility of professional employees, the recent globalization of accounting firms, and
similar changes in society at large. The rules greatly reduce the pool of people within
audit firms whose families are affected by the independence requirements. The following
paragraphs address the four categories of employment relationships that affect
independence.
Employment of Accountant by Audit Client
An accountant cannot be employed by his or her audit client and be independent.
Hence, an accountant is not independent if at any time during the audit and the
professional engagement period, a current partner, principal, shareholder, or professional
employee of the accounting firm is employed by the audit client. These individuals also
cannot serve as a member of the board of directors, or similar management or governing
body of the audit client.
Employment of Certain Relatives by Audit Client
A covered person’s spouse, spousal equivalent, dependent, parent, non-dependent
children, and siblings cannot perform and accounting role or an financial oversight role
with an audit client. And accounting role or financial reporting oversight 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; or
 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, vice
president of marketing, or any equivalent position.
Note that the scope of family relations is more extensive than that associated to the
financial interest rules. This is because employment is more transparent that a relatives
investments.
Employment at Audit Client of Former Accounting Firm Employee
Independence issues are raised when an individual with an accounting firm assumes a
position with and audit client and also remains linked to the accounting firm. Hence, if a
former partner, shareholder, principal or professional employee of an accounting firm are
employed in an accounting or financial reporting oversight role at an audit client, the
following conditions must be met in order for the audit firm to remain independent.
 The individual must not influence the accounting firms operations or financial
policies.
 The individual must not have a capital balance at the accounting firm.
 The individual must not have a financial arrangement with the accounting firm, other
than one providing for a regular payment of a fixed dollar amount (which is not
dependent on revenues, profits, or earnings of the accounting firm).
For example, an audit firm would not be independent if a former partner could took a
position working for a client in an accounting or financial reporting oversight role, if the
former partner’s retirement payments were dependent upon the firms revenues or
earnings.
Employment at the Audit Firm of a Former Employee of the Audit Client
The SEC’s independence rules address the revolving door issue both with audit firm
employees going to the audit client and with audit client employees taking positions at
the audit firm. An independent audit firm who hires individuals who were formerly
officers, directors, or employees of an audit client as a partner, principle, shareholder, or
professional employee must ensure that the individual does not participate in, or is in a
position to influence, the audit of the financial statements of the audit client covering any
period during which he or she was employed by or associated with the audit client. For
example, if a former controller is hired by the audit firm, the individual can neither
participate in the audit of his or her former employer nor be in a position to influence the
audit, such as a position in the chain of command relating to the audit.
BUSINESS RELATIONSHIPS
An accounting firm is not independent if at any time during the audit and professional
engagement period, the accounting firm or any covered person in the firm has any direct
or material indirect business relationship with an audit client. Hence, a covered person or
the accounting firm could not enter into a joint venture with an audit client. This rule
extends to business relationships with persons in a decision-making capacity at an audit
client, such as a director, officer, or substantial shareholder. The rule on business
relationships does not address professional services with are addressed below under the
discussion of non-audit services.
NON-AUDIT SERVICES
The provision of non-audit services to SEC clients has changed dramatically in the last
decade and is a major focus of attention of the new SEC rules. The new SEC rules
identify nine non-audit services that are deemed to be inconsistent with auditor
independence. Seven of the nine services are already restricted by the SEC, AICPA or
SECPS and the rules closely track the language found in existing prohibitions. Hence, an
accounting firm is not independent if, at any point during the audit and professional
engagement period, the accounting provides the following non-audit services to an audit
client.
Bookkeeping and Other Services Related to the Audit Client's Accounting
Records or Financial Statements
An audit firm can not maintain or prepare the audit client's accounting records or
prepare the audit client's financial statements that are either filed with, or form the basis
of financial statements filed with, the SEC. This rule parallels closely the current
prohibition on bookkeeping. This would place the auditor in a position of auditing the
firm’s own work. The SEC has made exceptions for providing services in emergency
situations, provided the accountant does not undertake any managerial actions or make
any managerial decisions. Exceptions also include bookkeeping for foreign divisions or
subsidiaries of an audit client, provided certain conditions exist.
Financial Information Systems Design and Implementation
One of the most controversial components of the new rule addressed non-audit
services associated with the design and implementation of financial information systems.
Auditors have long had significant skills in this area, and it has emerged into a significant
line of consulting business. Under the new rule the auditor cannot operate or supervise
the operation of the client's IT systems, including local area networks. However, the
auditor could provide IT consulting services provided the following criteria are met.
These criteria carefully define management’s responsibility for supervision and
implementation of the system, if the audit firm provides services regarding financial
information system design and implementation and remains independent. Management
must:
 Acknowledge to the auditor and audit committee management's responsibility for the
clients system of internal controls.
 Identify a person within management to make all management decisions with respect
to the project.
 Make all the significant decisions with respect to the IT project.
 Evaluate the adequacy and results of the project.
 Not rely on the accountant's work as the primary basis for determining the adequacy
of its financial reporting system.
The prohibition does not include services an accountant performs in connection with the
assessment, design, and implementation of internal accounting controls and risk
management controls. Finally, the client must disclose the total amount of fees for IT
services received from its auditor, as discussed further below.
Appraisal or Valuation Services or Fairness Opinions
An accounting firm cannot provide appraisal or valuation services, or fairness
opinions, where it is reasonably likely that the results of any valuation or appraisal would
be material to the financial statements, or where the accountant would audit the results.
Fairness opinions are opinions that an accounting firm provides on the adequacy of the
consideration in a transaction, usually a merger or acquisition. If the auditor provides
these services, it is likely that the accounting could well end up reviewing the firms own
work, including key assumptions or variables that underlie the entry in the client’s
financial statements.
Actuarial Services
Actuarial-oriented advisory services would be limited only when they involve the
determination of insurance company policy reserves and related accounts. This rule
closely tracks the SECPS prohibition on actuarial services, as the auditor would likely
end up having to evaluate the firms own work regarding the key assumptions and
variables that have an important impact on the financial statements.
Internal Audit Services
Internal audit outsourcing has become a major revenue source for many accounting
and auditing firms. Further, internal audit is an important aspect of an entity’s systems
of internal control. The SEC rule limits the amount of internal audit work that could be
performed by a company’s auditor. An audit firm would be allowed to perform up to 40
percent (measured in terms of hours) of an audit client's internal audit work. Further, the
rule would not restrict internal audit services regarding operational internal audits
unrelated to accounting controls, financial systems, or financial statements. The rule also
provides an exception for smaller businesses by excluding companies with less than $200
million in assets. Providing any internal audit services for an audit client, however, would
be contingent on management taking responsibility for and making all management
decisions concerning the internal audit function, including six specific responsibilities
defined in the rule.
Management Functions
The rule on management functions is straightforward. An auditor's independence is
impaired when 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 function for the audit client.
Human Resources
As accounting firms become multi-disciplinary, they often have significant executive
search, recruitment, and human resource divisions, designed to help clients with their
human resource needs. The final SEC rule closely parallels the SECPS rules in this area.
An auditor would not be able to recruit, act as a negotiator on the audit client's behalf,
develop employee testing or evaluation programs, or recommend, or advise that the audit
client hire, a specific candidate for a specific job. However, an accounting firm could,
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.
Broker-Dealer Services
The SEC rules in this area are consistent with current AICPA rules. An auditor cannot
serve as a broker-dealer, promoter or underwriter of an audit client's securities. However,
the AICPA and SEC rules allow an accounting firm to provide the following investment
advisory services to audit clients without impairing their independence:
 Preparing recommendations on the allocation of funds that an audit client should
invest in various asset classes based on the client’s risk tolerance and other factors.
 Providing a comparative analysis of the client’s investment to third party
benchmarks.
 Reviewing the manner in which the audit client’s portfolio is being managed by
investment account managers.
 Transmitting a client’s investment selection to a broker-dealer, provided that the
client has made the investment decision and has authorized the broker-dealer to
execute the transaction.
Legal Services
In Europe and other parts of the globe, the large accounting firms also are large law
firms. Providing both legal and audit service raises questions about acting as an advocate
for an audit client. Under the final rule an auditor could not provide any service to an
audit client under circumstances in which the person providing the service must be
admitted to practice before the courts of a U.S. jurisdiction. Note that the final rule does
not address the practices of accounting firms in foreign countries.
QUALITY CONTROL
The final SEC rules recognize the importance of a system of quality control (see
Chapter 1) and the role it plays in helping to prevent, and detect and correct auditor
independence problems. The SEC rules recognize this role by providing accounting
firms a limited exception from being deemed not independent if:
 The individual did not know the circumstances giving rise to his or her violation.
 The violation was corrected promptly once the violation became apparent.
 The firm has quality controls in place that provide reasonable assurance that the firm
and its employees maintain their independence. For the largest public accounting
firms, the basic controls must include, among others, written independence policies
and procedures, automated systems to identify financial relationships that may impair
independence, training, internal inspection and testing, and a disciplinary mechanism
for enforcement.
DISCLOSURE RULES
Finally, the SEC established certain disclosure requirements so that investors can
better evaluate the independence of auditors of the companies in whey they invest. The
disclosure requirement has following three components.
1. Companies would disclose in their annual proxy statements the fees for (a) audit, 9b)
I/T consulting and (c) all other services provided by their auditors during the last
fiscal year.
2. Companies will also state whether the audit committee has considered whether the
provision of the non-audit services is compatible with maintaining the auditor's
independence.
3. The registrant would be required to disclose the percentage hours worked on the audit
engagement by persons other than the accountant's full time employees, if that figure
exceeded 50 percent.
The final requirement responds to recent moves by some accounting firms to sell their
practices to financial services companies. The partners or employees often become
employees of the financial services firm. The accounting firm then leases assets, namely
auditors, back from those companies to complete audit engagements. In such cases, the
audit firm itself does not employ most of the auditors who work on an audit as full-time
employees. The public is often in the dark and unaware of these arrangements.