N EWS ALERT
SARBANES-OXLEY UPDATE
Strengthening the Commission’s Requirements Regarding Auditor Independence
Executive Summary
On January 23, 2003, the Securities and Exchange Commission ("SEC") issued final regulations1 for rules related
to the independence of auditors. These rules implement Sections 201, 202, 203 and 206 of the Sarbanes-Oxley
Act of 2002 ("Sarbanes-Oxley"). The final rules focus on the following key aspects of auditor independence:
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the prohibition of certain non-audit services;
the disclosure of fees paid to auditors;
the responsibility of audit committees to pre-approve audit and non-audit services provided by an issuer's
auditor;
rotation of audit partners;
a one-year "cooling off" period for an audit partner seeking employment with a client; and
a prohibition on compensation paid to audit partners for selling non-audit services.
Prohibited "Non-Audit Services". The final rules provide that an auditor's independence is impaired with respect to
an audit client if the auditor performs any "non-audit services" which fall into one of three general categories, or core
principles, or into nine specifically prohibited non-audit services.
Fee Disclosure. In an effort to improve the ability of investors to better evaluate the independence of a registrant's
auditor, the SEC has amended the proxy disclosure rules to expand the required disclosure of the fees paid to
auditors, divided into four categories:
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Audit Fees
Audit-Related Fees
Tax Fees
All Other Fees
Pre-Approval Procedures. The audit committee must pre-approve audit and permissible non-audit services and the
issuer must describe in its proxy statement any policies and procedures developed by the audit committee
concerning pre-approval of services, as well as the percentage of fees pre-approved, subject to a de minimis
exception.
When must companies begin complying with the new rules?
These new rules will be effective 90 days after publication of the final rules, unless a different time period is specified
below.
In addition to the provisions on prohibited non-audit services, fee disclosures and pre-approval procedures, the new
rules also contain provisions regulating the activities of public accounting firms and their partners:
Rotation of Audit Partners. The lead and concurring partners on an audit engagement may serve in their respective
capacities for no more than five consecutive years and, following the rotation, may not provide such services to the
same issuer for a period of five consecutive years. The rules also require a seven-year rotation cycle for other audit
partners with significant involvement in an audit.
January 2003
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One-Year "Cooling Off" Period. An accounting firm will not be considered independent with respect to an issuer if
the lead or concurring partner (as well as certain other engagement team members) becomes employed by the issuer
in a financial reporting oversight role within one year prior to the commencement of audit procedures for that year.
Limitation on Audit Partner Compensation. The final rules provide that an accountant is not independent if, at any
point during the audit and professional engagement period, any audit partner, other than specialty partners, earns or
receives compensation based on selling non-audit services to that audit client.
What actions should issuers take as a result of this action?
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Identify the fees paid to auditors in each of the four categories (audit fees, audit-related fees, tax fees, and all
other fees) over the prior two fiscal years and develop a system for identifying these categories of fees in the
future.
Identify and categorize the services provided by their auditors, ensuring that the auditor performs none of the
prohibited categories of services.
Develop procedures to ensure that no services performed by the auditor would violate the three core principles
of auditor independence, outlined below.
Develop and implement policies and procedures for pre-approval of audit and permissible non-audit services,
devoting significant attention to the pre-approval of tax services.
Discuss with accountants to ensure the accountant has implemented procedures to properly rotate auditors,
monitor "cooling off" periods" and limit compensation where the accountant has procured an engagement for
non-audit services.
Prohibited Non-Audit Services
What are the core principles in determining prohibited non-audit services?
Section 201(a) of Sarbanes-Oxley Act states that it is unlawful for a registered public accounting firm that performs
an audit of a company's financial statements (and any person associated with such a firm) to provide to that company,
contemporaneously with the audit, any non-audit service, including nine services that were specifically identified.
While the specific delineation of certain services put forth a bright line of prohibited activity, it failed to fully
encompass what the SEC believes are basic principles underlying auditor independence. The SEC's goal is to
prohibit any non-audit services provided by an accountant to an audit client during the audit and professional
engagement period in situations where it is possible that the accountant would:
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audit his or her own work;
perform management functions; or
act as an advocate for the client.
What are the specifically prohibited non-audit services?
Additionally, under the new rules, an accountant would not be independent if, at any point during the audit and
professional engagement period, the accountant provides the following non-audit services to an audit client:
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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, including human resources;
broker-dealer, investment adviser or investment banking services;
legal services; and
expert services unrelated to the audit.
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What are the "expert services unrelated to the audit" that are prohibited?
The SEC prohibited expert services unrelated to the audit which preclude an accountant from acting as an advocate
on behalf of an audit client. Such services would include providing expert opinions for an audit client in connection
with legal, administrative or regulatory proceedings, or acting as an advocate for an audit client in such proceedings.
In contrast, an auditor would be allowed to perform an internal investigation for the benefit of management, as the
auditor would not be acting as an advocate to the issuer. Neither would an auditor's independence be impaired by
providing factual information or testimony, or by explaining the positions taken or conclusions reached during the
performance of any service by the accountant.
The SEC focused on the extent to which the services were fact-based in differentiating between permissible and
impermissible expert services. For example, an auditor's independence is impaired by providing an expert opinion in
a regulatory proceeding as it is a service not grounded solely in fact. On the other hand, an auditor may permissibly
testify as to the procedures performed in an audit as such testimony is limited to a recital of facts. While this
distinction does provide some guidance in assessing the permissibility of expert services, there remains a lack of
clarity on precisely which expert services an auditor may perform for an audit client.
How do the rules affect the provision of Tax Services by the principal accountant?
While the proposing release indicated that accounting firms might be prohibited from providing a broad range of taxrelated services, the SEC did not take such a strong stance in the final rules. Rather, the audit committee has been
charged with pre-approving all tax services and permissible non-audit services. This places on the audit committee
the duty to assure itself that the tax services provided do not compromise the principal accountant's independence.
The SEC has indicated that traditional tax services, including tax compliance, planning and advice would not impair
independence, though they are subject to pre-approval under the final rules. The SEC's larger concern is with tax
strategies, including the provision of tax-shelters to audit clients. This creates the potential for the accounting firm
being required to audit its own work, in contravention of one of the core principals discussed above. The SEC has
urged audit committees to be especially vigilant in the approval of tax strategy services to be performed by the
principal accountant.
Are there additional services that might impair an auditor's independence?
The final rules do not purport to contain an exhaustive list of prohibited services. In order to determine whether the
provision of any non-audit service not specified in the proposed rules would impair an accountant's independence,
companies must look to Rule 2-01 of Regulation S-X2 and the core principles noted above.
Recognizing that audit clients may require a period of time to exit existing contracts, the final rules provide that
accountants may provide the nine types of prohibited non-audit services for 12 months following the effective date
without impairing their independence, provided those services are pursuant to contracts in existence as of 90 days
after publication of the rules.
Disclosure of Audit Fees
What disclosures are required regarding audit fees?
In an effort to enhance the ability of investors to better evaluate the independence of the auditor of a company's
financial statements, the SEC has amended the proxy disclosure rules to require additional disclosures related to
the types of fees that must be detailed and the years of service that are covered by the disclosure. The new rules
increase the number of disclosed categories of professional fees paid for audit and non-audit services from three to
four and includes Audit Fees, Audit-Related Fees, Tax Fees and All Other Fees.
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The new proxy disclosure must present fees for each of the two most recent fiscal years, rather than just the most
recent fiscal year as currently required. In addition, companies will be required to describe in subcategories the
nature of the services provided that are categorized as Audit-Related Fees and All Other Fees. To further promote
investors' understanding of how active an oversight role the audit committee has taken, issuers must identify the
percentage of the fees in each of the categories that were pre-approved by the audit committee pursuant to its
policies and procedures. Issuers are required to disclose this information in their annual reports as well, but may
incorporate it by reference to the proxy statement.
What types of services are included in "Audit Fees," "Audit-Related Fees," "Tax Fees" and "All Other Fees"?
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"Audit Fees" includes only the services necessary to complete the basic audit, sign the audit opinion and perform
the required quarterly reviews.
"Audit-Related Fees" includes assurance and related services that are traditionally performed by the
independent accountant such as employee benefit plan audits, due diligence related to mergers and acquisitions
and internal control reviews.
"Tax Fees" is defined broadly to include fees such as tax compliance, tax consulting and tax planning.
"All Other Fees" encompasses all fees paid to the auditor that are not included in any of the above three
definitions.
Audit Committee Pre-Approval Requirements and Disclosures
What are the Audit Committee's responsibilities for pre-approving services by the auditor?
The rules require the audit committee to pre-approve all permissible non-audit services and all audit, review or attest
engagements required under the securities laws. The rules require that either:
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before the accountant is engaged by the audit client to provide services other than audit, review or attest
services, the audit committee expressly approve the particular engagement; or
any such engagement be entered into pursuant to detailed pre-approval policies and procedures established by
the audit committee and the audit committee is informed on a timely basis of each service.
Are there any exceptions to these pre-approval requirements?
Sarbanes-Oxley provides a de minimis exception to the pre-approval requirements. Under this exception, the preapproval requirements are waived with respect to an issuer if:
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the aggregate amount of all such non-audit services provided to the issuer constitutes not more than five percent
of the total amount of the revenues paid by the issuer to its auditor during the fiscal year in which the non-audit
services are provided;
such services were not recognized by the issuer at the time of the engagement to be non-audit services; and
such services are promptly brought to the attention of the audit committee of the issuer and approved prior to
the completion of the audit by the audit committee or by one or more members of the audit committee who are
members of the board to whom authority to grant such approvals has been delegated by the audit committee.
What disclosures are required regarding pre-approvals?
The new rules require a company filing a proxy statement to disclose any policies and procedures developed by the
audit committee concerning pre-approval of the independent accountant to perform both audit and non-audit
services. The SEC expects registrants to provide clear, concise and understandable descriptions of the policies and
procedures. Alternatively, registrants may include a copy of those policies and procedures with the proxy statement.
Either method should allow shareholders to obtain a complete and accurate understanding of the audit committee's
policies and procedures. Additionally, these procedures would describe, if applicable, the specific processes in
place that permit and monitor activities meeting the de minimis exception.
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Audit Partner Rotation
How often will audit partners be required to rotate?
Section 203 of Sarbanes-Oxley requires rotation of certain audit partners on a five-year basis in order for the
accounting firm to retain its independence. While the concept of audit partner rotation is not new, the SEC's new
rules extend both beyond what has previously been accepted practice as well as what is required pursuant to
Sarbanes-Oxley. The SEC envisions its rules providing a better balance between the necessity of maintaining audit
quality and the need to give a fresh look at an issuer's books. Specifically, the new rules:
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require the lead and concurring partners on an audit engagement team to serve on the engagement in that
capacity for no more than five consecutive years and following the rotation, such partner may not provide such
services to the same issuer for a period of five consecutive years; and
require "audit partners" with significant involvement in an audit to rotate every seven years and following the
rotation, such partners may not be provide audit services to the same issuer for a period of at least two
consecutive years.
Which partners would be subject to the rotation?
The new rules go well beyond what was called for by Sarbanes-Oxley. Under the new rules, accounting firms are
required to rotate multiple partners, rather than just the lead and concurring partners as specified in Section 203.
Recognizing that partners who are members of the audit engagement team make significant decisions that can affect
the conduct and effectiveness of the audit, the SEC extended the rotation requirement to include not only the lead
partner and the concurring partner, but also all "audit partners."
The SEC defines "audit partner" as encompassing partners on an audit engagement team who have decisionmaking responsibility for significant accounting, auditing and reporting matters affecting the financial statements, or
who are in regular contact with the management and the audit committee of a client. With only a few minor
exceptions, as noted below, the definition encompasses all partners who serve at the issuer or parent level, in
addition to other partners on the team who provide more than ten hours of audit, review or attest services in
connection with the annual or interim financial statements of an issuer. Additionally, the definition includes those
partners serving the client at either the parent or the issuer level, other than specialty partners. It also includes a
lead partner who audits a subsidiary of an issuer, when such subsidiary's assets or revenues constitute twenty
percent or more of the issuer's consolidated assets or revenues.
The new rules do not apply to specialty partners, such as tax or valuation specialists or "national office" partners,
who are called upon to resolve specific accounting issues. The SEC believes that though these partners provide an
important role in the audit function, such role is not one in which the partners are routinely interacting or developing
relationships with the audit client.
Recognizing many commentators’ concerns about the effect of the rotation requirements on audit quality and the
ability of partners to become knowledgeable about the business and industry of an audit client prior to the lead or
concurring partner rotating, the SEC's new rules provide longer rotation periods for audit partners who are not lead
or concurring partners. The additional rotation period for these audit partners will allow accounting firms to stagger
the rotation for these partners to ensure that the engagement team continues to have appropriate expertise to allow
the audit engagement to be conducted in accordance with generally accepted auditing standards ("GAAS").
Which accounting firms are required to adhere to the rotation requirements?
The new rules contain an exemption from the rotation requirements for small accounting firms. The rules provide that
if an accounting firm has five or fewer public company clients and has ten or fewer partners, it is not subject to the
partner rotation requirements. However, all exempt engagements must be subject to inspection by the Public
Company Accounting Oversight Board at least once every three years.
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When does the rotation period begin?
The new rules do not provide for any transition period for lead partners. The rotation requirements are effective for
the first fiscal year ending after the effective date of the new rules. The new rules, however, do provide a transition
period for concurring partners, since such partners were not formerly subject to a rotation requirement. The rotation
requirements for concurring partners will be effective as of the end of the second fiscal year after the effective date
of the new rules. Additionally, any time that a lead or concurring partner has already spent on specific engagements
prior to the effective date of the new rules counts toward the five-year rotation period. The rotation requirements for
all other audit partners begin as of the beginning of the first fiscal year after the effective date of the new rules. Time
spent by all audit partners, other than lead or concurring partners, on specific engagements prior to the first day of
the issuer's fiscal year beginning on or after the effective date of the new rules will not count toward the seven-year
period. Lastly, the rules will not become effective for partners who work for foreign accounting firms until the
beginning of the first fiscal year after the effective date of the rules and such year will be the first year counted toward
the rotation period.
One-Year "Cooling Off" Period
Would any employment relationships violate the auditor independence rules?
Currently, an accounting firm is deemed not to be independent with respect to an audit client if a former partner
accepts employment with a client, if he has a continuing financial interest in the accounting firm or if he is in a position
to influence the accounting firm's operations or financial policies. With the new rules, an accounting firm is not
independent with respect to an issuer if the lead partner or the concurring partner becomes employed by the issuer
in a "financial reporting oversight role" within one year prior to the commencement of audit procedures for the year
that included the employment by the issuer of such partner. For purposes of the new rules, one would be in a
financial reporting oversight role if he or she has direct responsibility over those who prepare the company's financial
statements and related information (including management's discussion and analysis) that are included in filings with
the SEC.
The SEC views the one year "cooling off" period as a necessary safeguard to reduce an audit firm's perceived loss
of independence caused by a member of its engagement team being employed with an issuer. The same one-year
rule applies to any other member of the engagement team who provided more than ten hours of audit, review or
attest services for the issuer during the annual audit period. With the ten-hour threshold, the SEC recognizes that
a cooling off period is unnecessary for those engagement team members who spent an insignificant amount of time
on an audit engagement. However, there is no such carve out for lead and concurring partners. The SEC views
such partners' participation as always being significant to the audit engagement, regardless of the time actually spent
on the engagement.
In passing the new rules, the SEC noted that there were certain unique circumstances for which it needed to provide
accommodations. In doing this, it carved out an exemption for the situation where an individual who complies with
the rules and subsequent to beginning employment with an issuer, the issuer merges with or is acquired by another
entity, and such merger or acquisition results in a violation of the cooling off period. In this case, the SEC's new
rules provide that unless the employment is taken in contemplation of the merger or acquisition, the rules will not be
considered violated so long as the audit committee is made aware of the conflict. Lastly, the new rules provide an
exemption for emergency or unusual circumstances. However, in order to benefit from such exemption an issuer's
audit committee must determine that doing so is in the best interests of investors.
How is the cooling off period measured?
The new rules provide a uniform cooling off period for all engagement team members, which equates to being the
duration of one annual audit. The cooling off period begins upon the commencement of audit procedures. The SEC
has determined that audit procedures have commenced for the current audit engagement period the day after the
prior year's annual report is filed with the SEC. The period ends with the date on which the current year's annual
report is filed with the SEC.
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When does the cooling off period become effective?
The new rules do not apply to those audit engagement team members who, prior to the effective date of the rules,
become employed with an issuer in violation of the final rules. The cooling off period thus effectively begins as of
the effective date of the new rules.
Audit Partner Compensation
Will the new rules impact an audit partner's compensation?
The new rules provide that an accountant is not independent if, at any point during the audit and professional
engagement period, any audit partner other than specialty partners, earns or receives compensation based on selling
engagements to that audit client to provide any services, other than audit, review or attest services. The SEC defines
compensation broadly to include any form of cash or other assets, including partnership "units".
The purpose of this rule is to prevent audit partners from exploiting their relationships with an audit client's
management for personal profit by selling non-audit services. The SEC believes partners should be viewed as skilled
professionals, not conduits for the sale of non-audit services.
This rule does not prohibit other partners at the accounting firm from receiving compensation for selling non-audit
services, merely audit partners. For example, just as an audit partner can be compensated for selling audit and auditrelated services, so, too, can a tax partner be compensated for selling tax services without impairing independence.
This rule does not apply to compensation earned or received during the accounting firm's fiscal year that includes
the date 90 days after publication of this rule.
For more information, please contact any of the following Jenner & Block attorneys:
Robert S. Osborne
rosborne@jenner.com
Jerry J. Burgdoerfer
jburgdoerfer@jenner.com
Charles J. McCarthy
cmccarthy@jenner.com
Robert Z. Slaughter
rslaughter@jenner.com
John E. Welch*
Thomas A. Monson
Thaddeus J. Malik
Donald E. Batterson
Jonathan F. Allen
David R. Bowman
Bobby J. Hollis II*
Suzanne H. Johnson
Tobias L. Knapp*
David M. Neville
Edward G. Quinlisk
Jill R. Sheiman
Michael D. Thompson
Cari M. Weber
jwelch@jenner.com
tmonson@jenner.com
tmalik@jenner.com
dbatterson@jenner.com
jallen@jenner.com
dbowman@jenner.com
bhollis@jenner.com
sjohnson@jenner.com
tknapp@jenner.com
dneville@jenner.com
equinlisk@jenner.com
jsheiman@jenner.com
mthompson@jenner.com
cweber@jenner.com
All attorneys may be contacted by phone at 312 222-9350, except * at 202 639-6000.
Endnotes
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SEC Release Nos. 33-8183; 34-47265.
In considering [the standard of auditor independence], the [SEC] looks to whether the provision of a service: (a) creates a
mutual or conflicting interest between the accountant and the audit client; (b) places the accountant in the position of auditing
his or her own work; (c) results in the accountant acting as management or an employee of the audit client; or (d) places the
accountant in the position of being an advocate for the audit client. Preliminary Note to Rule 2-01 of Regulation S-X.
©2003 Jenner & Block, LLC. Jenner & Block is an Illinois Limited Liability Company. Although no longer a partnership, we use the term “partners” to refer to the attorneys who directly or indirectly hold membership interests in the LLC. This publication is not intended to provide legal advice but to provide information on legal matters and Firm news of interest to our clients and colleagues. Readers should seek specific legal advice before taking any action with respect to matters mentioned in this publication. Under professional rules, this news alert may be considered advertising material; the attorney responsible for this
publication is Jerry J. Burgdoerfer.
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