Auditor Independence

The role of the independent auditor in public company financial reporting has been a primary focus of the Sarbanes-Oxley Act of 2002. In the accounting scandals of the last two years, accounting firms have been severely criticized or held responsible for false or misleading public company financial statements due to the perceived lack of independence from their public company clients. The SEC has recently adopted new guidelines to promote the independence of accountants who audit and review the financial statements of public companies. Subject to transition periods, the rules are effective May 6, 2003.

An auditor’s independence and objectivity can be compromised when an accounting firm is called on to review transactions or programs recommended or implemented by the non-audit side of the firm. This is especially true if the non-audit services are more lucrative to the accounting firm than the actual audit services performed.

Sarbanes-Oxley and the new SEC rules on auditor independence list the non-audit services which, if performed, will be deemed to have impaired an auditor’s independence. The lists include:

• bookkeeping and services relating to accounting records and financial statements,
• design and implementation of a company’s financial information system,
• appraisal or valuation services, fairness opinions or contribution-in-kind reports,
• actuarial services,
• internal audit outsourcing services,
• management functions,
• human resources and executive search,
• broker-dealer, investment adviser or investment banking services,
• legal services (this prohibition now applies to the provision of legal services outside the United States, whereas previously the rules prohibited the auditor from providing legal services only within U.S. jurisdictions), and
• expert services unrelated to the audit.

The SEC rules largely prohibit an auditor from performing any services for the audit client if the services would be audited by that same firm. The prohibition on non-audit services is delayed until May 6, 2004, for services performed under contracts in existence prior to or on May 6, 2003.

Under the new SEC rules, a public company’s independent auditor may provide non-audit services if the services are not of the type listed above and the non-audit services are approved in advance by the company’s audit committee of the board of directors. The rules specify the standards the audit committee must apply as part of the approval process. These are described below:

• Before the accountant is engaged to provide either audit or permissible non-audit services, the audit committee must approve in advance the scope and cost of the engagement, or
• The engagement falls under pre-approval policies adopted by the audit committee, or
• All of the following conditions are met:

(1) The aggregate amount of all non-audit services constitutes no more than 5% of the total amount of revenues paid by the company to the accountant during the year in which such services are provided,

(2) At the time of engagement, the company did not recognize the services as being non-audit services, and

(3) The non-audit services are promptly brought to the attention of the audit committee and are approved prior to the completion of the audit.

The rule permits an audit committee to designate one or more independent audit committee members to pre-approve non-audit services. The designated member(s) must report periodically to the full audit committee as to any services approved. Policies and procedures that are set in advance for pre-approval of non-audit services must be disclosed in the company’s proxy statement or annual report.

The SEC has expanded the required proxy statement and annual report disclosures covering the services being provided by public company auditors. In particular, public companies must disclose the following items:

• audit fees for the last two fiscal years,
• audit-related fees for the last two fiscal years (including services by the accountant that are reasonably related to the performance of the audit but are not reported as audit fees),
• tax fees for the last two fiscal years (covering tax compliance, tax advice and tax planning advice),
• all other fees for the last two fiscal years, and
• the audit committee’s pre-approval policies and procedures, including the percentage of services (other than audit services) that were pre-approved by the audit committee.

The disclosure provisions are effective for periodic annual filings for the first fiscal year ending after December 15, 2003. The SEC encourages public companies to include this disclosure for annual filings made prior to such effective date.

Under pre-Sarbanes auditing standards, a lead audit partner for a public client was limited to a seven-year engagement with at least a two-year time-out period. Pursuant to the Sarbanes-Oxley Act and the SEC’s new rules, the lead as well as concurring audit partner must rotate after five years on the account, and must remain off the account for five years. Other firm partners on the account must rotate after seven years and must endure a two-year time-out period before undertaking further work on the account.

The "lead partner" is the audit firm partner having primary responsibility for the audit or review, and the "concurring" or "reviewing" partner is the audit firm partner who provides a second level of review. Other audit partners, who are subject to the longer service period, are those who spend more than ten hours of audit, review or attest services in connection with the review of annual or interim financial statements. This includes the lead partners for the audit team of a subsidiary that accounts for more than 20% of the assets or revenues of the parent company. "Audit partner" does not include the specialty partners of an accounting firm, e.g., partners who consult on specific transactions, technical requirements, or industry-specific issues.

The new partner rotation rules become effective in accordance with the following schedule:

• For the "lead partner," the rotation rules begin with the first fiscal year ending after May 6, 2003, with the calculation of the five-year period including time served as lead partner prior to May 6, 2003,
• For the "concurring partner," rotation rules start on the first day of the fiscal year beginning after May 6, 2004, with the calculation of the five-year period including time served as concurring partner prior to May 6, 2003, and
• For all other audit partners, the rotation rules are effective for the first fiscal year beginning after May 6, 2003, but this does not include time served as an audit partner prior to May 6, 2003.

Under generally accepted auditing standards, audit firms are required to communicate certain matters to the audit committee of the company, including significant accounting policies, treatment of unusual transactions, material audit adjustments to transactions recorded by management, any difficulties with management during the audit, the use of estimates, and similar information. Although these reports were required, they were not necessarily submitted prior to the release of the audit report.

The SEC’s new rules require that the auditors make a detailed report to the audit committee of the company prior to the filing of the audit report with the SEC. The following items must be included in the report:

• all critical accounting policies used by the company,
• all alternative accounting treatments of financial statements within generally accepted accounting principles that have been discussed with management, including the ramifications of such alternative treatments and disclosures, and the treatments preferred by the accounting firm, and
• other material written communications (including the management representation letter) between the accounting firm and management.

While the communication to the audit committee is not required to be in writing, it is recommended as a "best practice" that both the auditor and the audit committee document the report in some fashion. It is also likely to be considered a "best practice" if these reports, whether oral or written, are made quarterly, even though the rule requires only that the quarterly report be filed before the annual audit report.

With the new independence rules come additional penalties for violations. Breaches of the new independence requirements will constitute actual violations under the Exchange Act. Previous to Sarbanes-Oxley, the SEC would require an accountant to withdraw from representing a public company if egregious conflicts of interest were found.

The content of this article does not constitute legal advice and should not be relied on in that way. Specific advice should be sought about your specific circumstances.