650 Page Mill Road
Palo Alto, CA 94304-1050
PHONE
FAX
650.493.9300
650.493.6811
www.wsgr.com
SEC Adopts Rules Strengthening Auditor Independence
under Title II of the Sarbanes-Oxley Act of 2002
February 2003
Introduction
On January 22, 2003, pursuant to Title II of the
Sarbanes-Oxley Act of 2002, the Securities and
Exchange Commission issued final rules
strengthening auditor independence (see SEC
Release No. 33-8183).
after May 6, 2003. The final rules also provide limited
exceptions for conflicts of interest that arise through
mergers and acquisitions as well as emergencies and
other unusual situations, provided that the audit
committee determines that the relationship is in the
best interests of the issuer’s investors.
Time Frame for Compliance
Prohibited Non-Audit Services
The rules will generally be effective on May 6,
2003, with transition periods, described below, for
appropriate provisions.
Consistent with Section 201 of the Sarbanes-Oxley
Act, the final rules amend Section 2-01 of Regulation
S-X to list nine types of non-audit services that an
independent accountant may not provide to an audit
client:
Conflicts of Interest Resulting from Hiring Former
Employee of Company’s Auditor
To implement Section 206 of the Sarbanes-Oxley
Act, the final rules amend Section 2-01 of
Regulation S-X to require a “cooling off” period
before certain members of the audit engagement
team accept a position in a “financial reporting
oversight role” with an audit client. Accordingly,
the final rules require that the accounting firm
complete one annual audit for an issuer, based on the
date the issuer files its annual report on Form 10-K,
without the individual auditor in question serving on
the audit engagement team, prior to that individual
accepting a position in a financial reporting
oversight role with the issuer.
The affected members of the audit engagement team
are the lead partner, concurring partner, and any
other member of the audit engagement team who
provides more than ten hours of audit, review or
attest services for an issuer. In addition, the final
rules define a “financial reporting oversight role” as
a role in which an individual has direct
responsibility for or oversight of those who prepare
an issuer’s financial statements and related
information (including MD&A).
These rules are effective for employment
relationships with an issuer that commence
•
Bookkeeping or other services related to the
accounting records or financial statements of the
audit client;
•
Financial information systems design and
implementation;
•
Appraisal or valuation services, fairness opinions,
or contribution-in-kind reports;
•
Actuarial services;
•
Internal audit outsourcing services;
•
Management functions or human resources;
•
Broker or dealer, investment adviser, or
investment banking services;
•
Legal services and expert services unrelated to the
audit; and
•
Any other service that the Public Company
Accounting Oversight Board determines, by
regulation, is impermissible.
Three principles underlie the SEC’s prohibition on
these non-audit services: (1) an auditor cannot
function in the role of management, (2) an auditor
cannot audit its own work, and (3) an auditor cannot
serve in an advocacy role for its client.
Because of the critical roles of lead and concurring
partners and the need for a “fresh look” to the
independence of the audit, the final rules require lead
or concurring partners to rotate off of an audit
engagement after five years and to be subject to a five
year time-out period before working again on the audit
engagement.
Exceptions and Permissible Non-Audit Services
An audit committee may allow an independent
accountant to provide one of the first five prohibited
non-audit services listed above only if “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 SEC intends that this exception,
however, will be used only in very limited
circumstances where the audit client could overcome
the presumption that such services were prohibited
non-audit services.
Other audit partners are subject to a seven-year
rotation period with a two-year time out. These
partners include:
The final rules make clear that the audit committee
may engage the independent accountants to perform
internal fact-finding investigations (for example, in
connection with an investigation of accounting
fraud). In addition, the final rules permit an
independent accountant to provide most tax services
to its audit clients. Tax services that involve
advocacy before a court, however, are not
permissible. In addition, the SEC cautioned audit
committees to scrutinize carefully the retention of
their independent accountant for tax shelter-type
planning.
•
Partners on the engagement team who have
decision-making responsibility on significant
auditing, accounting and reporting matters that
affect the financial statements;
•
Partners who maintain regular contact with
management and the audit committee; and
•
Lead partners on subsidiaries of an issuer whose
assets or revenues constitute at least 20% of the
issuer’s consolidated assets or revenues.
These rules are effective according to the following
schedule:
The prohibition on certain non-audit services
described above is effective for new engagements
entered into after May 6, 2003. All engagements
with independent accountants to perform a
prohibited non-audit service entered into prior to
May 6, 2003 must be completed before May 6,
2004.
•
For rotation of lead partners, the rules are effective
for the first fiscal year ending after May 6, 2003
(meaning that rotation may be required in the
following fiscal year), and time served as a lead
partner prior to such date is included in the fiveyear rotation period; therefore, many current lead
partners will be transitioning at the end of the
current fiscal year;
•
For rotation of concurring partners, the rules are
effective as of the end of the second fiscal year
after May 6, 2003 (meaning that rotation may be
required in the third fiscal year), and time served
as a concurring partner prior to such date is
included in the five-year rotation period; and
•
For other audit partners, the rules are effective as
of the beginning of the first fiscal year after May
6, 2003, and time served as an audit partner prior
to such date is not included in the seven-year
rotation period.
Audit Partner Rotation
The final rules implement Section 203 of the
Sarbanes-Oxley Act by amending Section 2-01 of
Regulation S-X to require the rotation of various
audit partners from an audit engagement at different
intervals. The audit partners may work again on an
engagement after a “time-out” period. The intervals
and time-out periods depend upon the type of audit
partner.
2
Pre-approval and Disclosure of Services Provided
by Auditor
Disclosure of Services
In addition to the pre-approval requirements described
above, the final rules require a company to provide
expanded disclosure to that currently provided in its
proxy statement (or 10-K if no proxy is filed)
regarding the audit committee’s pre-approval of
services provided by the independent accountant, as
well as the types of services performed. If a company
uses pre-approval policies and procedures, it must
either describe or provide a copy of such policies and
procedures. Additionally, the company must disclose
what percentage of the total fees paid to the
independent accountants were approved pursuant to
the “de minimis” exception described above.
Pre-approval of Services
To implement Section 202 of the Sarbanes-Oxley
Act, the final rules amend Section 2-01 of
Regulation S-X to require that all audit and
permissible non-audit services performed by the
independent accountant are either:
•
Pre-approved by the audit committee; or
•
Approved pursuant to pre-approval policies and
procedures established by the audit committee
that are detailed as to the particular service to be
rendered and do not delegate approval authority
to management.
The disclosure must also include fees paid to the
independent accountant for the two most recent fiscal
years in each of the following categories, as well as a
description of the services rendered in the last three
categories:
Pre-approval policies and procedures may include:
•
An audit committee delegating authority to one
member of the audit committee to pre-approve
audit and permissible non-audit services; or
•
Audit fees;
•
Audit-related fees;
•
Tax fees; and
If engagements for audit or permissible non-audit
services are entered into pursuant to pre-approval
policies and procedures, the audit committee must be
informed of such engagements.
•
All other fees.
The final rules contain a de minimis exception that
waives pre-approval for permissible non-audit
services provided that:
The expanded annual report or proxy statement
disclosure will be required for fiscal years ending on
or after December 15, 2003, although the SEC
encourages voluntary compliance prior to that date.
•
•
An audit committee pre-approving a certain
dollar limit of services to be performed.
The final rules contain guidance on what types of
services fall under each of these categories.
All such services do not aggregate more than
five percent of total revenues paid by the audit
client to its accountant in the fiscal year when
services are provided;
•
Such services were not recognized as non-audit
services at the time of the engagement; and
•
The services are promptly brought to the audit
committee’s attention and approved prior to the
completion of the audit.
Compensation
While not required by the Sarbanes-Oxley Act to do
so, the final rules amend Section 2-01 of Regulation SX to provide that an accountant is not independent of
an audit client if, during the audit and professional
engagement period, any audit partner, other than a
specialty partner, earns or receives compensation
based on selling engagements to that client to provide
any services other than audit, review or attest services.
While the rules do not prohibit senior staff members
on the audit engagement team from receiving
compensation for selling such services, the SEC
3
indicates that an audit committee may wish to
consider such compensation when determining an
auditor’s independence. These rules are effective as
of the accounting firm’s fiscal year that includes
May 6, 2003.
The final rules explain the type of information
regarding these items that the SEC expects accountants
to provide to audit committees. Accountants must
inform the audit committee of these items prior to the
filing of the audit report with the SEC, although the
SEC indicated that it expected such discussions to
occur on a quarterly or real-time basis. Such
communication is not required to be in writing,
although the SEC expects that both the audit
committee and independent accountants will
appropriately document the communication.
Communication with Audit Committee
As directed by Section 204 of the Sarbanes-Oxley
Act, the final rules amend Section 2-07 of
Regulation S-X to require that the independent
accountants inform the audit committee of the
following items:
•
Critical accounting policies and practices;
•
Alternative accounting treatments (for both
specific transactions and general accounting
policies);
•
Other material written communications with
management, including, among others:
o
Management representation letter;
o
Reports on observations and
recommendations on internal controls;
o
Schedule of unadjusted audit differences,
and a listing of adjustments and
reclassifications not recorded, if any;
o
Engagement letter; and
o
Independence letter.
Retention of Records Relevant to Audits and Reviews
Separately, on January 24, 2003, pursuant to Section
802 of the Sarbanes-Oxley Act, the SEC issued final
rules requiring independent auditors to retain records
relating to their audits and reviews for seven years (see
SEC Release No. 33-8180). While we expect that
your independent accountants will provide you with
more information regarding these rules, we would like
to remind you of the following points:
•
The attorney-client privilege may not be
maintained for any privileged communication that
is subsequently provided to your independent
accountants.
•
Independent accountants regularly document oral
conversations with their audit clients in their audit
workpapers, which will, under these final rules, be
retained for seven years.
This memorandum is intended only as general information about the matters discussed, and should not be
construed as legal advice. For more information about these matters, please contact your Wilson Sonsini
Goodrich & Rosati partner.
4