[Federal Register Volume 68, Number 24 (Wednesday, February 5, 2003)]
[Rules and Regulations]
[Pages 6006-6051]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 03-2364]
[[Page 6005]]
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Part III
Securities and Exchange Commission
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17 CFR Parts 210, 240, et al.
Strengthening the Commission's Requirements Regarding Auditor
Independence; Final Rule
Federal Register / Vol. 68, No. 24 / Wednesday, February 5, 2003 /
Rules and Regulations
[[Page 6006]]
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SECURITIES AND EXCHANGE COMMISSION
17 CFR Parts 210, 240, 249 and 274
[Release No. 33-8183; 34-47265; 35-27642; IC-25915; IA-2103, FR-68,
File No. S7-49-02]
RIN 3235-AI73
Strengthening the Commission's Requirements Regarding Auditor
Independence
AGENCY: Securities and Exchange Commission.
ACTION: Final rule.
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SUMMARY: The Securities and Exchange Commission (``SEC'' or
``Commission'') is adopting amendments to its existing requirements
regarding auditor independence to enhance the independence of
accountants that audit and review financial statements and prepare
attestation reports filed with the Commission. The final rules
recognize the critical role played by audit committees in the financial
reporting process and the unique position of audit committees in
assuring auditor independence. Consistent with the direction of Section
208(a) of the Sarbanes-Oxley Act of 2002, we are adopting rules to:
revise the Commission's regulations related to the non-audit services
that, if provided to an audit client, would impair an accounting firm's
independence; require that an issuer's audit committee pre-approve all
audit and non-audit services provided to the issuer by the auditor of
an issuer's financial statements; prohibit certain partners on the
audit engagement team from providing audit services to the issuer for
more than five or seven consecutive years, depending on the partner's
involvement in the audit, except that certain small accounting firms
may be exempted from this requirement; prohibit an accounting firm from
auditing an issuer's financial statements if certain members of
management of that issuer had been members of the accounting firm's
audit engagement team within the one-year period preceding the
commencement of audit procedures; require that the auditor of an
issuer's financial statements report certain matters to the issuer's
audit committee, including ``critical'' accounting policies used by the
issuer; and require disclosures to investors of information related to
audit and non-audit services provided by, and fees paid to, the auditor
of the issuer's financial statements. In addition, under the final
rules, an accountant would not be independent from an audit client if
an audit partner received compensation based on selling engagements to
that client for services other than audit, review and attest services.
As described further in the release, these rules also will have an
impact on foreign accounting firms that conduct audits of foreign
subsidiaries and affiliates of U.S. issuers, as well as of foreign
private issuers. Many of the modifications to the proposed rules, such
as those limiting the scope of partner rotation and personnel subject
to the ``cooling off period,'' have the added benefit of addressing
particular concerns raised about the international implications of
these requirements. Moreover, additional time is being afforded to
foreign accounting firms with respect to compliance with rotation
requirements. The release also provides guidance on the provision of
non-audit services by foreign accounting firms, including the treatment
of legal services and tax services.
DATES: Effective Date: May 6, 2003. Transition Dates: Provided the
following relationships did not impair the accountant's independence
under pre-existing requirements of the Commission, the Independence
Standards Board, or the accounting profession in the United States, an
accountant's independence will not be deemed to be impaired:
(1) By employment relationships described in Sec. 210.2-
01(c)(2)(iii)(B) that commenced at the issuer prior to May 6, 2003;
(2) By compensation earned or received, as described in Sec.
210.2-01(c)(8), during the accounting firm's fiscal year that includes
May 6, 2003;
(3) Until May 6, 2004 by the provision of services described in
Sec. 210.2-01(c)(4) provided those services are pursuant to contracts
in existence on May 6, 2003;
(4) Until May 6, 2003 by the provision of services that have not
been pre-approved by an audit committee as required in Sec. 210.2-
01(c)(7);
(5) An accountant's independence will not be deemed to be impaired
until the first day of the issuer's fiscal year beginning after May 6,
2003 by a ``lead'' partner and other audit partner (other than the
``concurring'' partner) providing services in excess of those permitted
under Sec. 210.2-01(c)(6); and
(6) An accountant's independence will not be deemed to be impaired
until the first day of the issuer's fiscal year beginning after May 6,
2004 by a ``concurring'' partner providing services in excess of those
permitted under Sec. 210.2-01(c)(6).
For the purposes of calculating periods of service under Sec.
210.2-01(c)(6):
(1) For the ``lead'' and ``concurring'' partner, the period of
service includes time previously served as the ``lead'' or
``concurring'' partner prior to May 6, 2003; and
(2) For audit partners other than the ``lead'' partner or
``concurring'' partner, and for audit partners in foreign firms, the
period of service does not include time served on the audit engagement
team prior to the first day of issuer's fiscal year beginning on or
after May 6, 2003.
FOR FURTHER INFORMATION CONTACT: Samuel L. Burke, Associate Chief
Accountant, Paul Munter, Academic Fellow, or Robert E. Burns, Chief
Counsel, at (202) 942-4400, Office of the Chief Accountant, or, with
respect to questions about investment companies, Brian D. Bullard,
Chief Accountant, at (202) 942-0590, Division of Investment Management,
U.S. Securities and Exchange Commission, 450 Fifth Street, NW.,
Washington, DC 20549.
SUPPLEMENTARY INFORMATION: We are adding Rule 2-07 to Regulation S-
X,\1\ amending Rule 2-01 of Regulation S-X,\2\ amending Item 9 of
Regulation S-K,\3\ amending Forms 10-K, 10-KSB, 20-F and 40-F,\4\
amending Form N-CSR \5\ and adding new Exchange Act Rule 10A-2.\6\
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\1\ 17 CFR 210.2-07.
\2\ 17 CFR 210.2-01.
\3\ 17 CFR 240.14a-101.
\4\ 17 CFR 249.310; 17 CFR 249.310b; 17 CFR 249.220f; 17 CFR
249.240f.
\5\ 17 CFR 249.331; 17 CFR 274.128.
\6\ 17 CRF 240.10A-2.
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I. Introduction and Background
On July 30, 2002, the Sarbanes-Oxley Act of 2002 (``Sarbanes-Oxley
Act'' or ``the Act'') was enacted.\7\ Title II of the Sarbanes-Oxley
Act, entitled ``Auditor Independence,'' requires the Commission to
adopt, by January 26, 2003, final rules under which certain non-audit
services will be prohibited, conflict of interest standards will be
strengthened, auditor partner rotation and second partner review
requirements will be strengthened, and the relationship between the
independent auditor and the audit committee will be clarified and
enhanced.
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\7\ Pub. L. 107-204, 116 Stat. 745 (2002).
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We are adopting amendments to our current rules regarding auditor
independence.\8\ The final rules advance our important policy goal of
protecting the millions of people who invest in our securities markets
in reliance on financial statements that are prepared by public
companies and other issuers
[[Page 6007]]
and that, as required by Congress, are audited by independent auditors.
We believe the final rules strike a reasonable balance among
commenters' differing views about the proposals while achieving our
important public policy goals.\9\
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\8\ The amendments were proposed in Securities Act Release No.
8154 (December 2, 2002) 67 FR 76779-76817.
\9\ In addition to soliciting comments in the Proposing Release,
we held one roundtable (December 17, 2002). The public comments we
received can be reviewed in our Public Reference Room at 450 Fifth
Street, NW., Washington, DC 20549, in File No. S7-49-02. Public
comments submitted by electronic mail are on our Web site,
www.sec.gov.
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As directed by the Sarbanes-Oxley Act, the rules focus on key
aspects of auditor independence: the provision of certain non-audit
services, the unique ability and responsibility of the audit committee
to insulate the auditor from the pressures that may be exerted by
management, the potential conflict of interest that can be created when
a former member of the audit engagement team accepts a key management
position with the audit client, and the need for effective
communications between the auditor and audit committee. In addition,
under the final rules, an accountant would not be independent from an
audit client if any audit partner received compensation based directly
on selling engagements to that client for services other than audit,
review and attest services.
Title II of the Sarbanes-Oxley Act adds new subsections (g) through
(l) to Section 10A of the Securities Exchange Act of 1934 as follows:
[sbull] Section 201 adds sub-section (g), which specifies that a
number of non-audit services are prohibited. Many of these services
were previously prohibited by the Commission's independence standards
adopted in November 2000 (with some exceptions and qualifications).\10\
The rules we are adopting amend the Commission's existing rules on
auditor independence and clarify the meaning and scope of the
prohibited services under the Sarbanes-Oxley Act.
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\10\ The Commission adopted a set of rules governing auditor
independence on November 21, 2000. See Release No. 33-7919 (Nov. 21,
2000); 65 FR 76008 (Dec. 5, 2000) (hereinafter ``November 2000
release'').
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[sbull] Section 201 also adds sub-section (h), which requires that
non-audit services that are not prohibited under the Sarbanes-Oxley Act
and the Commission's rules be subject to pre-approval by the
registrant's audit committee. These rules specify the requirements for
obtaining such pre-approval from the registrant's audit committee.
[sbull] Section 202 adds sub-section (i), which requires an audit
committee to pre-approve allowable non-audit services and specifies
certain exceptions to the requirement to obtain pre-approval. These
rules specify the requirements of the registrant's audit committee for
pre-approving non-audit services by the auditor of the registrant's
financial statements.
[sbull] Section 203 adds sub-section (j), which establishes
mandatory rotation of the lead partner and the concurring partner every
five years. These rules expand the number of engagement personnel
covered by the rotation requirement and clarify the ``time out''
period.
[sbull] Section 204 adds sub-section (k), which requires that the
auditor report on a timely basis certain information to the audit
committee. In particular, the Sarbanes-Oxley Act requires that the
auditor report to the audit committee on a timely basis (a) all
critical accounting policies used by the registrant, (b) alternative
accounting treatments that have been discussed with management along
with the potential ramifications of using those alternatives, and (c)
other written communications provided by the auditor to management,
including a schedule of unadjusted audit differences.\11\ These rules
strengthen the relationship between the audit committee and the
auditor.
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\11\ SAS No. 89, ``Audit Adjustments,'' (Dec. 1999) at AU Sec.
380.
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[sbull] Section 206 adds sub-section (l) addressing certain
conflict of interest provisions. The Sarbanes-Oxley Act prohibits an
accounting firm from performing audit services for a registrant if
certain key members of management have recently been employed in an
audit capacity by the audit firm. These rules clarify which members of
management are covered by these conflict of interest rules.
In addition, under the final rules, an accountant would not be
independent of an audit client if an audit partner received
compensation based on selling engagements to that client for services
other than audit, review and attest services.
As noted above, the rules establish and clarify the important roles
and responsibilities of registrant audit committees as well as the
registrant's independent accountant.\12\
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\12\ The Commission's rules respond not only to the provisions
of the Sarbanes-Oxley Act but also the rulemaking petitions filed by
the AFL-CIO on December 11, 2001 and The Honorable H. Carl McCall on
January 21, 2002.
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We have adopted a separate rule under Exchange Act Section 10A (17
CFR 240.10A-2) to implement Section 3(b)(1) of the Sarbanes-Oxley Act
and clarify that our rules implementing Title II of Sarbanes-Oxley not
only define conduct that impairs independence but also constitute
separate violations under the Exchange Act. We have otherwise adopted
rules (except for the proxy disclosure changes) as part of Regulation
S-X, and placed them among the current auditor independence provisions.
II. Discussion of Rules
A.Conflicts of Interest Resulting From Employment Relationships
The Commission's previous rules deem an accounting firm to be not
independent with respect to an audit client if a former partner,
principal, shareholder, or professional employee of an accounting firm
\13\ accepts employment with a client if he or she has a continuing
financial interest in the accounting firm or is in a position to
influence the firm's operations or financial policies. These rules
renumber, but do not otherwise change, that existing requirement.
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\13\ Consistent with our existing rules, the terms accounting
firm and accountant are used interchangeably in this release. The
term ``accountant'' is defined in Sec. 210.2-01(f)(1) below.
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Consistent with Section 206 of the Sarbanes-Oxley Act, we are
adding a restriction on employment with audit clients by former
employees of the accounting firm. The Act specifies that an accounting
firm cannot perform an audit for a registrant:
* * *[i]f a chief executive officer, controller, chief financial
officer, chief accounting officer, or any person serving in an
equivalent position for the issuer, was employed by that registered
independent public accounting firm and participated in any capacity
in the audit of that issuer during the 1-year period preceding the
date of the initiation of the audit.\14\ (emphasis added)
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\14\ See, Section 206 of the Sarbanes-Oxley Act.
Thus, the Act requires a ``cooling off '' period of one year before
a member of the audit engagement team can begin working for the
registrant in certain key positions. Based on the provisions of the
Act, we proposed that the employment of former audit engagement team
\15\ members of an accounting firm in a financial reporting oversight
role \16\ at an audit client would cause the accounting firm not to be
independent with respect to that registrant if they were members of the
audit engagement team within one year prior to the commencement of
procedures for the current audit engagement. The rules that we proposed
would have applied to employment relationships entered into between
[[Page 6008]]
``audit engagement team'' members and their ``audit clients.'' \17\
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\15\ See, Rule 2-01(f)(7).
\16\ See, Rule 2-01(f)(3)(ii).
\17\ See, Rule 2-01(f)(6).
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The concept of a ``cooling-off '' period before an auditor can take
a position at the audit client was previously considered by the
Independence Standards Board.\18\ In considering a cooling-off period,
the Independence Standards Board noted that a mandated cooling-off
period for partners and professional staff might create a greater
appearance of independence between the accounting firm and the
registrant.\19\ Ultimately, however, the Independence Standards Board
provided for an alternative to a cooling-off period. The Independence
Standards Board concluded that:
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\18\ The Independence Standards Board was a private sector body
that, from 1997 to 2001, was charged with the responsibility to set
auditor independence standards for auditors of the financial
statements of SEC registrants. See Financial Reporting Release Nos.
50 (February 18, 1998) and 50A (July 17, 2001).
\19\ Independence Standards Board, ``Employment with Audit
Clients,'' Discussion Memorandum 99-1 (March 12, 1999).
An audit firm's independence is impaired with respect to an
audit client that employs a former firm professional who could, by
reason of his or her knowledge of and relationships with the audit
firm, adversely influence the quality or effectiveness of the audit,
unless the firm has taken steps that effectively eliminate such
risk.\20\
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\20\ Independence Standards Board, ``Employment with Audit
Clients,'' Standard No. 3 (July 2000).
Independence Standards Board's Standard No. 3 specifically notes
that additional caution is warranted when it has been less than one
year since the professional disassociated him or herself from the
firm.\21\ The provisions of the Sarbanes-Oxley Act reflect the view
that the passage of time is an additional safeguard to reduce the
perceived loss of independence for the audit firm caused by the
acceptance of employment by a member of the engagement team with an
audit client.
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\21\ Id., ] 2(b)(iii).
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Some commenters \22\ stated that the rule should apply only to
partners on the audit engagement team. However, we believe that the Act
is clear that the cooling off period should apply more broadly.
Additionally, our proposal would have applied to relationships between
members of the audit engagement team and the audit client. Some
commenters \23\ believe that extending the requirement to the audit
client was too broad. In some situations (such as certain affiliate
companies), it could be difficult for the accounting firm and its audit
clients to monitor and, in some cases, control the employment
relationship.
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\22\ See, e.g., letter from Asahi & Co., dated January 10, 2003;
letter from CPA Associates, dated January 3, 2003; letter from
International Group of Accounting Firms, dated December 24, 2002.
\23\ See, e.g., letter from Eli Lilly and Company, dated January
9, 2003; letter from KPMG, dated January 9, 2003; letter from
PricewaterhouseCoopers, dated January 8, 2003; letter from Roland G.
Ley, dated January 9, 2003.
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Our proposed rule did not make a distinction based on the number of
hours of audit, review, or attest services provided in determining who
would be subject to this rule. The Act refers to individuals who
``participated in any capacity in the audit.'' Commenters \24\ noted
that not all members of the audit engagement team, as that term is
currently defined, necessarily participate in a meaningful audit
capacity.
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\24\ See, e.g., letter from American Institute of Certified
Public Accountants, dated January 9, 2003; letter from KPMG, dated
January 9, 2003; letter from Instituted of Chartered Accountants of
Scotland, dated January 8, 2003.
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As discussed both in our proposing release and in this release, the
term ``financial reporting oversight role'' refers to any individual
who has direct responsibility for oversight over those who prepare the
registrant's financial statements and related information (e.g.,
management's discussion and analysis) that are included in filings with
the Commission. Some commenters \25\ stated that the final rule only
should apply to the four named positions in the Act (e.g., chief
executive officer, controller, chief financial officer, chief
accounting officer). Other commenters,\26\ however, agreed with the
Commission's approach of using the concept of financial reporting
oversight role.
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\25\ See, e.g., letter from Eli Lilly and Company, dated January
9, 2003; letter from McGladrey & Pullen LLP, dated January 9, 2003;
letter from PricewaterhouseCoopers, dated January 8, 2003; letter
from Computer Sciences Corporation, dated January 13, 2003.
\26\ See, e.g., letter from Consumer Federation of America,
dated January 13, 2003.
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In response to the issues raised by commenters,\27\ we are
requiring that when the lead partner, the concurring partner, or any
other member of the audit engagement team \28\ who provides more than
ten hours of audit, review or attest services for the issuer accepts a
position with the issuer in a financial reporting oversight role within
the one year period preceding the commencement of audit procedures for
the year that included employment by the issuer of the former member of
the audit engagement team, the accounting firm is not independent with
respect to that registrant. Our rule applies to all members of the
audit engagement team unless specifically exempted, as discussed later
in this section of the release.
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\27\ See, e.g., letter from Deloitte & Touche, dated January 10,
2003; letter from KPMG, dated January 9, 2003; letter from
PricewaterhouseCoopers, dated January 8, 2003.
\28\ See, Rule 2-01(f)(7).
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We agree with the commenters \29\ who noted that extending the
requirement to the ``audit client'' might be difficult to monitor
because of the potentially broad scope of that defined term--
particularly in situations where a member of the audit engagement team
begins employment with an affiliate of the audit client.\30\
Accordingly, the rules that we are adopting apply to employment
relationships entered into between members of the audit engagement team
and the ``issuer.'' \31\
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\29\ See, e.g., letter from KPMG, dated January 9, 2003; letter
from PricewaterhouseCoopers, dated January 8, 2003.
\30\ See, Rule 2-01(f)(4).
\31\ See, Section 3(a)(8) of the Securities Exchange Act of 1934
(15 U.S.C. 78c(a)(8)).
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The Commission recognizes that, in certain instances, there are
individuals who meet the definition of engagement team members while
spending a relatively small amount of time on audit-related matters of
the issuer. For example, a staff member may be asked to spend one day
of time to observe inventory. While the input may have been important
to resolving specific aspects of the audit, the staff member likely has
not had significant interaction with the audit engagement team or
management of the issuer. However, it is likely that those who spent
more than a de minimis amount of time on the engagement team did
participate in a meaningful audit capacity. Because of their roles in
the engagement, the lead and concurring partner always should
participate in a meaningful audit capacity, regardless of the number of
hours spent on the engagement.
In order to provide useful guidance, our rule on conflicts of
interest resulting from employment relationships specifies that, other
than the lead and concurring partner, an individual \32\ must provide
more than ten hours of service during the annual audit period \33\ as a
member of the engagement team to have participated in an audit
capacity. The Commission previously has considered a threshold based on
the number of hours of service and, based on our experience, concluded
that use of ten hours of service to the client
[[Page 6009]]
constitutes a reasonable basis for distinguishing whether there has
been participation on the audit.\34\
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\32\ It should be noted that the ten hour threshold does not
apply to the lead or concurring review partner. Such individuals are
always subject to these rules, regardless of the number of hours of
audit, review or attest services provided.
\33\ This includes hours of service provided in reviewing the
issuer's quarterly filing or in providing attest services for the
issuer related to the audit.
\34\ Use of ten hours as a threshold is consistent with the
determination of a ``covered person'' as specified by Sec. 210.2-
01(f).
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The Commission has determined that using the ``financial reporting
oversight role'' is a better test for the scope of the provision than
the four particular officers named in the Act. As discussed in the
definitions section of this release, the term financial reporting
oversight role is not a new concept. Furthermore, in addition to naming
four specific positions, the Act also states that the cooling off
period applies to ``any person serving in an equivalent position for
the issuer.'' Because issuers do not use uniform titles nor do all
named positions (e.g., controller) have uniform duties among all
issuers, we believe that a more complete definition of the applicable
positions is needed. Furthermore, the term financial reporting
oversight role captures other key positions, such as members of the
board of directors, who may have significant interaction with the audit
engagement team.
While the rule is intended to apply broadly to members of the audit
engagement team, we recognize the need to provide accommodations for
certain unique situations. In addition to the exemption discussed
previously for those who provided ten or fewer hours of audit, review,
or attest services, the final rule provides an exception for conflicts
that are created through merger or acquisition. Some commenters \35\
noted that an individual may have complied fully with the rule and,
subsequent to his or her beginning employment with an issuer, the
issuer merged with or was acquired by another entity resulting in he or
she becoming a person in a financial reporting oversight role of the
combined entity and the combined entity being audited by the
individual's previous employer. In such a situation, unless the
employment was taken in contemplation of the combination, the
individual or the issuer could not be expected to know that his or her
employment decision would result in a conflict. Thus, as long as the
audit committee is aware of this conflict, the audit firm would
continue to be independent under these rules.
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\35\ See, e.g., letter from Deloitte & Touche, dated January 10,
2003; letter from KPMG, dated January 9, 2003; letter from
PricewaterhouseCoopers, dated January 8, 2003.
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Further, we recognize that other unusual situations that may arise.
For example, some commenters \36\ have stated that in certain foreign
jurisdiction it may be extremely difficult or costly to comply with
these requirements. Accordingly, we have provided an additional
exemption for emergency or unusual circumstances which we anticipate
being invoked very rarely. However, in order for a company to avail
itself of this exemption, the audit committee \37\ must determine that
doing so is in the best interests of investors.
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\36\ See, e.g., letter from Deloitte & Touche, dated January 10,
2003; letter from European Commission, dated January 13, 2003.
\37\ These rules do not require the company to have an
independent audit committee. See, discussion of definitions in this
release.
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Some commenters \38\ stated that determining the time period of the
prohibition would be difficult to apply as proposed. We recognize the
difficulties when there is, potentially, a different applicable date
for each member of the engagement team. For that reason, our final rule
adopts a uniform date for all members of the engagement team.
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\38\ See, e.g., letter from Ernst & Young, dated January 6,
2003; letter from KPMG, dated January 9, 2003; letter from Sullivan
& Cromwell LLP, dated January 10, 2003; letter from California
Public Employees' Retirement System, dated January 10, 2003.
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For purposes of this rule, audit procedures are deemed to have
commenced for the current audit engagement period the day after the
prior year's periodic annual report (e.g., Form 10-K, 10-KSB, 20-F or
40-F) is filed with the Commission. The audit engagement period for the
current year is deemed to conclude the day the current year's periodic
annual report (for example, Form 10-K, 10-KSB, 20-F or 40-F) is filed
with the Commission.
To illustrate the application of this rule, assume that Issuer A's
Forms 10-K are filed on March 15, 2003, April 5, 2004, March 10, 2005,
and March 30, 2006. Issuer A is a calendar-year reporting entity. The
audit engagement periods would be deemed to commence and end:
------------------------------------------------------------------------
Engagement Period
Annual Period Commences Engagement Period Ends
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2003 March 16, 2003........ April 5, 2004
2004 April 6,.............. 2004 March 10, 2005
2005 March 11, 2005........ March 30, 2006
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If audit engagement person B provided audit, review or attest
services for Issuer A at any time during the 2003 engagement period
(March 16, 2003--April 5, 2004), and he or she begins employment with
Issuer A in a financial reporting oversight role prior to March 11,
2005, the accounting firm would be deemed to be not independent with
respect to Issuer A. For example, if person B last performed audit,
review or attest services for Issue A on March 24, 2003 and he or she
began employment with Issuer A in a financial reporting oversight role
prior to March 11, 2005, the accounting firm would be deemed to be not
independent with respect to Issuer A. Likewise, if person B provided
audit, review or attest services for Issuer A at any time during the
2004 engagement period (April 6, 2004--March 10, 2005) and he or she
began employment with Issuer A in a financial reporting oversight role
prior to March 31, 2006, the accounting firm would be deemed to be not
independent with respect to Issuer A.
The Act specifies that the cooling off period must be one year.
Under our rules, the prohibition would require that the accounting firm
has completed one annual audit \39\ subsequent to when an individual
was a member of the audit engagement team. As previously discussed, the
measurement period is based upon the dates the issuer filed its annual
financial information with the Commission.
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\39\ As used here, the term annual audit also includes
procedures needed to conduct timely review of interim periods as
well as procedures needed to attest to the registrant's internal
controls.
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With respect to investment companies, we proposed that the
employment of a former audit engagement team member in a financial
reporting oversight role at any entity in the same investment company
complex during the one year period after the completion of the last
audit would impair the independence of the accounting firm with respect
to the audit client. The proposed rule was designed to prevent a former
audit engagement team member from taking a position in an investment
company complex where they could influence the preparation of the
financial statements or the conduct of the audit.
Several commenters \40\ suggested this requirement was too broad
and could have unintended consequences, such as preventing a former
audit engagement team member on an investment company audit engagement
from taking a financial reporting position at an entity in the
investment company complex whose operations are unrelated to the
investment company. Some
[[Page 6010]]
commenters \41\ acknowledged, however, that it was in investors'
interests to prevent audit engagement team members from leaving the
firm and assuming a financial reporting oversight role at an entity in
the investment company complex that had responsibility for the
financial reporting or operations of the investment company audit
client. One commenter \42\ suggested the rule should not apply to
positions at service providers solely because they are in the
investment company complex.
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\40\ See, letter from Deloitte & Touche, dated January 10, 2003;
letter from PricewaterhouseCoopers, dated January 8, 2003; letter
from Investment Company Institute, dated January 13, 2003.
\41\ See, letter from Investment Company Institute, dated
January 13, 2003; letter from Deloitte & Touche, dated January 10,
2003.
\42\ See, letter from PricewaterhouseCoopers dated January 8,
2003.
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Due to the unique structure of investment companies, where the
normal operating activities, including activities related to the
preparation of financial statements, are provided by outside service
providers, we believe the rules need to extend beyond the investment
company itself. After considering the comments, we agree, however, that
the reach of the rule as proposed was too broad and have determined to
tailor the scope of the rule with respect to investment companies to
those situations where independence could be impaired. As adopted, an
accounting firm would not be independent if a former audit engagement
team member is employed in a financial reporting oversight role with
not only the registered investment company, but also with any entity in
the same investment company complex that is responsible for the
financial reporting or operations of the registered investment company
or any other registered investment company in the same investment
company complex. The adopted rule prohibits employment in positions at
an investment company complex that would allow a former audit
engagement team member to bring undue influence over the audit process
of an investment company. The rule recognizes that certain positions
exist at an entity in the investment company complex that would be
considered financial reporting or oversight positions but those
positions have no direct influence in the financial reporting or
operations of an investment company in the investment company complex.
In these instances, we believe tailoring the focus of this rule will
not harm investor interests.
We recognize the need to provide for orderly transition. We believe
it would be unfair to expect those who began employment before the
effective date of these rules to be asked to sever those employment
relationships. Accordingly, these rules are effective for employment
relationships with the issuer that commence after the effective date of
these rules.
B. Scope of Services Provided by Auditors
Section 201(a) of the Sarbanes-Oxley Act adds new Section 10A(g) to
the Securities Exchange Act of 1934. Except as discussed below, this
section states that it shall be unlawful for a registered public
accounting firm that performs an audit of an issuer's financial
statements (and any person associated with such a firm) to provide to
that issuer, contemporaneously with the audit, any non-audit services,
including the nine categories of services set forth in the Act.
Additionally, the Act provides that the provision of ``any non-audit
service, including tax services, that is not described'' as a
prohibited service, can be provided by the auditor without impairing
the auditor's independence ``only if'' the service has been pre-
approved by the issuer's audit committee. The nine categories of
prohibited non-audit services included in the Act are:
[sbull] Bookkeeping or other services related to the accounting
records or financial statements of the audit client;
[sbull] Financial information systems design and implementation;
[sbull] Appraisal or valuation services, fairness opinions, or
contribution-in-kind reports;
[sbull] Actuarial services;
[sbull] Internal audit outsourcing services;
[sbull] Management functions or human resources;
[sbull] Broker or dealer, investment adviser, or investment banking
services;
[sbull] Legal services and expert services unrelated to the audit;
and
[sbull] Any other service that the Board \43\ determines, by
regulation, is impermissible.
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\43\ As used in this section of the Act, the term Board refers
to the Public Company Accounting Oversight Board.
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The Commission's principles of independence with respect to
services provided by auditors are largely predicated on three basic
principles, violations of which would impair the auditor's
independence: (1) An auditor cannot function in the role of management,
(2) an auditor cannot audit his or her own work, and (3) an auditor
cannot serve in an advocacy role for his or her client.\44\
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\44\ See, Preliminary note to Rule 2-01 of Regulation S-X, 17
CFR 210.2-01.
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Some commenters \45\ stated that the Commission should prohibit the
audit firm from performing most, if not all, non-audit services. Other
commenters \46\ supported a less strict approach. Consistent with our
proposing release,\47\ we are adopting rules related to the scope of
services that independent accountants can provide to their audit
clients. In adopting these rules, the Commission is clarifying the
scope of the prohibited services. The prohibited services contained in
these rules only apply to non-audit services provided by independent
accountants to their audit clients. These rules do not limit the scope
of non-audit services provided by an accounting firm to a non-audit
client. Under the Act, the responsibility falls on the audit committee
to pre-approve all audit and non-audit services provided by the
accountant.
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\45\ See, e.g., letter from California Public Employees'
Retirement System, dated January 10, 2003; letter from William E.
Fraser, dated November 26, 2002, letter from Ellen Sweet, dated
November 26, 2002, letter from Council on Institutional Investors,
dated January 10, 2003.
\46\ See, e.g., letter from Chamber of Commerce of the United
States of America, dated January 9, 2003; letter from America's
Community Bankers, dated January 13, 2003; letter from Deloitte &
Touche LLP, dated January 10, 2003; letter from American Society of
Corporate Secretaries, dated January 13, 2003.
\47\ 17 CFR parts 210, 240, 249 and 274.
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Recognizing that audit clients may need a period of time to exit
existing contracts our rules provide that until May 6, 2004 the
provision of services described in Sec. 210.2-01(c)(4) will not impair
an accountant's independence provided those services are pursuant to
contracts in existence on May 6, 2003.\48\
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\48\ Additionally, in the unusual instance where additional time
is needed to exit an existing contract, the staff in the Office of
the Chief Accountant or the Public Company Accounting Oversight
Board may be consulted on a case by case basis.
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1. Bookkeeping or Other Services Related Accounting Records or
Financial Statements of the Audit Client
Previously, an auditor's independence was impaired if the auditor
provided bookkeeping services to an audit client, except in limited
situations, such as in an emergency or where the services are provided
in a foreign jurisdiction and certain conditions were met. The current
Rule 2-01(c)(4)(i) continues the prohibition on bookkeeping, but we
have eliminated the limited situations where bookkeeping services could
have been provided under the previous rules.
Some commenters \49\ suggested that bookkeeping services should be
permitted, especially under the previous exceptions. However, our
independence
[[Page 6011]]
rules are predicated on the three basic principles enumerated earlier.
One of those principles is that an auditor cannot audit his or her own
work and maintain his or her independence. When an accounting firm
provides bookkeeping services for an audit client, the firm may be put
in the position of later auditing the accounting firm's own work. If,
during an audit, an accountant must audit the bookkeeping work
performed by his or her accounting firm, it is questionable that the
accountant could, or that a reasonable investor would believe that the
accountant could, remain objective and impartial. If the accountant
found an error in the bookkeeping, the accountant could well be under
pressure not to raise the issue with the client if raising the issue
could jeopardize the firm's contract with the client for bookkeeping
services or result in heightened litigation risk for the firm. In
addition, keeping the books is a management function, which also is
prohibited.\50\
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\49\ See, e.g., letter from American Institute of Certified
Public Accountants, dated January 9, 2003; letter from Radin, Gloss
& Co., dated December 31, 2002; letter from Grant Thornton LLP,
dated January 13, 2003; letter from International Federation of
Accountants, dated January 10, 2003.
\50\ Letter of Samuel L. Burke, Associate Chief Accountant, SEC,
to Florida Institute of Certified Public Accountants re: bookkeeping
(March 4, 2002).
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Accordingly, we are adopting rules stating that all bookkeeping
services would cause the auditor to lack independence unless it is
reasonable to conclude that the results will not be subject to audit
procedures. We proposed to prohibit bookkeeping services unless it was
``reasonably likely that such services would not be subject to audit
procedures.'' Our final rules make clear the presumption to emphasize
the responsibility the accounting firm has in making a determination
that the bookkeeping services will not be subject to audit procedures.
The rules utilize the previous definition of bookkeeping or other
services, which focuses on the provision of services involving: (1)
Maintaining or preparing the audit client's accounting records, (2)
preparing financial statements that are filed with the Commission or
the information that forms the basis of financial statements filed with
the Commission, or (3) preparing or originating source data underlying
the audit client's financial statements. Our experience with this
definition demonstrates that the concept of bookkeeping and other
services is well understood in practice.
We understand that accountants sometimes are asked to prepare
statutory financial statements for foreign companies, and these are not
filed with us. Consistent with the Commission's previous rules, an
accountant's independence would be impaired where the accountant
prepared the statutory financial statements if those statements form
the basis of the financial statements that are filed with us. Under
these circumstances, an accountant or accounting firm who has prepared
the statutory financial statements of an audit client is put in the
position of auditing its own work when auditing the resultant U.S. GAAP
financial statements.
With respect to the prohibitions on (1) bookkeeping; (2) financial
information systems design and implementation; (3) appraisal,
valuation, fairness opinions, or contribution-in-kind reports; (4)
actuarial; and (5) internal audit outsourcing, the rules state that the
service may not be provided ``unless 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.'' \51\ As
proposed, for bookkeeping, appraisal or valuation, and actuarial
services, the provision was ``where it is reasonably likely that the
results of these services will be subject to audit procedures during an
audit of the audit client's financial statements'' while for the other
two services, there was no such wording. We have added the new wording
to all five services to provide consistency in application.
Additionally, the change from ``reasonably likely * * *'' to ``unless
it is reasonable to conclude'' is intended to narrow the circumstances
in which that condition can be invoked to justify the provision of such
services.\52\
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\51\ An example of a situation where it would be reasonable to
conclude that the results would not be subject to audit procedures
would be where an accounting firm provides a prohibited service to
an affiliate of the client, as defined in Rule 2-01(f)(4), but the
accounting firm is not the auditor of the entity or entities that
controls the accounting firm's audit client or its affiliate.
\52\ As such, there is a rebuttable presumption that the
services are subject to audit procedures.
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2. Financial Information Systems Design and Implementation
Currently, Paragraph (c)(4)(ii) identifies certain information
technology services that, if provided to an audit client, impair the
accountant's independence. The proposed rules identified information
technology services that would impair the auditor's independence. Under
Paragraph (c)(4)(ii)(A) of the proposed rule, an accountant would not
be independent if the accountant directly or indirectly operates or
supervises the operation of the audit client's information system or
manages the audit client's local area network or information system.
Further, Paragraph (c)(4)(ii)(B) of the proposed rule provided that an
accountant is not deemed independent if the accountant designs or
implements a hardware or software system that aggregates source data
underlying the financial statements or generates information that is
significant to the audit client's financial statements taken as a
whole. These services were deemed to impair an accountant's
independence under our previous rules.
Some commenters \53\ suggested that the Commission's rules should
include a dollar threshold limit or other qualifying language. Others
\54\ suggested that the Commission should clarify that the prohibition
on designing and implementing systems would include selecting and
testing a client's financial information system. Commenters \55\ also
believe that the Commission should clarify that recommendations for
improvements in the systems should be permitted.
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\53\ See, e.g., letter from Radin, Glass & Co., dated December
31, 2002; letter from Institute of Chartered Accountants in England
& Wales, dated December 24, 2002; letter from Deloitte & Touche LLP,
dated January 10, 2003.
\54\ See, e.g., letter from HarborView Partners LLC, dated
December 4, 2002; letter from California Public Employees'
Retirement System, dated January 10, 2003; letter from Center for
Investor Trust, dated January 13, 2003.
\55\ See, e.g., letter from Sullivan & Cromwell LLP, dated
January 10, 2003.
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The Commission is adopting rules, consistent with our previous
rules, that prohibited the accounting firm from providing any service
related to the audit client's information system, unless 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. These rules do not preclude an accounting firm
from working on hardware or software systems that are unrelated to the
audit client's financial statements or accounting records as long as
those services are pre-approved by the audit committee.
As noted above, the rule prohibits the accountant from designing or
implementing a hardware or software system that aggregates source data
or generates information that is ``significant'' to the financial
statements taken as a whole. In this context, information would be
``significant'' if it is reasonably likely to be material to the
financial statements of the audit client. Since materiality
determinations may not be complete before financial statements are
generated, the audit client and accounting firm by necessity will need
to evaluate the general nature of the information as well as system
output during the period of the audit engagement. An accountant, for
[[Page 6012]]
example, would not be independent of an audit client for which it
designed an integrated Enterprise Resource Planning (``ERP'') or
similar system since the system would serve as the basis for the audit
client's financial reporting system.
Designing, implementing, or operating systems affecting the
financial statements may place the accountant in a management role, or
result in the accountant auditing his or her own work or attesting to
the effectiveness of internal control systems designed or implemented
by that accountant.\56\ For example, if an auditor designs or installs
a computer system that generates the financial records, and that system
generates incorrect data, the accountant is placed in a position of
having to report on his or her firms' own work. Investors may perceive
that the accountant would be unwilling to challenge the integrity and
efficacy of the client's financial or accounting information collection
systems that the accountant designed or installed.
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\56\ See, Section 404(b) of the Sarbanes-Oxley Act.
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However, this prohibition does not preclude the accountant from
evaluating the internal controls of a system as it is being designed,
implemented or operated either as part of an audit or attest service
and making recommendations to management. Likewise, the accountant
would not be precluded from making recommendations on internal control
matters to management or other service providers in conjunction with
the design and installation of a system by another service provider.
3. Appraisal or Valuation Services, Fairness Opinions, or Contribution-
in-Kind Reports
The Commission's previous independence rules stated that an
accountant is deemed to lack independence when providing appraisal or
valuation services, fairness opinions, or contribution-in-kind reports
for audit clients. However, the previous rules contained certain
exemptions that we proposed to eliminate.\57\ The proposals provided
that the auditor is not independent if the auditor provides appraisal
or valuation services, or contribution-in-kind reports,\58\ where it is
reasonably likely that the results of the service will not be subject
to audit procedures by the auditor because the auditor is in a position
of auditing his or her own work. Additionally, an accountant was not
independent under the proposal if he or she provided a fairness opinion
because to do so requires the accountant to function as a part of
management and may require the accountant to audit the results of his
or her own work.
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\57\ Exemptions proposed to be eliminated included: (1) Firm's
valuation expert can review the work of a client's specialist; (2)
firm's actuaries can value a client's pension or other post-
retirement benefit obligation provided that the client assumes
responsibility for significant assumptions; (3) valuations performed
for planning and implementing tax-planning strategies; and (4)
valuations for non-financial purposes which do not affect the
financial statements.
\58\ Laws or regulations in certain foreign countries require
the auditor in connection with designated transactions of its audit
clients, to provide contribution-in-kind reports that express an
opinion on the fairness of the transaction, the value of a security,
or the adequacy of consideration to shareholders.
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Appraisal and valuation services include any process of valuing
assets, both tangible and intangible, or liabilities. They include
valuing, among other things, in-process research and development,
financial instruments, assets and liabilities acquired in a merger, and
real estate. Fairness opinions and contribution-in-kind reports are
opinions and reports in which the firm provides its opinion on the
adequacy of consideration in a transaction.
Some commenters \59\ believe that our proposed prohibitions were
appropriate and others would be even more restrictive.\60\ Other
commenters,\61\ however, believe that certain valuation services should
be permissible.
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\59\ See, e.g., letter from Piercy, Bowler, Taylor & Kern, dated
January 7, 2003; letter from Robert G. Beard, undated; letter from
BDO Seidman LLP, dated January 13, 2003.
\60\ See, e.g., letter from Stikeman Elliot, dated January 13,
2003; letter from California Public Employees' Retirement System,
dated January 10, 2003.
\61\ See, e.g., letter from American Institute of Certified
Public Accountants, dated January 9, 2003; letter from HSBC, dated
January 1, 2003; letter from PricewaterhouseCoopers, dated January
8, 2003.
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We continue to believe that providing these services to audit
clients raises several independence concerns. When it is time to audit
the financial statements, it is likely that the accountant would review
his or her own work, including key assumptions or variables that
underlie an entry in the financial statements. Also, if the appraisal
methodology involves a projection of future results of operations and
cash flows, some \62\ believe that the accountant that prepares the
projection may be unable to evaluate skeptically and without bias the
accuracy of that valuation or appraisal. Accordingly, the rules we are
adopting prohibit the accountant from providing any appraisal service,
valuation service or any service involving a fairness opinion or
contribution-in-kind report for an audit client, unless 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.
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\62\ See, e.g., letter from Aurora Group, dated January 13,
2003; letter from Cowhey, Girard Consulting, dated December 30,
2002.
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Our rules do not prohibit an accounting firm from providing such
services for non-financial reporting (e.g., transfer pricing studies,
cost segregation studies, and other tax-only valuations) purposes.
Also, the rule does not prohibit an accounting firm from utilizing its
own valuation specialist to review the work performed by the audit
client itself or an independent, third-party specialist employed by the
audit client, provided the audit client or the client's specialist (and
not the specialist used by the accounting firm) provides the technical
expertise that the client uses in determining the required amounts
recorded in the client financial statements. In those instances the
accountant will not be auditing his or her own work because a third
party or the audit client is the source of the financial information
subject to the audit. Additionally, the quality of the audit may be
improved where specialists are utilized in such situations.
Some commenters \63\ believe that a strict application of these
rules related to contribution-in-kind reports may create conflicts in
certain foreign jurisdictions. We are sensitive to these issues and, as
we have done in the past,\64\ we will continue to work with other
regulatory agencies.
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\63\ See, e.g., letter from Japanese Institute of Certified
Public Accountants, dated January 13, 2003; letter from The Hundred
Group of Finance Directors, dated January 13, 2003; letter from
European Commission, dated January 13, 2003.
\64\ Letter of Lynn Turner, Chief Accountant, SEC, to
Commissione Nazionale per le Societa e la Borsa re: auditor
independence (August 24, 2000). In that letter, the Chief Accountant
did not deem the auditor's independence to be impaired where there
were certain agreed-upon procedures for the contribution-in-kind
report and the accountant represented in the report that the report
did not express an opinion on the fairness of the transaction, the
value of the security, or the adequacy of consideration to
shareholders. This letter is available on our website.
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4. Actuarial Services
The previous rules generally bar auditors only from providing
actuarial services related to insurance company policy reserves and
related accounts. Our proposal provided that the accountant is not
independent if the auditor provides any actuarial service involving the
amounts recorded in the financial statements and related accounts for
the audit client where it is reasonably likely that the results of
[[Page 6013]]
these services will be subject to audit procedures during an audit of
the audit client's financial statements because providing these
services may cause an accountant later to audit his or her own work.
Additionally, accountants providing these services assume a key
management task. In addition, actuarially-oriented advisory services
may affect amounts reflected in some company's financial statements.
Some commenters \65\ agreed with our proposed prohibition of
actuarial services. Others,\66\ however, believe that some types of
actuarial services should be permitted.
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\65\ See, e.g., letter from California Public Employees'
Retirement System, dated January 10, 2003; letter from Aon
Consulting, dated January 13, 2003.
\66\ See, e.g., letter from PricewaterhouseCoopers, dated
January 8, 2003; letter from Deloitte & Touche LLP, dated January
10, 2003; letter from General Electric Company, dated January 9,
2003.
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Consistent with our proposal, we continue to believe that when the
accountant provides actuarial services for the client, he or she is
placed in a position of auditing his or her own work. Accordingly, the
rules we are adopting prohibit an accountant from providing to an audit
client any actuarially-oriented advisory service involving the
determination of amounts recorded in the financial statements and
related accounts for the audit client other than assisting a client in
understanding the methods, models, assumptions, and inputs used in
computing an amount, unless 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.
As can be seen, however, we believe that it is appropriate to
advise the client on the appropriate actuarial methods and assumptions
that will be used in the actuarial valuations. It is not appropriate
for the accountant to provide the actuarial valuations for the audit
client.
The rules also provide that the accountant may utilize his or her
own actuaries to assist in conducting the audit provided the audit
client uses its own actuaries or third-party actuaries to provide
management with its actuarial capabilities.
5. Internal Audit Outsourcing
Our previous rules on internal audit outsourcing allowed a company
to outsource part of its internal audit function to the independent
audit firm subject to certain exemptions. For example, smaller
businesses were exempt from the internal audit outsourcing prohibition
because there had been concerns about the potentially disproportionate
impact on such companies.
Some companies ``outsource'' internal audit functions by
contracting with an outside source to perform, among other things, all
or part of their audits of internal controls. As emphasized by the
Committee of Sponsoring Organizations (``COSO''), internal auditors
play an important role in evaluating and monitoring a company's
internal control system.\67\ As a result, some argue that internal
auditors are, in effect, part of a company's system of internal
accounting control.\68\
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\67\ See, Committee of Sponsoring Organizations of the Treadway
Commission (COSO), Internal Control--Integrated Framework, at 7
(1992) (the ``COSO Report'').
\68\ See, SAS No. 65, ``The Auditor's Consideration of the
Internal Audit Function in an Audit of Financial Statements,'' AU
Sec. 322.
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Since the external auditor typically will rely, at least to some
extent, on the existence of an internal audit function and consider its
impact on the internal control system when conducting the audit of the
financial statements,\69\ the accountant may be placed in the position
of auditing his or her firm as part of the internal control system. In
other words, if the internal audit function is outsourced to an
accountant, the accountant assumes a management responsibility and
becomes part of the company's control system. Our proposed rule
provided that an accountant is not independent when the accountant
performs internal audit services related to the internal accounting
controls, financial systems, or financial statements, for an audit
client.
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\69\ SAS No. 55, ``Consideration of Internal Control in a
Financial Audit,'' AU Sec. 319.
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Some commenters \70\ agreed with the proposed rule. While some
commenters \71\ believed that our rule should contain exemptions for
smaller companies, others \72\ did not. Some commenters \73\ believed
that the final rule should include a ``reasonably likely to be subject
to audit procedures'' provision similar to other prohibited services
(e.g., bookkeeping). Still other commenters \74\ suggested that the
Commission should clarify that services provided in conjunction with an
audit or attest service are permissible.
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\70\ See, e.g., letter from Perry Adkins, dated December 24,
2002; letter from The Center for Investor Trust, dated January 13,
2003.
\71\ See, e.g., letter from James L. Crites, dated December 28,
2002; letter from Cranmore, FitzGerald & Meaney, dated December 27,
2002; letter from America's Community Bankers, dated January 13,
2003; letter from Dixon Odom LLC, dated December 20, 2002.
\72\ See, e.g., letter from California Public Employees'
Retirement System, dated January 10, 2003; letter from Institute of
Internal Auditors, dated January 13, 2003.
\73\ See, e.g., letter from Deloitte & Touche, dated January 10,
2003; letter from Ernst & Young LLP, dated January 6, 2003.
\74\ See, e.g., letter from Hansen, Barnett & Maxwell, dated
January 13, 2003; letter from Deloitte & Touche LLP, dated January
10, 2003; letter from PricewaterhouseCoopers, dated January 8, 2003;
letter from American Institute of Certified Public Accountants,
dated January 9, 2003.
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The rules we are adopting prohibit the accountant from providing to
the audit client internal audit outsourcing services. This prohibition
would include any internal audit service that has been outsourced by
the audit client that relates to the audit client's internal accounting
controls, financial systems, or financial statements unless 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.
During the conduct of the audit in accordance with generally
accepted auditing standards (``GAAS'') or when providing attest
services related to internal controls, the auditor evaluates the
company's internal controls and, as a result, may make recommendations
for improvements to the controls. Doing so is a part of the
accountant's responsibilities under GAAS or applicable attestation
standards and, therefore, does not constitute an internal audit
outsourcing engagement.
Along those lines, this prohibition on ``outsourcing'' does not
preclude engaging the accountant to perform nonrecurring evaluations of
discrete items or other programs that are not in substance the
outsourcing of the internal audit function. For example, the company
may engage the accountant, subject to the audit committee pre-approval
requirements, to conduct ``agreed-upon procedures'' engagements \75\
related to the company's internal controls, since management takes
responsibility for the scope and assertions in those engagements. The
prohibition also does not preclude the accountant from performing
operational internal audits unrelated to the internal accounting
controls, financial systems, or financial statements.
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\75\ See, AT Sec. 201, ``Agreed-Upon Procedures.''
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6. Management Functions
In our proposal, we did not propose any significant change to our
previous rule on management functions. Some commenters \76\ suggested
that we clarify
[[Page 6014]]
that evaluations of and recommendations for improvements in a company's
systems or controls does not constitute a management function.
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\76\ See, e.g., letter from American Institute of Certified
Public Accountants, dated January 9, 2003; letter from Grant
Thornton, LLP dated January 13, 2003; letter from Sullivan &
Cromwell LLP, dated January 10, 2003; letter from Computer Sciences
Corporation, dated January 13, 2003.
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Consistent with our proposal, the final rules prohibit the
accountant from acting, temporarily or permanently, as a director,
officer, or employee of an audit client, or performing any decision-
making, supervisory, or ongoing monitoring function for the audit
client.
We believe, however, that services in connection with the
assessment of internal accounting and risk management controls, as well
as providing recommendations for improvements, do not impair an
accountant's independence. Accountants must gain an understanding of
their audit clients' systems of internal controls when conducting an
audit in accordance with GAAS.\77\ With this insight, accountants often
become involved in diagnosing, assessing, and recommending to audit
committees and management ways in which their audit client's internal
controls can be improved or strengthened.\78\ The resulting
improvements in the audit client's controls not only result in improved
financial reporting to investors but also can facilitate the
performance of high quality audits. For these reasons, we are
continuing to allow accountants to assess the effectiveness of an audit
client's internal controls and to recommend improvements in the design
and implementation of internal controls and risk management controls.
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\77\ AU Sec. 319, ``Consideration of Internal Control in a
Financial Statement Audit.'' In addition, Section 404(b) of the Act
requires a company's audit to attest to the internal control report
provided annually by management.
\78\ AU Sec. 325, ``Communication of Internal Control Related
Matters Noted in an Audit,'' requires the auditor to communicate
reportable conditions and material weaknesses in internal control to
the company's audit committee or equivalent.
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As discussed in the previous section on financial information
systems design and implementation, when an accountant designs and
implements its audit client's internal accounting and risk management
control systems, some believe that the accountant will lack objectivity
if called upon to audit financial statements that are derived, at least
in part, from data from those systems or to report on those controls or
on management's assessment of those controls. As such, we believe that
designing and implementing internal accounting and risk management
controls is fundamentally different from obtaining an understanding of
the controls and testing the operation of the controls which is an
integral part of any audit of the financial statements of a company.
Likewise, design and implementation of these controls involves
decision-making and, therefore, is different from recommending
improvements in the internal accounting and risk management controls of
an audit client (which is permissible, if pre-approved by the audit
committee).
For example, management could engage a third-party service provider
to design and implement an inventory control system. In the course of
that engagement, the third-party service provider might ask the
accountant to make recommendations on internal control and accounting
system components that have been included in the system being designed.
Providing such recommendations to the third-party service provider
would not place the independent accountant in the role of management.
Because of this fundamental difference, we believe that designing
and implementing internal accounting and risk management controls
impairs the accountant's independence because it places the accountant
in the role of management. Conversely, obtaining an understanding of,
assessing effectiveness of, and recommending improvements to the
internal accounting and risk management controls is fundamental to the
audit process and does not impair the accountant's independence.
Furthermore, the accountant may be engaged by the company, subject to
the audit committee pre-approval requirements, to conduct an agreed-
upon procedures engagement \79\ related to the company's internal
controls or to provide attest services related to the company's
internal controls without impairing his or her independence.
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\79\ See, AT Sec. 201, ``Agreed-Upon Procedures.''
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7. Human Resources
Our previous rules deem an accountant to lack independence when
performing certain human resources functions, and we did not propose
any significant change to those rules. Many commenters \80\ agreed that
the accountant should be prohibited from providing certain human
resources functions for audit clients.
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\80\ See, e.g., letter from California Public Employees'
Retirement System, dated January 10, 2003; letter from Aon
Consulting, dated January 13, 2003.
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Consistent with our proposal, these rules provide that an
accountant's independence is impaired with respect to an audit client
when the accountant searches for or seeks out prospective candidates
for managerial, executive or director positions; acts as negotiator on
the audit client's behalf, such as determining position, status,
compensation, fringe benefits, or other conditions of employment; or
undertakes reference checks of prospective candidates. Under the rule,
an accountant's independence also is impaired when the accountant
engages in psychological testing, or other formal testing or evaluation
programs, or recommends or advises the audit client to hire a specific
candidate for a specific job.
Assisting management in human resource selection or development
places the accountant in the position of having an interest in the
success of the employees that the accountant has selected, tested, or
evaluated. Accordingly, observers may perceive that an accountant would
be reluctant to suggest the possibility that those employees failed to
perform their jobs appropriately, or at least reasonable investors
might perceive the accountant to be reluctant, because doing so would
require the accountant to acknowledge shortcomings in its human
resource service. The accountant also might have other incentives not
to report such employees' ineffectiveness, including that the
accountant would identify and be identified with the recruited
employees.
8. Broker-Dealer, Investment Adviser or Investment Banking Services
Our previous rules deem an accountant to lack independence when
performing brokerage or investment advising services for an audit
client.\81\ We are adopting rules that add serving as an unregistered
broker-dealer \82\ to
[[Page 6015]]
our rules that prohibit serving as a promoter or underwriter, making
investment decisions on behalf of the audit client or otherwise having
discretionary authority over an audit client's investments, or
executing a transaction to buy or sell an audit client's investment, or
having custody of assets of the audit client. The rule is substantially
the same as the Commission's previous rule related to the provision of
these types of services to audit clients. We are including unregistered
broker-dealers within the rules because the nature of the threat to
independence is unchanged whether the entity is or is not a registered
broker-dealer.
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\81\ These rules are not meant to change the Commission's
previous position that an audit firm's broker-dealer division can
cover an industry (including industry surveys and analyses) which
includes an audit client when performing analyst functions. However,
analysis of a specific audit client's stock places the auditor in
the position of acting as an advocate for the client and would cause
the auditor to lack independence.
\82\ Accountants and the companies that retain them should
recognize that the key determination required here is a functional
one (i.e., Is the accounting firm or its employee acting as a
broker-dealer?). The failure to register as a broker-dealer does not
necessarily mean that the accounting firm is not a broker-dealer. In
relevant part, the statutory definition of ``broker'' captures
persons ``engaged in the business of effecting transactions in
securities for the account of others.'' Securities Exchange Act of
1934 3(a)(4). Unregistered persons who provide services related to
mergers and acquisitions or other securities-related transactions
should limit their activities so they remain outside of that
statutory definition. A person may ``effect transactions,'' among
other ways, by assisting an issuer to structure prospective
securities transactions, by helping an issuer to identify potential
purchasers of securities, or by soliciting securities transactions.
A person may be ``engaged in the business,'' among other ways, by
receiving transaction-related compensation or by holding itself out
as a broker-dealer. Involvement of accounting personnel as
unregistered broker-dealers not only can impair auditor
independence, but also would violate Section 15(a) of the Exchange
Act.
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Selling--directly or indirectly--an audit client's securities is
incompatible with the accountant's responsibility of assuring the
public that the company's financial condition is fairly presented. When
an accountant, in any capacity, recommends to anyone (including non-
audit clients) that they buy or sell the securities of an audit client
or an affiliate of the audit client, the accountant has an interest in
whether those recommendations were correct. That interest could affect
the audit of the client whose securities, or whose affiliate's
securities, were recommended. These concepts are echoed in the ``simple
principles'' included in the legislative history to the Sarbanes-Oxley
Act.\83\ In such a situation, if an accountant uncovers an accounting
error in a client's financial statements, and the accountant, in an
investment adviser capacity, had recommended that client's securities
to investment clients, the accountant performing the audit may be
reluctant to recommend changes to the client's financial statements if
the changes could negatively affect the value of the securities
recommended by the accountant to its investment adviser clients.
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\83\ Floor Statement of Senator Sarbanes, 148 Cong. Rec. S7364
(July 25, 2002) ``* * * A public company auditor should not be a
promoter of the company's stock or other financial interest (as it
would be if it served as broker-dealer, investment adviser, or
investment banker for the company).'' To do so places the auditor in
a position of serving as an advocate for his or her audit client.
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Broker-dealers \84\ often give advice and recommendations on
investments and investment strategies. The value of that advice is
measured principally by the performance of a customer's securities
portfolio. When the customer is an audit client, the accountant has an
interest in the value of the audit client's securities portfolio, even
as the accountant must determine whether management has properly valued
the portfolio as part of an audit. Thus, the accountant would be placed
in a position of auditing his or her own work. Furthermore, the
accountant is placed in a position of acting as an advocate on behalf
of the client.
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\84\ In the past, some have expressed concern that terms such as
``securities professional'' and ``analyst'' are not defined in the
securities laws and use of the terms could cause confusion. Because
of that concern, we have not used those terms in these rules. We
note, however, that broker-dealers provide an array of services that
may include certain analyst activities.
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9. Legal Services
Our previous rule stated that an accountant is deemed to lack
independence when he or she provides legal services to an audit client.
The proposed rule provided that an accountant was not independent of an
audit client if the accountant provides any service to the audit client
that, under circumstances in which the service is provided, could be
provided only by someone licensed, admitted or otherwise qualified to
practice law in the jurisdiction in which the service is provided.
We believe that a lawyer's core professional obligation is to
advance clients' interests. Rules of professional conduct in the U.S.
require the lawyer to ``represent a client zealously and diligently
within the bounds of the law.'' \85\ The lawyer must ``take whatever
lawful and ethical measures are required to vindicate a client's cause
or endeavor * * * In the exercise of professional judgment, a lawyer
should always act in a manner consistent with the best interests of the
client.'' \86\ We have long maintained that an individual cannot be
both a zealous legal advocate for management or the client company, and
maintain the objectivity and impartiality that are necessary for an
audit.\87\ The Supreme Court has agreed with our view. In United States
v. Arthur Young, the Supreme Court emphasized, ``If investors were to
view the accountant as an advocate for the corporate client, the value
of the audit function itself might well be lost.'' \88\
Some commenters \89\ believed that the prohibition on legal
services should apply to all registrants, regardless of their
jurisdiction. Others believed that certain accommodations should be
made for foreign jurisdictions \90\ or for routine or ministerial
duties.\91\
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\85\ See, e.g., D.C. Rules of Professional Conduct, Rule 1.3(a).
\86\ Id. at Rule 1.5.
\87\ In the Matter of Charles Falk, AAER No. 1134 (May 19, 1999)
(formally disciplining an attorney/accountant who gave legal advice
to an audit client of another partner in his accounting firm).
\88\ United States v. Arthur Young, 465 U.S. 805 (1984) at 819-
20 n.15.
\89\ See, e.g., letter of Lynn E. Turner, dated January 13,
2003; letter from California Public Employees' Retirement System,
dated January 10, 2003.
\90\ See, e.g., letter from HSBC, dated January 10, 2003; letter
from Institute of Chartered Accountants in England and Wales, dated
December 24, 2002; letter from Institut der Wirtschaftsprufer, dated
December 27, 2002; letter from Federation des Experts Comptables
Europeens, dated January 13, 2003.
\91\ See, e.g., letter from KPMG, dated January 9, 2003.
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The rules we are adopting are consistent with our proposal.
Accordingly, an accountant is prohibited from providing to an audit
client any service that, under circumstances in which the service is
provided, could be provided only by someone licensed, admitted, or
otherwise qualified to practice law in the jurisdiction in which the
service is provided.
We recognize that there may be implications for some foreign
registrants from this rule. For example, we understand that in some
jurisdictions it is mandatory that someone licensed to practice law
perform tax work, and that an accounting firm providing such services,
therefore, would be deemed to be providing legal services. As a general
matter, our rules are not intended to prohibit foreign accounting firms
from providing services that an accounting firm in the United States
may provide. In determining whether or not a service would impair the
accountant's independence solely because the service is labeled a legal
service in a foreign jurisdiction, the Commission will consider whether
the provision of the service would be prohibited in the United States
as well as in the foreign jurisdiction.
Evaluating and determining whether services are permissible may
require a comprehensive analysis of the facts and circumstances. We
are, however, sensitive to these issues and, as we have done in the
past,\92\ we encourage accounting firms and foreign regulators to
consult with the staff to address these issues.
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\92\ Letter of Lynn Turner, Chief Accountant, SEC, to
Commissione Nazionale per le Sonieta e la Borsa re: statutory
procedures (August 24, 2000).
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10. Expert Services
The Sarbanes-Oxley Act includes expert services in the list of non-
audit services an accountant is prohibited from performing for an audit
client. As
[[Page 6016]]
discussed earlier, the legislative history related to expert services
is focused on the accountant's role when serving in an advocacy
capacity.
Some commenters \93\ believed that the prohibition on expert
services should be limited to instances of public advocacy or public
adversarial proceedings and should not extend to situations where the
accountant is advising a client or its counsel on technical matters
apart from a public proceeding. Other commenters \94\ believed a
distinction exists between serving as an expert witness and serving as
a fact witness in a proceeding. Additionally, many commenters \95\
simply raised concerns over the lack of clarity of the term ``expert''
indicating that, as proposed, the meaning of the term is unclear.
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\93\ See, e.g., letter from Sullivan & Cromwell LLP, letter from
Deloitte & Touche LLP, dated January 10, 2003; letter from American
Institute of Certified Public Accountants, dated January 9, 2003;
letter from Federation des Experts Comptables Europeens, dated
January 13, 2003.
\94\ See, e.g., letter from Sullivan & Cromwell LLP, dated
January 10, 2003; letter from California Public Employees'
Retirement System, dated January 10, 2003; letter from Grant
Thornton LLP, dated January 13, 2003; letter from American Academy
of Actuaries, dated January 6, 2003.
\95\ See, e.g., letter from Eli Lily and Co., dated January 9,
2003; letter from Federation des Experts Comptables Europeens, dated
January 13, 2003; letter from PG&E Corporation, dated January 10,
2003; letter from America's Community Bankers, dated January 13,
2003.
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Clients retain experts to lend authority to their contentions in
various proceedings by virtue of the expert's specialized knowledge and
experience. In situations involving advocacy, the provision of expert
services by the accountant makes the accountant part of the ``team''
that has been assembled to advance or defend the client's
interests.\96\ The appearance of advocacy created by providing such
expert services is sufficient to deem the accountant's independence
impaired. The prohibition on providing ``expert'' services included in
this rule covers engagements that are intended to result in the
accounting firm's specialized knowledge, experience and expertise being
used to support the audit client's positions in various adversarial
proceedings.\97\
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\96\ The accountant becomes an advocate under such circumstances
even if the accountant is working behind the scenes to advance the
client's interests.
\97\ As we discussed in our proposing release, virtually all
services provided by an accountant may be perceived to be expert
services. This prohibition, however, only applies to those services
that involve advocacy in proceedings and investigations (as
discussed in this section of the release) and does not apply to
other permitted non-audit services, such as tax services.
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The rules we are adopting prohibit an accountant from providing
expert opinions or other services to an audit client, or a legal
representative of an audit client, for the purpose of advocating that
audit client's interests in litigation or regulatory, or administrative
investigations or proceedings. For example, under this rule an
auditor's independence would be impaired if the auditor were engaged to
provide forensic accounting services to the audit client's legal
representative in connection with the defense of an investigation by
the Commission's Division of Enforcement. Additionally, an accountant's
independence would be impaired if the audit client's legal counsel, in
order to acquire the requisite expertise, engaged the accountant to
provide such services in connection with a litigation, proceeding or
investigation.\98\
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\98\ For purposes of this release, an investigation is an
inquiry by a regulatory body, including by its staff.
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Our rules do not, however, preclude an audit committee or, at its
direction, its legal counsel, from engaging the accountant to perform
internal investigations or fact finding engagements. These types of
engagements may include, among others, forensic or other fact-finding
work that results in the issuance of a report to the audit client. The
involvement by the accountant in this capacity generally requires
performing procedures that are consistent with, but more detailed or
more comprehensive than, those required by GAAS. Performing such
procedures is consistent with the role of the independent auditor and
should improve audit quality. If, subsequent to the completion of such
an engagement,\99\ a proceeding or investigation is initiated, the
accountant may allow its work product to be utilized by the audit
client and its legal counsel without impairing the accountant's
independence. The accountant, however, may not then provide additional
services, but may provide factual accounts or testimony about the work
performed.
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\99\ See, infra, discussion stating that if litigation arises or
an investigation commences during the auditor's performance of such
procedures, completion of the procedures is not prohibited provided
the auditor remains in control of his or her work and that work does
not become subject to the direction or influence of legal counsel
for the issuer.
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Accordingly, our rules would not prohibit an accountant from
assisting the audit committee \100\ in fulfilling its responsibilities
to conduct its own investigation of a potential accounting
impropriety.\101\ For example, if the audit committee is concerned
about the accuracy of the inventory accounts at a subsidiary, it may
engage the auditor to conduct a thorough inspection and analysis of
those accounts, the physical inventory at the subsidiary, and related
matters without impairing the auditor's independence.
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\100\ For example, Section 301 of the Act stipulates that each
audit committee shall have the authority to engage independent
counsel and other advisers, as it determines necessary to carry out
its duties.
\101\ An auditor's independence would, however, be impaired if
its assistance to the audit committee included defending, or helping
to defend, the audit committee or the company generally in a
shareholder class action or derivative lawsuit, other than as a fact
witness.
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We recognize that auditors have obligations under Section 10A of
the Exchange Act and GAAS \102\ to search for fraud that is material to
an issuer's financial statements and to make sure the audit committee
and others are informed of their findings. Auditors should conduct
these procedures whether they become aware of a potential illegal act
as a result of audit, review or attestation procedures they have
performed or as a result of the audit committee expressing concerns
about a part of the company's operations or compliance with the
company's financial reporting system. In these situations, we believe
that the auditor may conduct the procedures, with the approval of the
audit committee, and provide the reports that the auditor deems
appropriate. Should litigation arise or an investigation commence
during the time period that the auditors are conducting such
procedures, we would not deem the completion of these procedures to be
prohibited expert services so long as the auditor remains in control of
his or her work and that work does not become subject to the direction
or influence of legal counsel for the issuer.
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\102\ See, SAS No. 99, ``Consideration of Fraud in a Financial
Statement Audit,'' AU Sec. 316.
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Furthermore, under this rule, an accountant's independence will not
be deemed to be impaired if, in an investigation or proceeding, an
accountant provides factual accounts or testimony describing work it
performed. Further, an accountant's independence will not be deemed to
be impaired if an accountant explains the positions taken or
conclusions reached during the performance of any service provided by
the accountant for the audit client.
11. Tax Services
Since the Commission issued its auditor independence proposal,
there has been considerable debate regarding whether an accountant's
provision of tax services for an audit client can impair the
accountant's independence.
[[Page 6017]]
Tax services are unique among non-audit services for a variety of
reasons. Detailed tax laws must be consistently applied, and the
Internal Revenue Service has discretion to audit any tax return.
Additionally, accounting firms have historically provided a broad range
of tax services to their audit clients.\103\
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\103\ The provision of tax services by accountants to their
audit clients existed and continued without change when Congress
formulated the securities laws in the 1930s. The Sarbanes-Oxley Act
also recognized that accountants may engage in certain non-audit
services ``including tax services * * * only if the activity is
approved in advance by the audit committee.''
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In the proposing release, we suggested that in determining whether
a given tax service should be allowed, the audit committee should be
mindful of the three basic principles. In response, some commenters
\104\ indicated that asking audit committees to evaluate the provision
of tax services by the accountant in light of the three basic
principles would significantly alter the Commission's historic position
related to tax services. Other commenters raised significant clarity
and certainty issues. Some commenters \105\ that urged clarity would,
for example, prohibit accountants from providing any tax services to
audit clients. Other commenters \106\ believed that accountants should
be permitted to provide only certain types of tax services to their
audit clients.\107\ Some commenters \108\ believed that allowing the
accountant to perform tax services both enhances the quality of the
audit and provides greater independent oversight over the provision of
tax services than would occur if a non-audit firm were engaged to
provide these services. Additionally, one commenter's research suggests
that higher levels of tax services fees are associated with
substantially lower instances of financial restatements.\109\
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\104\ Some commenters (see, e.g., letter from Ernst & Young,
dated January 6, 2003; letter from Deloitte & Touche, dated January
10, 2003; letter from KPMG, dated January 9, 2003; letter from the
Chamber of Commerce of the United States of America, dated January
9, 2003; letter from SafeCo Corporation, dated January 7, 2003;
letter from Pfizer, dated January 13, 2003; letter from The Business
Roundtable, dated January 14, 2003) believe that asking audit
committees to evaluate tax services in light of the three principles
in its pre-approval process creates an unnecessary degree of
uncertainty in the marketplace.
\105\ See, e.g., letter from Norman Marks, dated December 9,
2002; letter from Harbor View Partners, dated December 4, 2002;
letter from Douglas Estes, dated November 30, 2002; letter from
William Fraser, dated November 26, 2002; letter from M.E. Saunders,
dated November 26, 2002.
\106\ See, e.g., letter from Robert T. Bossart, dated January 2,
2003; letter from FedEx Corporation, dated December 31, 2002; letter
from the American Bar Association Section of Taxation, dated January
6, 2003; letter from California Public Employees' Retirement System,
dated January 10, 2003.
\107\ Commenters identified a variety of tax services they
believe should be prohibited. However, there was no ``consensus''
view on what tax services should be prohibited.
\108\ See, e.g., letter from Philip A. Laskawy, dated January 2,
2003; letter from FedEx Corporation, dated December 31, 2002; letter
from The Business Roundtable, dated January 14, 2003.
\109\ See, comment letter of William Kinney, University of
Texas, Zoe-Vonna Palmrose, University of Southern California, and
Susan Scholz, University of Kansas.
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The Commission reiterates its long-standing position that an
accounting firm can provide tax services to its audit clients without
impairing the firm's independence. Accordingly, accountants may
continue to provide tax services such as tax compliance, tax planning,
and tax advice to audit clients, subject to the normal audit committee
pre-approval requirements under 2-01(c)(7). Additionally, the rules we
are adopting require registrants to disclose the amount of fees paid to
the accounting firm for tax services. The rules are consistent with the
Act which states that:
A registered public accounting firm may engage in any non-audit
service, including tax services, that is not described in any of
paragraphs (1) through (9) of subsection (g) for an audit client,
only if the activity is approved in advance by the audit committee
of the issuer.\110\ (Emphasis added)
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\110\ Sarbanes-Oxley Act of 2002, Section 201.
Nonetheless, merely labeling a service as a ``tax service'' will
not necessarily eliminate its potential to impair independence under
Rule 2-01(b).\111\ Audit committees and accountants should understand
that providing certain tax services to an audit client would, as
described below, or could, in certain circumstances, impair the
independence of the accountant. Specifically, accountants would impair
their independence by representing an audit client before a tax court,
district court, or federal court of claims. In addition, audit
committees also should scrutinize carefully the retention of an
accountant in a transaction initially recommended by the accountant,
the sole business purpose of which may be tax avoidance and the tax
treatment of which may be not supported in the Internal Revenue Code
and related regulations.\112\
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\111\ It would not be appropriate to provide a prohibited
service, label it a ``tax service,'' and argue that it is,
therefore, permissible. For example, an accountant seeking to
provide a broker-dealer service and arguing that, because there are
tax implications of certain brokerage activities, the service is
permissible would constitute an attempt to improperly circumvent the
list of prohibited services. See, letter of Ernst & Young dated
January 6, 2003 (p. 16).
\112\ The Commission on Public Trust and Private Enterprise
recently concluded as a ``best practice'' that an accounting firm
should not be providing ``novel and debatable tax strategies and
products that involve income tax shelters and extensive off-shore
partnerships or affiliates'' to audit clients. See The Conference
Board Commission on Public Trust and Private Enterprise, Findings
and Recommendations, January 9, 2003, p. 37.
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C. Partner Rotation
For 25 years, partner rotation has been a component of quality
control processes for a vast majority of the accounting firms that
audit SEC registrants.\113\ The judgment about who should be subject to
rotation and how long the partner(s) should remain on the engagement
prior to rotating involves balancing the need to bring a ``fresh look''
to the audit engagement with the need to maintain continuity and audit
quality.
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\113\ American Institute of Certified Public Accountants
(AICPA), Division for CPA Firms SEC Practice Section Peer Review
Manual, 1978.
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The Sarbanes-Oxley Act requires rotation of certain audit partners
on a five-year basis in order to continue to provide audit services for
a registrant. Section 203 of the Sarbanes-Oxley Act of 2002 specifies
that:
It shall be unlawful for a registered public accounting firm to
provide audit services to an issuer if the lead (or coordinating)
audit partner (having primary responsibility for the audit), or the
audit partner responsible for reviewing the audit, has performed
audit services for that issuer in each of the 5 previous fiscal
years of that issuer.
Section 301 of the Sarbanes-Oxley Act specifies that the Commission
is to direct the national securities exchanges and associations to
adopt company listing standards stating that the company's audit
committee has the responsibility for appointment, compensation, and
oversight of the work of the company's audit firm.\114\ In that
capacity, the audit committee has the responsibility for evaluating and
determining that the audit engagement team has the competence necessary
to conduct the audit engagement in accordance with GAAS. Additionally,
the accountant is required to conduct the audit in accordance with
GAAS.\115\
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\114\ See, Release No. 33-8173 (Jan 8, 2003).
\115\ In addition to the audit, registrants are required to have
their quarterly financial information subjected to a timely review
by the accounting firm. Such review is typically conducted according
to the provisions required by GAAS--see, AU Sec. 722. Furthermore,
Section 404 of the Sarbanes-Oxley Act, as well as the Commission's
proposed rules--see, Release No. 33-8138, Oct. 22, 2002, (67 FR
66208)--would require the accounting firm to attest to management's
report on the registrant's internal controls. Both a timely review
engagement and an attestation engagement require the accounting firm
to be independent with respect to the registrant. Accordingly, the
Commission's rules for partner rotation extend to partners who serve
on the engagement team that conducts the timely review of the
registrant's interim financial information as well as the engagement
team that conducts the attest engagement on management's report on
the registrant's internal controls.
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[[Page 6018]]
In particular, the third general standard requires that the
accountant exercise due professional care in the conduct of the
audit.\116\ In order to exercise due professional care, it is necessary
to ensure that the engagement is properly staffed with individuals
competent to understand the unique issues relevant to that audit.
Additionally, the accounting profession's quality control standards
require that the firm have processes in place to ensure that
appropriate personnel are assigned to each audit engagement.\117\
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\116\ See, AU Sec. 150.02.
\117\ See, QC Sec. 20.13.
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In our proposing release, we proposed that all partners on the
audit engagement team, with the exception of certain ``technical
services'' or ``national office'' partners and those serving on
significant subsidiaries as defined in 1-02(w) of Regulation S-X, be
subject to rotation after five years and that after rotation, they
would be subject to a five year time-out before they could return to
that engagement. Furthermore, the proposed rules would have applied the
partner rotation requirements at the audit client \118\ level.
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\118\ As defined in Rule 2-01(f).
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Some commenters \119\ have suggested that the fresh look can only
be accomplished by requiring mandatory rotation of audit firms. In
contrast, others \120\ expressed the concern that the loss of
continuity and audit competence created by mandatory firm rotation
creates an even greater risk to audit quality. The issue of mandatory
audit firm rotation as an effective means of safeguarding auditor
independence has been debated for many years. Several different groups,
including appointed commissions, professional organizations, and
academics, have researched and analyzed the issue of audit firm
rotation.\121\ The results of those efforts have raised many of the
same concerns as our commenters which the Commission considered in this
rule-making. This issue will continue to be monitored by the Commission
and others. As directed by Section 207 of the Sarbanes-Oxley Act, the
issue of mandatory firm rotation is a matter requiring further
study.\122\
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\119\ See, e.g., letter from Jason Zahner, dated December 23,
2002; letter from Hugh Higgins, dated November 20, 2002.
\120\ See, e.g., letter from American Institute of Certified
Public Accountants, dated January 9, 2003.
\121\ See, The Commission on Auditors' Responsibilities,
``Report, Conclusions, and Recommendations,'' 1978, p. 109; Report
of the National Commission on Fraudulent Financial Reporting, 1987,
p. 54; research commissioned by the Committee of Sponsoring
Organizations of the Treadway Commission, ``Report of the National
Commission on Fraudulent Financial Reporting,'' 1987, p. 113;
Committee of Sponsoring Organizations of the Treadway Commission,
``Fraudulent Financial Reporting: 1987-1997 An Analysis of U.S.
Public Companies,'' 1999, p. 28; United States General Accounting
Office, Report to the Ranking Minority Member, Committee on
Commerce, House of Representatives, ``The Accounting Profession,
Major Issues: Progress and Concerns,'' 1996, p. 56; Arrunada,
Benito, ``Mandatory Rotation of Company Auditors: A Critical
Examination,'' International Review of Law And Economics, March
1997; St. Pierre, K. and J. Anderson, ``An Analysis of Factors
Associated with Lawsuits Against Public Accountants,'' Accounting
Review (1984), p. 256; and Dallocchio, M. and A. Vigano``The Impact
Of Mandatory Audit Rotation On Audit Quality And On Audit Pricing:
The Case Of Italy,'' SDA Universita Bocconi, 2003.
\122\ Section 207 of the Act directs the Comptroller General of
the United States to conduct a study and review of the potential
effects of mandatory rotation of firms.
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1. Rotation of the Lead and Concurring Partner
Under the current requirements of the profession, the balance
between the need for a fresh look with concerns about loss of
continuity and competence is accomplished by requiring the lead partner
to rotate off the audit engagement of SEC registrants after seven years
with a two year time out period.\123\ However, some commenters \124\
believed that extending the partner rotation requirements to other
audit partners would be a better balance of the need for a fresh look
with concerns about continuity and competence.
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\123\ AICPA, SEC Practice Section, Requirements of Members, at
item e. The membership requirements are available online at
www.aicpa.org/members/div/secps/require.htm. Audit firms which are
members of the SEC Practice Section must comply with its rules
(e.g., partner rotation) and undergo periodic peer review to ensure
that the firms' audit practice is consistent with both the rules of
the AICPA and those of the Commission.
\124\ See, e.g., letter from California Public Employees'
Retirement System, dated January 10, 2003; letter from Denzil Dias,
dated December 11, 2002; letter from HSBC, dated January 11, 2003.
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These commenters' views are consistent with the provisions of the
Sarbanes-Oxley Act, which clearly specify that, at a minimum, two
partners be subject to rotation: the lead audit partner and the
concurring partner. Furthermore, the Act specifies a five-year period
prior to rotation rather than the current seven-year period specified
in the membership requirements of the SECPS.\125\ While the Act
specified that these two partners were subject to rotation after five
years, the Act is silent with regard to the time out period. One
approach to the partner rotation rules could have been to preclude the
partner from returning to the audit client after he or she rotates off
to that engagement. Many commenters,\126\ however, believed that the
time out should be shorter than in our proposal. Other commenters \127\
did not object to or even agreed with the five-year time out period for
the lead and concurring partners.
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\125\ While the current lead partner rotation requirements
specify a seven-year period prior to rotation, the original rotation
requirements developed by the SECPS specified a five-year rotation
period. See, AICPA, Division for CPA Firms SEC Practice Section Peer
Review Manual, 1978, p.1-5.
\126\ See, e.g., letter from The Putnam Funds, not dated; letter
from Commercial Federal Bank, dated January 13, 2003; letter from
Dixon Odom, dated December 20, 2002; letter from American Institute
of Certified Public Accountants, dated January 9, 2003.
\127\ See, e.g., letter from Aetna, Inc., dated January 13,
2003; letter from Royal Philips Electronics, dated January 9, 2003;
letter from Lynn Turner, dated January 13, 2003; letter from
Medtronic, Inc., dated January 13, 2003.
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The Commission is adopting rules to require the lead and concurring
partners to rotate after five years and, upon rotation, be subject to a
five-year ``time out'' period. Because of the importance of achieving a
fresh look to the independence of the audit function, we believe that a
five-year time out period is appropriate for these two partners.
2. Additional Partner Rotation
Clearly, the lead partner and the concurring partner perform
critical functions that affect the conduct and effectiveness of the
engagement. However, in many larger engagements, the engagement team
will include more than just the lead partner and the concurring
partner. Often, those other partners on the engagement team play a
significant role in the conduct of the audit and maintaining ongoing
relationships with the audit client.
Our proposal would have applied the same rotation requirements to
all partners on the audit engagement team with the exception of certain
``national office'' technical partners and those who did not work on
significant subsidiaries as defined in Rule 1-02(w) of Regulation S-X.
Some commenters \128\ believed that the rotation requirements should be
at or extend beyond our proposal level to include, for example,
``national office'' or ``technical'' partners \129\ or other audit
engagement team members below the level of
[[Page 6019]]
partner.\130\ Other commenters, \131\ however, believed that extending
the rotation requirements beyond the two partners named in the Act
could potentially harm audit quality and could impose additional costs
on registrants. For example, one commenter \132\ indicated that the
proposed rotation requirements would cause the firm to have to rotate
181 partners in 88 countries for one large multi-national client.
Another commenter \133\ estimated that more than 250 partners in 80
countries would be subject to the rotation requirements under the
proposed rules. Additionally, some commenters stated that the
additional costs that accounting firms would incur to rotate and, in
many cases, relocate audit partners would have to be passed on to
registrants.
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\128\ See, e.g., letter from Denzil Dias, dated December 11,
2002.
\129\ See, e.g., letter from California Public Employees'
Retirement System dated January 10, 2003.
\130\ See, e.g., letter from Lynn E. Turner dated January 13,
2003.
\131\ See, e.g., letter from Aramark Corporation, dated December
26, 2002; letter from Aetna, Inc., dated January 13, 2003; letter
from PricewaterhouseCoopers, dated January 8, 2003; letter from
Mellon Financial Corporation, dated January 10, 2003; letter from
SAP AG, undated; letter from Chamber of Commerce of the United
States of America, dated January 9, 2003; letter from The Business
Roundtable, dated January 14, 2003.
\132\ See, letter from PricewaterhouseCoopers dated January 8,
2003.
\133\ See, letter from HSBC dated January 10, 2003.
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While other commenters \134\ agreed with the concept of extending
the partner rotation requirements beyond the two partners named in the
Act, they suggested that the final rules should not apply as broadly as
the Commission had proposed. One commenter suggested that assessing the
``right cut'' in identifying partners for rotation was a balance
between the responsibility for final decisions on accounting and
financial reporting issues affecting the financial statements and the
level of the relationship with management.\135\
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\134\ See, e.g., letter from Ernst & Young LLP, dated January 6,
2003; letter from Robert G. Beard, undated; letter from Institute of
Chartered Accountants in England and Wales, dated January 10, 2003.
\135\ See, letter from Deloitte & Touche LLP, dated January 10,
2003.
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Commenters \136\ noted that applying the rotation requirements too
deeply could threaten the quality of the audit in certain situations.
For example, in certain countries there may be a limited pool of audit
partners who are familiar with U.S. GAAP and GAAS. In certain
``specialty'' areas, there may be a limited number of ``specialty''
partners available to service the client.\137\ In certain industries
there may be limited industry expertise. Also, by applying the rotation
requirements more deeply, firms might have a difficult time grooming
another partner to both have sufficient knowledge of the industry and
the client and have sufficient time remaining prior to rotation when
the lead partner or concurring partner must rotate. Also, some
commenters \138\ noted that applying the proposed rotation requirements
to specialty partners could impact audit quality.
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\136\ See, e.g., letter from The Business Roundtable, dated
January 14, 2003; PricewaterhouseCoopers, dated January 8, 2003;
letter from KPMG, dated January 9, 2003; letter from Philip A.
Laskawy, dated January 9, 2003; letter from Pfizer, dated January
13, 2003; letter from Aetna, Inc., dated January 13, 2003.
\137\ Specialty partners are, among others, those partners who
consult with others on the audit engagement team during the audit,
review or attestation engagement regarding technical or industry-
specific issues. For example, such partners would include tax
specialist and valuation specialist.
\138\ See, e.g., letter from Ernst & Young LLP, dated January 6,
2003; letter from Deloitte & Touche, dated January 10, 2003.
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We believe that the partner rotation requirements must strike a
balance between the need to achieve a fresh look on the engagement and
a need for the audit engagement team to be composed of competent
accountants. We believe that a proper balance is one that weighs the
responsibility for decisions on accounting and financial reporting
issues impacting the financial statements with the level of the
relationship with senior management of the client. Such a balancing
clearly would include the lead (high on both dimensions) and concurring
partners (high on responsibility for final decisions, somewhat lower on
level of relationship with management). In addition to that, the lead
partner at significant operating units has a high involvement with
senior management and, for significant operations, responsibility for
decisions on accounting matters that affect the financial statements.
Likewise, other audit partners at the parent or issuer have a high
involvement with senior management and some responsibility for
accounting matters to be included in the financial statements.
In contrast, partners at smaller operating units and ``specialty''
partners typically have a low level of involvement with senior
management and the responsibility for the overall presentation in the
financial statements is relatively low.
Nonetheless, the Commission is sensitive to the impact that its
proposed rotation requirements would have on audit competence in
certain instances as well as costs to registrants. Consistent with this
approach, we believe that the proper balance is achieved by extending
the partner rotation requirements beyond the lead and concurring
partner but less deeply than we proposed. In response to the concerns
of commenters that our proposed rules went too deep, thus imposing
significant costs on registrants and accountants as well as creating
potential concerns of audit quality, the rules we are adopting will
subject a smaller number of partners to the rotation requirement.
Accordingly, we are adopting rules that apply the partner rotation
requirements to ``audit partners'' which is a new term defined in these
rules.
In addition to the lead and concurring partners, ``audit partners''
include partners on the audit engagement team who have responsibility
for decision-making on significant auditing, accounting, and reporting
matters that affect the financial statements or who maintain regular
contact with management and the audit committee. In particular, audit
partners would include all those who serve the client at the issuer or
parent level, other than specialty partners. Further, the lead partner
on subsidiaries of the issuer whose assets or revenues constitute 20%
or more of the consolidated assets or revenues are included within the
definition of ``audit partner.''
Thus, the term audit partner does not extend to all partners on the
audit engagement team. For example, partners serving on subsidiaries
which constitute less than 20% of the assets and revenues of the issuer
would not be audit partners as we have defined that term and, thus,
would not be subject to rotation. Likewise, partners on subsidiaries
above the 20% threshold, other than the lead partner on those
subsidiaries, are not subject to rotation.\139\
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\139\ A threshold of 20% often has been used in the accounting
literature as a basis for ``significance'' tests. See, e.g., APB
Opinion No. 18, ``The Equity Method of Accounting for Investments in
Common Stock,'' and ARB No. 43, Chapter 7, ``Capital Accounts.''
---------------------------------------------------------------------------
Audit partners also would exclude ``specialty'' partners because
they typically do not have significant interaction with management on
an ongoing basis regarding significant audit, accounting, and reporting
matters. It is the lead partner (who is subject to rotation) who has
the ultimate responsibility for the audit. We believe that this
addresses the concern that many commenters expressed regarding certain
``specialty'' partners.
We believe that defining the term ``audit partners'' as the basis
for defining those partners who are subject to the rotation
requirements is responsive to the concerns expressed by some commenters
of the problems that would be created by applying the
[[Page 6020]]
rotation requirements deeper in the firm. Accordingly, we believe that
this requirement establishes an appropriate balance between the need
for a fresh look with the difficulties encountered in certain locations
where the pool of available talent is limited.
In many cases, registrants have complex business transactions and
other situations which may require that the engagement team consult
with the accounting firm's national office or others on technical
issues. Consistent with our proposal, partners assigned to ``national
office'' duties (which can include technical accounting and auditing--
whether at a local or national level--as well as centralized quality
control functions) who may be consulted on specific accounting issues
related to a client are not audit partners even though they may
periodically consult on client matters.\140\ While these partners play
an important role in the audit process, they serve, primarily, as a
technical resource for members of the audit team. Because these
partners are not involved in the audit per se and do not routinely
interact or develop relationships with the audit client, we do not
believe that it is necessary to rotate the involvement of these
personnel.
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\140\ 17 CFR 210.2-01(f)(7).
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3. Rotation Period for Partners Other Than the Lead and Concurring
Partners
Some commenters \141\ believed that a different rotation period
should be provided to partners other than the lead and concurring
partners. In particular, if other partners subject to the rotation
requirements had a longer period before they were required to rotate,
firms would be better able to establish appropriate transition plans
from one lead or concurring partner to the next. The longer rotation
period for the other partners would allow them to spend time on the
engagement team to learn about the business and the industry before
having the ultimate responsibility for the engagement.
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\141\ See, e.g., letter from Ernst & Young, dated January 6,
2003; letter from Deloitte & Touche, dated January 10, 2003; letter
from KPMG, dated January 9, 2003; letter from Dixon Odom, dated
December 20, 2002; letter from The Business Roundtable, dated
January 14, 2003.
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In response to these concerns, the rules we are adopting require
partners subject to the rotation requirements, other than the lead and
concurring partner, to rotate after no more than seven years and to be
subject to a two-year time-out. In this way, a partner could serve
either as the lead partner on a significant subsidiary or as an ``audit
partner'' at the parent or issuer level for a period of time (e.g., two
years) prior to becoming the lead or concurring partner on the
engagement and still be able to serve in that lead or concurring role
for five years.\142\
In conducting its oversight review of registered public accounting
firms, we expect that the Public Company Accounting Oversight Board
(``the Board'') will monitor the impact of these rules on audit quality
and independence.
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\142\ An audit partner who starts in a position other than the
lead or concurring partner and subsequently moves to the lead or
concurring partner cannot serve the client in an audit partner
capacity for more than seven consecutive years. For example, a
person serving as the lead partner on a significant subsidiary for a
period of four years who then becomes the lead partner on the issuer
would be able to serve in that capacity for three additional years
before reaching a total of seven years as an audit partner on that
client.
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4. Small Business/Small Firm Considerations
Many commenters \143\ stated that if the rotation requirements were
applied to smaller firms, many smaller firms would be unable to provide
audit services to their public clients and would be forced to give up
their public clients. Many commenters \144\ suggested that this would
result in those clients incurring greater costs such as from having to
identify a new accounting firm, from the need to familiarize
accountants with the client firm's industry and business practices and
from the resulting reduction in competition among firms.\145\ As we
noted in the proposal, we are sensitive to the impact of our rules on
smaller business and smaller firms.
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\143\ See, e.g., letter from Piercy, Bowler, Taylor & Kern,
dated January 7, 2003; letter from Witt, Mares & Company PLC, dated
January 11, 2003; letter from Burton, McCumber & Cortez LLP, dated
January 2, 2003; letter from American Institute of Certified Public
Accountants, dated January 9, 2003; letter from Spence, Marston,
Bunch, Morris & Co., dated January 13, 2003; letter from The
Business Roundtable, dated January 14, 2003.
\144\ See, e.g., letter from Weaver & Martin LLC, dated December
31, 2002; letter from CPA Associates, dated January 3, 2003; letter
from Symonds, Evans & Company PC, dated December 19, 2002.
\145\ See, e.g., letter from U.S. Small Business
Administration's Office of Advocacy, January 13, 2003. We note that
the GAO also is conducting a study on the consolidation in the
accounting industry as directed by Section 701 of the Sarbanes-Oxley
Act.
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Commenters \146\ made a number of suggestions about how to
accommodate the needs of smaller issuers and smaller firms including:
(1) Exempting the firms based on criteria such as number of partners,
number of SEC clients, firm revenue, or number of professional
personnel and (2) exempting accountants of smaller issuers as measured
by revenue, assets, market capitalization, or profitability.
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\146\ See, e.g., letter from Castaing, Hussey & Lolan LLC, dated
January 10, 2003; letter from Piercy, Bowler, Taylor & Kern, dated
January 7, 2003; letter from Trice, Geary & Myers LLC, dated January
13, 2003; letter from Smith, Carney & Co., dated January 7, 2003;
letter from Cranmore, FitzGerald & Meaney, dated December 27, 2002.
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The existing professional standards on partner rotation contain an
exemption for firms with fewer than five audit clients and fewer than
ten partners.\147\ We recognize the need to consider the impact of our
rules on smaller businesses and smaller firms. While we believe it is
appropriate to codify that exemption, we remain concerned about the
quality of audits of all registrants. Accordingly, in order for audit
firms with fewer than five audit clients that are issuers \148\ and
fewer than ten partners to qualify for the exemption from partner
rotation, the Board must conduct a review of all of the firm's
engagements subject to the rule at least once every three years. This
special review should focus on the overall quality of the audit and, in
particular, the independence and competence of the key personnel on the
audit engagement teams.
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\147\ AICPA, SEC Practice Section, Requirements of Members, at
item e.
\148\ As defined in section 10A(f) of the Securities Exchange
Act of 1934 (15 U.S.C. 78j-1(f)).
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5. Investment Companies
Under the proposed rule, a partner performing audit, review, or
attestation services for any entity in the investment company complex
could only do so if they had not served five consecutive years on any
entity in the same investment company complex. The rotation requirement
would have extended not only to the audit partners, but also those
specialized partners, such as tax partners, that work on significant
aspects of the audit. Those partners affected by the rotation
requirement would have had to remain completely off any engagements in
the investment company complex for a period of five years before they
could again audit the investment company.
Commenters \149\ raised significant concerns in the application of
the proposed rule to investment companies. Two commenters \150\ were
concerned with the prohibition of partners who had served five
consecutive years at a service provider or other non-investment company
entity in the
[[Page 6021]]
investment company complex from serving on the audit of a registered
investment company in the same investment company complex without first
observing the five year ``time out'' period.\151\ One commenter \152\
was concerned with the prohibition against partners who had served five
consecutive years at an unregistered fund from serving on the audit of
a registered investment company in the same investment company complex
without first observing the five year ``time out'' period. One
commenter \153\ emphasized the financial reporting personnel and
accounting control systems used by investment companies are different
from those used for other entities in the investment company complex.
As a result, the rotation of an audit partner from a non-registered
investment company entity in the investment company complex to a
registered investment company would provide a ``fresh look'' at the
accounting control systems and the financial reporting process. In
addition, due to the structure of the investment company complex
organizations, the rotated partner typically would not be dealing with
the same individuals in management or on the audit committee that they
might have dealt with previously as the audit partner on an entity in
the investment company complex.
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\149\ See, e.g., letter from Deloitte & Touche, dated January
10, 2003; letter from Putnam Mutual Funds, not dated; letter from
The Vanguard Group, dated January 13, 2003; letter from
PricewaterhouseCoopers, dated January 8, 2003.
\150\ See, letter from PricewaterhouseCoopers, dated January 8,
2003; letter from Investment Company Institute, dated January 13,
2003.
\151\ Commenters also were concerned with the availability of
competent audit, tax and other specialized partners to effectively
rotate between the investment company audits. One commenter
indicated tax partners typically served a far greater number of
investment company audit clients per partner than their counterparts
in the other industry practices (see, letter from Investment Company
Institute, dated January 13, 2003). Commenters were concerned that
lack of depth in this industry would ultimately reduce audit quality
and harm investors (see, e.g., letter from Putnam Mutual Funds, not
dated). Commenters also were concerned with the depth of audit
resources in certain markets (see, e.g., letter from Oppenheimer
Funds, Inc., dated January 13, 2003). One commenter indicated the
proposed rule would effectively bar them from performing audits of
investment companies (see, letter from McCurdy & Associates, CPAs,
Inc., dated December 12, 2002). We have addressed these concerns by
the changes to the partner rotation requirements that impact all
issuers in addition to registered investment companies.
\152\ See, letter from PricewaterhouseCoopers, dated January 8,
2003.
\153\ See, letter from PricewaterhouseCoopers, dated January 8,
2003. See, also, letter from Investment Company Institute, dated
January 6, 2003.
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We believe that the rotation requirements with regard to investment
companies should prohibit the rotation of partners between different
investment companies in the same investment company complex. We do not
believe, however, that it is necessary for the rule to prohibit
accountants from rotating to other entities in the investment company
complex. Consequently, the rule, as adopted, will not allow audit
partners to satisfy the partner rotation requirements by rotating
between investment companies in the same investment company complex.
The individual required to rotate and the applicable periods for
rotation and ``time-out'' from the audit client will be applied in the
same manner to investment companies as to other issuers. Lead and
concurring partners will be required to rotate after a total of five
consecutive years in either role. At a minimum, all audit partners that
audit investment companies will be required to rotate after a total of
seven years of consecutive service on any of the investment companies
in the same investment company complex. Lead and concurring partners
will be required to observe a ``time out'' period for five years before
returning to the investment company and all other audit partners will
be subject to a two year ``time out'' period.
The unique structure of investment company complexes allows for
many different fiscal year-ends within the same investment company
complex. In order to allow a partner to serve the total number of
allowable periods on any one investment company audit in the complex,
while still requiring partners to rotate off an investment company
complex at the end of their specific periods, we have defined
consecutive years of service for investment companies. A consecutive
year of service for audit partners includes all fiscal year-end audits
of investment companies in the same investment company complex that are
performed in a continuous 12-month period. This would allow audit
partners auditing multiple investment companies in the same investment
company complex to audit each investment company for five or seven
complete fiscal years, as appropriate.
6. Effective Date and Transition
In order to allow firms to establish an orderly transition of their
audit engagement teams, the Commission is establishing transition
provisions related to the partner rotation requirements. Since the lead
partner was previously subject to rotation requirements, these rotation
requirements should not impose a significant incremental burden on
accounting firms. Accordingly, the rotation requirements applicable to
the lead partner are effective for the first fiscal year ending after
the effective date of these rules. Furthermore, in determining when the
lead partner must rotate, time served in the capacity of lead partner
prior to the effective date of these rules is included. For example,
for a lead partner serving a calendar year audit client, if 2003 was
that partner's fifth, sixth or seventh year as lead partner for that
audit client, he or she would be able to complete the current year's
audit and he or she must rotate off for the 2004 engagement.
The other partners subject to these rotation requirements were not
previously subject to rotation. Accordingly, we believe that some
additional transition is needed for these partners. In order to
maintain continuity on the engagement, firms will need to stagger the
rotation of partners. This is especially critical for the lead and
concurring partners. As a consequence, to facilitate the process of
staggering the rotation of the lead and concurring partners, the
rotation requirements for the concurring partner are effective as of
the end of the second fiscal year after the effective date of the
rules. Therefore, a concurring partner for a calendar year audit client
for which 2003 was his or her fourth or greater year in that role,\154\
he or she would be able to serve in that capacity for the 2004 audit
before being subject to rotation.
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\154\ Since concurring partners were not previously subject to
rotation requirements, it is quite likely that many partners will
have served in significantly more than five years in that capacity
at the time of transition.
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Since the other partners covered by these rules were neither
identified in the Act nor previously subject to rotation requirements,
we believe, consistent with many commenters, that a longer transition
period is warranted. Accordingly, for other partners, the rules are
effective as of the beginning of the first fiscal year after the
effective date of these rules. However, in determining the time served,
that first fiscal year will constitute the first year of service for
such partners. For example, for a lead partner on a significant
subsidiary with a calendar year reporting period, 2004 would constitute
the first year in the seven year rotation period, regardless of how
many years he or she had previously served in that capacity.
Finally, we recognize that in many foreign jurisdictions partners
previously were not subject to rotation requirements. Accordingly, for
all partners with foreign accounting firms who are subject to rotation
requirements, the rules are effective as of the beginning of the first
fiscal year after the effective date of these rules. Likewise, in
determining the time served, that first fiscal year will
[[Page 6022]]
constitute the first year of service for such partners. Thus, for a
partner from a foreign firm who is serving as the lead partner for an
issuer with a calendar year, 2004 would constitute the first year of
the five year rotation period for that partner, without regard to the
number of years he or she had previously served in that capacity.
D. Audit Committee Administration of the Engagement
Historically, management has retained the accounting firm,
negotiated the audit fee, and contracted with the accounting firm for
other services. Our proposed rules, however, recognized the critical
role that audit committees can play in the financial reporting process
and in helping accountants maintain their independence from audit
clients. An effective audit committee may enhance the accountant's
independence by, among other things, providing a forum apart from
management where the accountants may discuss their concerns. It may
facilitate communications among the board of directors, management,
internal auditors and independent accountants. An audit committee also
may enhance auditor independence from management by appointing,
compensating and overseeing the work of the independent accountants.
In that light, Section 202 of the Sarbanes-Oxley Act requires that
audit committees pre-approve the services--both audit and permitted
non-audit--of the accounting firm.
Specifically, our proposed rules would have required the audit
committee to approve the engagement of the independent accountant to
audit the issuer and its subsidiary's financial statements and have
ongoing communications with the accountant. The proposals also would
have required that the audit committee pre-approve all permissible non-
audit services and all audit, review or attest engagements required
under the securities laws either:
[sbull] before the accountant is engaged by the audit client to
provide services other than audit, review or attest services, the audit
client's audit committee expressly approve the particular engagement;
or
[sbull] any such engagement be entered into pursuant to detailed
pre-approval policies and procedures established by the audit committee
and the audit committee be informed on a timely basis of each service.
Finally, consistent with the provisions of the Act, under our
proposals, audit committees could apply a de minimis exception to the
pre-approval requirements in certain circumstances.
Some commenters \155\ believed that the pre-approval alternatives
stated above, coupled with the disclosure of fees based on the pre-
approval practices conveyed an impression that one method of pre-
approval was preferable. Other commenters \156\ stated that it was
uncertain whether audit committees could use policies and procedures as
the basis for pre-approving audit services.
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\155\ See, e.g., letter from The Business Roundtable, dated
January 13, 2003; letter from Chamber of Commerce of the United
States of America, dated January 9, 2003; letter from Investment
Company Institute, dated January 13, 2003; letter from Pfizer, dated
January 13, 2003; letter from Sullivan & Cromwell LLP, dated January
10, 2003; letter from Wells Fargo & Company, dated January 13, 2003.
\156\ See, e.g., letter from America's Community Bankers, dated
January 13, 2003; letter from American Society of Corporate
Secretaries, dated January 13, 2003; letter from Ernst & Young,
dated January 6, 2003.
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The rules we are adopting are intended to clarify that, to the
extent permitted by the Sarbanes-Oxley Act,\157\ the audit committee
may pre-approve audit and non-audit services based on policies and
procedures and that explicit approval and approval based on policies
and procedures are equally acceptable. As discussed later in this
release, we have revised the proposed disclosures to match our
conclusions about pre-approval processes.
---------------------------------------------------------------------------
\157\ Section 202 of the Sarbanes-Oxley Act.
---------------------------------------------------------------------------
Accordingly, the final rules require that the audit committee pre-
approve all permissible non-audit services and all audit, review or
attest engagements required under the securities laws. The rules
require that before the accountant is engaged by the issuer or its
subsidiaries, or the registered investment company or its subsidiaries,
to render the service, the engagement is:
[sbull] approved by the issuer's or registered investment company's
audit committee; or
[sbull] entered into pursuant to pre-approval policies and
procedures established by the audit committee of the issuer or
registered investment company, provided the policies and procedures are
detailed as to the particular service, the audit committee is informed
of each service, and such policies and procedures do not include
delegation of the audit committee's responsibilities to management.
As provided in the Sarbanes-Oxley Act, the rules recognize audit
services to be broader than those services required to perform an audit
pursuant to GAAS. For example, the Act identifies services related to
the issuance of comfort letters and services related to statutory
audits required for insurance companies for purposes of state law as
audit services.\158\ We recognize that domestically and internationally
there are various requirements for statutory audits. These rules
recognize this fact; accordingly, such engagements are viewed as audit
services in the context of these rules.
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\158\ Section 202 of the Sarbanes-Oxley Act; 15U.S.C 78j-
1(i)(1)(A).
---------------------------------------------------------------------------
Furthermore, audit services also would include services performed
to fulfill the accountant's responsibility under GAAS. For example, in
some situations, a tax partner may be involved in reviewing the tax
accrual that appears in the company's financial statements. Since that
is a necessary part of the audit process, that activity constitutes an
audit service. Likewise, complex accounting issues may require that the
firm engage in consultation with ``national office'' or other technical
reviewers to reach an audit judgment. Whether or not the firm
separately charges for that consultation, the activity constitutes an
audit service since it is a necessary procedure used by the accountant
in reaching an opinion on the financial statements.
This would contrast with a situation where a registrant is
evaluating a proposed transaction and asks the independent accountant
to evaluate the accounting for the proposed transaction. After research
and consultation, the accounting firm provides an answer to the
registrant and bills for those services. In considering the nature of
the services, these services would not be considered to be audit
services.
These rules require that the audit committee pre-approve all
services. In doing so, the Act permits the audit committee to establish
policies and procedures for pre-approval provided they are detailed as
to the particular service and designed to safeguard the continued
independence of the accountant. For example, the Sarbanes-Oxley Act
allows for one or more audit committee members who are independent
board directors to pre-approve the service. Decisions made by the
designated audit committee members must be reported to the full audit
committee at each of its scheduled meetings.\159\
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\159\ The Act permits the audit committee to pre-approve a
service at any time in advance of the activity. We expect that audit
committees will establish policies for the maximum period in advance
of the activity the approval may be granted. See ``Report of the
Senate Committee on Banking, Housing and Urban Affairs, Public
Company Accounting Reform and Investor Protection Act of 2002,''
107th Cong., 2nd Sess., at 20 (Report 107-205. July 3, 2002).
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Consistent with the Sarbanes-Oxley Act, our rules also reflect a de
minimis
[[Page 6023]]
exception solely related to the provision of non-audit services for an
issuer. This exception waives the pre-approval requirements for non-
audit services provided that: (1) All such services do not aggregate to
more than five percent of total revenues paid by the audit client to
its accountant in the fiscal year when services are provided, (2) were
not recognized as non-audit services at the time of the engagement, and
(3) are promptly brought to the attention of audit committee and
approved prior to the completion of the audit by the audit committee or
one or more designated representatives. Lastly, as further discussed
later in this release, the audit committee's policies for pre-approvals
of services should be disclosed by registrants in periodic annual
reports.
As noted earlier, the proposed rules provided two alternatives
related to pre-approval of permissible non-audit services as well as
all audit, review, or attest engagements required under the securities
laws: either pre-approval before the accountant is engaged to provide
the services or the engagement is entered into pursuant to detailed
pre-approval policies and procedures established by the audit
committee, with the audit committee informed on a timely basis of each
service. In response to issues raised by commenters, the final rule has
been modified to remove the appearance of an implicit preference of one
alternative over another.
With respect to investment companies, the proposed rule would have
required pre-approval not only of the non-auditing services provided to
the investment company, but also require pre-approval by the investment
company's audit committee of the non-auditing services provided to the
investment company's investment adviser and any entity controlling,
controlled by, or under common control with the investment adviser that
provides services to the investment company.
Commenters \160\ expressed concern over the breadth of this
proposed rule and the unintended consequences of the pre-approval
process. Commenters \161\ observed that an auditor could provide a non-
audit service to an entity in an investment company complex that would
require the pre-approval of multiple audit committees. Some commenters
\162\ indicated investment company complexes often have more than one
audit committee for the various investment companies in the complex.
Additionally, the other entities in the complex, themselves, will often
have their own audit committees. As proposed, the rule would require
not only the audit committee of the entity engaging the auditor to
provide the non-audit service to pre-approve the use of the accountant,
but also would require each audit committee of an investment company
registrant in the complex to pre-approve the use of the accountant.
This would ultimately result in each investment company audit committee
having veto power over all non-audit services provided to the complex
even if those services did not relate directly to the financial
reporting or operations of the investment company. One commenter \163\
expressed concern over the burden this would place on the investment
company's audit committee. Other commenters \164\ expressed concern
with whether the members of the audit committee would be capable of
evaluating the appropriateness of services provided to entities
unrelated to the investment company's operations or financial
reporting.
---------------------------------------------------------------------------
\160\ See, e.g., letter from Deloitte & Touche, dated January
10, 2003; letter from Ernst & Young, dated January 6, 2003; letter
from Investment Company Institute, dated January 13, 2003.
\161\ See, e.g., letter from Ernst & Young, dated January 6,
2003; letter from Deloitte & Touche, dated January 10, 2003; letter
from PricewaterhouseCoopers, dated January 8, 2003.
\162\ See, letter from PricewaterhouseCoopers, dated January 8,
2003; letter from Investment Company Institute, dated January 13,
2003.
\163\ See, letter from Investment Company Institute, dated
January 13, 2003.
\164\ See, letter from PricewaterhouseCoopers, dated January 8,
2003; letter from Deloitte & Touche, LLP, dated January 10, 2003.
---------------------------------------------------------------------------
Commenters \165\ suggested the rule should require the audit
committee of the investment company to only pre-approve those audit and
non-audit services provided directly to the investment company. One
commenter \166\ suggested the rule should require the audit committee
of the investment company to pre-approve those audit and non-audit
services that relate to the operations of the investment company.
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\165\ See, letter from Ernst & Young, LLP, dated January 6,
2003; letter from Investment Company Institute, dated January 13,
2003.
\166\ See, letter from PricewaterhouseCoopers, dated January 8,
2003.
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After considering the comments, we believe modifying the approach
by requiring the pre-approval of non-audit services to only those
provided to the investment company directly, as suggested by several of
the commenters, would not be consistent with the spirit or intent of
the Sarbanes-Oxley Act. To address the commenters' concerns, but
preserve the intent of the legislation, the rules as adopted would
limit the investment company's audit committee pre-approval
responsibility to those services provided directly to the investment
company and those services provided to an entity in the investment
company complex where the nature of the services provided have a direct
impact on the operations or financial reporting of the investment
company. The final rules would allow the investment company's audit
committee to assess and determine before the work is conducted the
impact that the services might reasonably have on the investment
company accountant's independence as it relates to the audits of the
investment company's financial statements. In addition, in response to
one commenter's \167\ suggestion concerning the non-audit services that
should be disclosed, we have clarified the entities that provide
services to the investment company that must be pre-approved. As
adopted only the service providers that provide ``ongoing'' services to
the investment company must have their non-audit services pre-approved.
Thus, the final rules would limit the number of instances where pre-
approval would be sought from multiple audit committees in the complex.
---------------------------------------------------------------------------
\167\ See, letter from PricewaterhouseCoopers, dated January 8,
2003.
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Although it may not be practical or feasible for the investment
company audit committee to pre-approve all services provided to the
investment company complex, we continue to believe the audit committee
should be aware of all services the accountant is providing to entities
in the investment company complex. One commenter \168\ agreed with this
position suggesting non-audit services be disclosed quarterly. As a
result, we are adopting a requirement in the rule that the accountant
disclose to the audit committee all services provided to the investment
company complex, including the fees associated with those services.
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\168\ See, letter from KPMG, LLP, dated January 9, 2003.
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The de minimis exception that was proposed would have calculated
the percentage threshold based on the total revenues paid to the
investment company's accountant by the investment company, its
investment adviser and any entity controlling, controlled by, or under
common control with the investment adviser that provided services to
the investment company. We asked for comment on the appropriate
methodology for calculating the de minimis exception. One commenter
\169\ suggested it would be
[[Page 6024]]
unfair to determine the calculation of the de minimis exception based
on the total fees paid to the accountant by the investment company
because the resulting threshold would be so low; the practical effect
would be no de minimis exception for investment companies. Therefore,
the commenter suggested the threshold should coincide with the scope of
the pre-approval requirement. We agree with the commenter and believe
that the calculation of the de minimis exception should not relate
solely to the level of services provided to the investment company. We
have modified the proposed rule to determine the threshold based on the
services provided to the investment company complex that were subject
to the pre-approval requirements for the investment company's audit
committee.
---------------------------------------------------------------------------
\169\ See, letter from PricewaterhouseCoopers, dated January 8,
2003.
---------------------------------------------------------------------------
The proposed rules would require the audit committee to pre-approve
all audit, review, and attest reports required under the securities
laws. Section 32(a) of the Investment Company Act requires that a
majority of the directors who are not interested persons appoint the
independent accountant of the investment company. We requested comment
on who should approve the selection of the accountant of the investment
company, for example, the independent directors, the audit committee or
both. One commenter \170\ stated that the audit committee should select
the accountant and the independent directors should ratify the
selection, thereby retaining the independent directors as the ultimate
decision making authority with respect to accountant selection. After
consideration of these matters, we have determined to adopt the rules
as proposed.
---------------------------------------------------------------------------
\170\ See, letter from Investment Company Institute, dated
January 13, 2003.
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Also, as discussed later in this release, these provisions are
supplemented as a result of the proxy disclosure requirements. We
believe that disclosure of the procedures the audit committee uses to
pre-approve audit services, as well as the disclosure of all non-audit
services by category, including those meeting the de minimis exception
stated above, will provide investors valuable information that may be
used to evaluate the relationships that exist between the accountant
and the audit client.
These rules apply to all audit, review, and attest services and
non-audit services that are entered into after the effective date of
these rules. For arrangements for non-audit services entered into prior
to the effective date of these rules--regardless of whether or not they
were pre-approved by the audit committee--the accounting firm will have
12 months from the effective date of these rules to complete these
services. For example, an engagement to provide non-audit services that
was entered into in December 2002, which may or may not be complete by
the effective date of these rules, is not subject to these rules, but
must be completed within 12 months of the effective date of these
rules. We believe these transition provisions will permit an orderly
completion of existing engagements and permit accountants and audit
committees adequate time to prepare to implement the new rules.
E. Compensation
We understand that some accounting firms offer their professionals
cash bonuses and other financial incentives to sell products or
services, other than audit, review, or attest services, to their audit
clients. Such compensation arrangements may create a financial or other
self-interest that could constitute a threat to the accountant's
objectivity.\171\ These arrangements also may detract from audit
quality by incentivizing the audit partner to focus on selling non-
audit services rather than providing high quality audit services.
---------------------------------------------------------------------------
\171\ See, e.g., AICPA, Practice Alert 99-1, Guidance for
Independence Discussions with Audit Committees, (May 1999).
---------------------------------------------------------------------------
We also question whether a reasonable investor with full knowledge
of such incentive programs would believe that the accountant could
function with the independence and objectivity that is necessary for
him or her to maintain, both in fact and in appearance. We are
concerned that an accountant might be viewed as compromising accounting
judgments in order not to jeopardize the potential for increased income
from the act of selling non-audit services to the audit client. Because
of this concern, we proposed that an accountant's independence would be
deemed to have been impaired when he or she is compensated for selling
or performing non-audit services for an audit client. Our proposed rule
limited such compensation, direct or otherwise, that could be provided
to any audit engagement team partner.
Commenters expressed two primary concerns with the proposals.
First, \172\ because the compensation was not directly related to sales
activities, the operation of the rule would have been difficult given
the size and nature of some firms' national and global operations. For
example, read literally as proposed, a partner's compensation could not
include a proportionate share of the accounting firm's overall profits,
because some of those profits would be derived from the provision of
non-audit services by other firm personnel. Second, some commenters
\173\ observed that the provisions were perceived to be overly broad
because, as proposed, they would have applied to partners who provide
specialized services and would have prevented them from being rewarded
for selling or performing services in their area of expertise. For
example, under the proposal an audit partner could be rewarded for
selling audit, review or attest services; however, tax partners could
not be rewarded for selling additional tax services to audit clients if
they were members of the audit engagement team. That is, audit partners
could be rewarded for selling within their own discipline, but tax
partners could not.
---------------------------------------------------------------------------
\172\ See, e.g., letter from American Institute of Certified
Public Accountants, dated January 9, 2003; letter from Deloitte &
Touche, LLP, dated January 10, 2003; letter from Ernst & Young, LLP,
dated January 6, 2003; letter from Federation des Experts Comptables
Europeens, dated January 13, 2003; letter from Institute of
Chartered Accountants in England and Wales, dated December 24, 2002;
letter from KPMG, LLP, dated January 9, 2003; letter from
PricewaterhouseCoopers, dated January 8, 2003.
\173\ See, e.g., letter from Ernst & Young, LLP, dated January
6, 2003; letter from Deloitte & Touche, LLP, dated January 10, 2003;
letter from KPMG, LLP, dated January 9, 2003; letter from McGladrey
& Pullen, LLP, dated January 9, 2003.
---------------------------------------------------------------------------
We are addressing these concerns by clarifying that the
compensation concerns exist where the audit partner's compensation is
based on the act of selling non-audit services and specifying that the
rule applies to audit partners. As described more fully in our
discussion of definitions, the term audit partner refers to the lead
and concurring partners and other partners on the audit engagement team
who have responsibility for decision-making on significant auditing,
accounting, and reporting matters that affect the financial statements
or who maintain regular contact with management or the audit committee.
In particular, audit partners, other than specialty partners, would
include all audit partners serving the client at the issuer or
parent.\174\ Further, the lead partner on subsidiaries of the issuer
whose assets or revenues constitute 20% or more of the consolidated
assets or revenues are included within the definition of audit partner.
Conceivably, ``compensation'' could include any form of cash or other
assets distributed to the audit partner, including any income or
benefit based
[[Page 6025]]
on an evaluation of the partner's performance.
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\174\ As discussed previously, partners who provided ten or
fewer hours of service are excluded from the definition of audit
partner.
---------------------------------------------------------------------------
This rule prohibits accounting firms from establishing an audit
partner's compensation or allocation of partnership ``units'' based on
the sale \175\ of non-audit services to the partner's audit
clients.\176\ This provision also reinforces the position that
accountants at the partner level should be viewed as skilled
professionals and not as conduits for the sale of non-audit services to
the audit partner's individual clients. This provision recognizes and
focuses on the need for independence of the most senior members of the
engagement team. However, this rule does not preclude an audit partner
from sharing in the profits of the audit practice and those of the
overall firm.\177\ And, an audit partner's evaluation could take into
account a number of factors directly or indirectly related to selling
services to an audit client.\178\
Accordingly, we are amending the auditor independence rules to
address the practice of accountants being compensated by their firms
for selling non-audit products and services to their audit
clients.\179\ The new rule would provide that an accountant is not
independent if, at any point during the audit and professional
engagement period,\180\ any audit partner,\181\ other than specialty
partners,\182\ earns or receives compensation \183\ based on selling
engagements to that audit client, to provide any services,\184\ other
than audit, review, or attest services.
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\175\ For purposes of this rule, the term ``sale'' is meant to
encompass any revenue, fees, or compensation related to non-audit
services provided over the period of the evaluation, regardless when
contracted.
\176\ Id.
\177\ Consistent with the idea that an audit partner cannot be
directly compensated for selling non-audit services, no part of that
partner's distribution or other form of compensation should be
directly received from selling of non-audit services (for example,
from a ``pool'' of profits generated by a valuation services
business unit). In contrast, that partner may receive distributions
or other compensation from the ``pool'' attributable to the audit
practice, a geographic unit comprised of several services or
offices, or the entire firm.
\178\ For example, an audit partner could be evaluated on the
complexity of his or her engagements, the overall management of the
relationship with an audit client including the provision of non-
audit services, and/or the attainment of explicit sales goals.
\179\ An audit partner could be compensated for selling audit or
audit-related services to an audit client. Additionally, an audit
partner could be compensated for selling either audit or non-audit
services to a non-audit client.
\180\ ``Audit and professional engagement period'' includes both
the period covered by the financial statements being audited or
reviewed and the period of engagement to audit or review the
client's financial statements or to prepare a report filed with the
Commission. The period of engagement begins when the auditor signs
an initial engagement letter or begins audit, review or attest
procedures, and ends when the client or the auditor notifies the
Commission that the client is no longer the auditor's audit client.
See Rule 2-01(f)(5) of Regulation S-X, 17 CFR 210.2-01(f)(5).
\181\ 17 CFR 210.2-01(f)(7)(ii).
\182\ Specialty partners are, among others, those partners who
consults with others on the audit engagement team during the audit,
review or attestation engagement regarding technical or industry-
specific issues. For example, such partners would include tax
specialist and valuation specialist.
\183\ Nothing in these rules is meant to limit the ability of an
accounting firm from distributing profits in a manner that is
consistent with the operation of a partnership or service
organization.
\184\ For purposes of this discussion, services include tangible
products as well as professional services.
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The lead partner is responsible for managing not only the audit
engagement but also the client relationship. The lead partner is in a
position to identify potential services that could benefit the audit
client. Furthermore, because of the lead partner's frequent interaction
with management, he or she has the opportunity to ``pitch'' those
services to management. Thus, the lead partner relationship with
management has been used by some as a conduit to sell non-audit
services to the audit client.\185\ In contrast, partners at smaller
operating units and ``specialty'' partners typically have a low level
of involvement with senior management and the responsibility for the
overall presentation in the financial statements is relatively low.
---------------------------------------------------------------------------
\185\ See e.g., In the Matter of Arthur Andersen LLP, Accounting
and Auditing Enforcement Release No. 1405 (June 19, 2001), at notes
15-17.
---------------------------------------------------------------------------
The application of these rules allows partners to be compensated
for selling services with their discipline. Thus, just as an audit
partner can be compensated for selling audit and audit-related
services, so, too, can a tax partner be compensated for selling tax
services. A specialty partner receiving compensation for selling within
his or her discipline does not create the same threat to independence
as when an audit partner is compensated for selling those non-audit
services because the lead partner retains overall responsibility for
the conduct of the audit. Additionally, there is a concurring partner
who reviews the work on the audit engagement team. Finally, specialty
partners have limited relationships with management in the context of
their activities as a member of the audit engagement team.
The rules that we are adopting mitigate the concerns that an audit
partner might be viewed as compromising audit judgments in order not to
jeopardize the potential for selling non-audit services. These rules do
not specifically address the provision of compensation to other audit
engagement team members for directly selling non-audit services. We
believe that, however, the other audit engagement team members will
perform in a fashion that is consistent with the direction and tone set
by the audit partners. Nonetheless, as it pre-approves non-audit
services an audit committee may wish to consider whether, in the
company's particular circumstances, compensating a senior staff member
on the audit engagement team based on his or her success in selling the
service to the company compromises that individual's or the firm's
independence.
Further, in conducting its oversight review of registered public
accounting firms, we expect that the Board will monitor the impact of
these rules on audit quality and independence.
With respect to investment companies, the proposed rule on
compensation would have prohibited all partners, principals and
shareholders of an accounting firm that are members of the audit
engagement team from being compensated for selling non-audit services
to a registered investment company audit client or any other entity in
the investment company complex. One commenter \186\ suggested the rule
on partner compensation for investment companies should apply only to
the selling of non-audit services to the investment company itself and
not to other entities in the investment company complex. We disagree
and continue to believe a partner on a registered investment company
audit should not be directly compensated for selling non-audit services
to other entities in the investment company complex, for example, the
investment company's investment adviser. Thus, we have not made changes
to this aspect of the rule.
---------------------------------------------------------------------------
\186\ See, letter from Investment Company Institute, dated
January 13, 2003.
---------------------------------------------------------------------------
We understand that because of the seasonal nature of accounting
firms that many firms have fiscal periods that end in the April to
September time frame. In recognition of this fact and understanding
that individuals may be operating in the current period under an
established set of performance goals, the provisions of this paragraph
will be effective in the fiscal periods of the accounting firm that
commence after the effective date of these rules. Further, recognizing
that the application of this rule could have a disproportionate
economic impact on small firms, we are exempting firms with fewer than
five
[[Page 6026]]
audit clients that are issuers \187\ and fewer than ten partners from
the provisions of this requirement.
---------------------------------------------------------------------------
\187\ As defined in section 10A(f) of the Securities Exchange
Act of 1934 (15 U.S.C. 78j-1(f)).
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F. Definitions
The rules that the Commission is adopting impact various parties
involved in the audit and financial reporting process of issuers. To
more clearly identify those parties, we have revised and added to the
definitions in Rule 2-01(f) of Regulation S-X. This section discusses
those definitions.
1. Accountant
The term ``accountant'' previously was defined under the rules of
the Commission as a ``certified public accountant or public accountant
performing services in connection with an engagement for which
independence is required.'' \188\ We have added to the definition the
phrase, ``registered public accounting firm.'' Under the provisions of
the Sarbanes-Oxley Act, public accounting firms must register with the
Board in order to prepare or issue, or to participate in the
preparation or issuance of, any audit report with respect to any
issuer.\189\ Thus, the term ``registered public accounting firm''
refers to a firm that has registered with the Board in accordance with
the requirements of the Sarbanes-Oxley Act.
---------------------------------------------------------------------------
\188\ 17 CFR 2-01(f)(1).
\189\ See, Section 102(a) of the Sarbanes-Oxley Act.
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2. Accounting Role
Under the previous rules of the Commission, ``accounting role or
financial reporting oversight role'' was a defined term. However,
because the rules requiring a cooling-off period for employment at the
issuer relate only to those performing a financial reporting oversight
role, the Commission has separated the definition of ``accounting
role'' from that of ``financial reporting oversight role.'' The term
``accounting role'' refers to a role where a person can or does
exercise more than minimal influence over the contents of the
accounting records or over any person who prepares the accounting
records. All persons in a ``financial reporting oversight role''
(defined below) also are in an ``accounting role.'' Persons in an
accounting role include individuals in clerical positions responsible
for accounting records (e.g., payroll, accounts payable, accounts
receivable, purchasing, sales) as well as those who report to
individuals in financial reporting oversight roles (e.g., assistant
controller, assistant treasurer, manager of internal audit, manager of
financial reporting).
3. Financial Reporting Oversight Role
The term ``financial reporting oversight role'' refers to a role in
which an individual has direct responsibility for or oversight of those
who prepare the registrant's financial statements and related
information (e.g., management discussion and analysis), which will be
included in a registrant's document filed with the Commission. As noted
above, ``accounting role and financial reporting oversight role''
previously was one definition. In order to subject the appropriate
individuals to certain portions of these rules, we have bifurcated the
definitions.
4. Audit Committee
Section 205 of the Sarbanes-Oxley Act defines an audit committee
as:
A committee (or equivalent body) established by and amongst the
board of directors of an issuer for the purpose of overseeing the
accounting and financial reporting processes of the issuer and
audits of the financial statements of the issuer.
The Act further stipulates that if no such committee exists, then
the audit committee is the entire board of directors. For purposes of
these independence rules, the Commission is adopting the same meaning
for audit committee as used in the Act.
The audit committee serves as an important body, serving the
interests of investors, to help ensure that the registrant and its
accountants fulfill their responsibilities under the securities laws.
Because the definition of an audit committee can include the entire
board of directors if no such committee of the board exists, these
rules do not require registrants to establish audit committees.
Likewise, the auditor independence rules do not require that the
committee be composed of independent members of the board.\190\
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\190\ See, Release No. 33-8173 (Jan. 8, 2003).
---------------------------------------------------------------------------
Some entities do not have boards of directors and therefore do not
have audit committees. For example, some limited liability companies
and limited partnerships that do not have a corporate general partner
may not have an oversight body that is the equivalent of an audit
committee. We are not exempting these entities from the requirements.
Rather, such issuers should look through each general partner of the
successive limited partnerships until a corporate general partner or an
individual general partner is reached. With respect to a corporate
general partner, the registrant should look to the audit committee of
the corporate general partner or to the full board of directors as
fulfilling the role of the audit committee. With respect to an
individual general partner, the registrant should look to the
individual as fulfilling the role of the audit committee.
We are, however, exempting asset-backed issuers \191\ and unit
investment trusts \192\ from this requirement. Because of the nature of
these entities, such issuers are subject to substantially different
reporting requirements. Most significantly, asset-backed issuers are
not required to file financial statements like other companies.
Similarly, unit investment trusts are not required to provide
shareholder reports containing audited financial statements. Also, such
entities typically are passively managed pools of assets. Therefore, we
are not applying the requirements related to audit committees in this
release to such entities.
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\191\ As defined in 17 CFR 240.13a-14(g) and 240.15d-14(g).
\192\ As defined by Section 4(2) of the Investment Company Act
[15 U.S.C. 80a-4(2)].
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5. Audit Engagement Team
As discussed earlier in this release, the cooling off period
applies to members of the audit engagement team. As used in this
release, the term audit engagement team means all partners (or person
in an equivalent position) and professional employees participating in
an audit, review, or attestation engagement of an audit client.
Included within the audit engagement team would be partners and all
other persons who consult with other members of the engagement team
during the audit, review, or attestation engagement regarding technical
or industry-specific issues, transactions, or events.
6. Audit Partner
The term audit partner is an integral part of the rules we are
adopting related to partner compensation and partner rotation. In each
case, the affected parties are audit partners. As used in this rule,
the term audit partner means a partner (or person in an equivalent
position) who is a member of the audit engagement team (as defined
above) who has responsibility for decision-making on significant
auditing, accounting, and reporting matters that affect the financial
statements or who maintains regular contact with management and the
audit committee.
The term audit partner would include the lead and concurring
partners, partners such as relationship partners who serve the client
at the issuer or
[[Page 6027]]
parent level, other than a partner who consults with others on the
audit engagement team during the audit, review, or attestation
engagement regarding technical or industry-specific issues,
transactions, or events, and the lead partner on subsidiaries of the
issuer whose assets or revenues constitute 20% or more of the
consolidated assets or revenues of the issuer.\193\
---------------------------------------------------------------------------
\193\ The term ``audit partner'' also would include any audit
partner on a registered investment company whether or not the
investment company issues consolidated financial statements.
---------------------------------------------------------------------------
G. Communication With Audit Committees
Auditors are required by GAAS to communicate certain matters to the
audit committee. In particular, GAAS require that the accountant should
determine that the audit committee is informed about matters such as:
[sbull] Auditor's responsibility under GAAS,
[sbull] Significant accounting policies,
[sbull] Methods used to account for significant unusual
transactions,
[sbull] Effects of significant accounting policies in controversial
or emerging areas for which there is a lack of authoritative guidance
or consensus,
[sbull] Process used by management in formulating particularly
sensitive accounting estimates and the basis for the auditor's
conclusions regarding the reasonableness of those estimates,
[sbull] Material audit adjustments proposed and immaterial
adjustments not recorded by management,
[sbull] Auditor's judgments about the quality of the company's
accounting principles,
[sbull] Auditor's responsibility for other information in documents
containing audited financial statements,
[sbull] Auditor's views about significant matters that were the
subject of consultation between management and other accountants,
[sbull] Major issues discussed with management prior to retention,
[sbull] Difficulties with management encountered in performing the
audit, and
[sbull] Disagreements with management over the application of
accounting principles, the basis for management's accounting estimates,
and the disclosures in the financial statements.\194\
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\194\ See, AU Sec. 380, ``Communication with Audit
Committees.'' There are additional GAAS requirements related to
auditor communications that are not included in this rule, such as
the auditor's responsibilities under GAAS, the auditor's
responsibilities related to documents containing audited financial
statements, and disagreements with management, consultations with
other accountants, major issues discussed with management prior to
retention, and difficulties encountered in performing the audit, to
the extent that those matters do not relate to accounting policies
and practices.
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Accountants are required under GAAS to provide these communications
in a timely manner but not necessarily before the issuance of the audit
report.\195\ Accountants also may communicate with audit committees on
matters in addition to those specifically required by GAAS, including
auditing issues, engagement letters, management representation letters,
internal controls, auditor independence, and others.
---------------------------------------------------------------------------
\195\ Id.
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Section 204 of the Sarbanes-Oxley Act directs the Commission to
issue rules requiring timely reporting of specific information by
accountants to audit committees. In response to the Act, we proposed
amending Regulation S-X to require each public accounting firm
registered with the Board that audits an issuer's financial statements
to report, prior to the filing of such report with the Commission, to
the issuer or registered investment company's audit committee: (1) All
critical accounting policies and practices used by the issuer or
registered investment company, (2) all alternative accounting
treatments of financial information within generally accepted
accounting principles (``GAAP'') that have been discussed with
management, including the ramifications of the use of such alternative
treatments and disclosures and the treatment preferred by the
accounting firm, and (3) other material written communications between
the accounting firm and management of the issuer or registered
investment company.
Some commenters \196\ believe that these communications should be
the responsibility of management alone. Others,\197\ however, believe
that both the accountant and management should share the responsibility
for informing the audit committee about such matters. While we
understand that management has the primary responsibility for the
information contained in the financial statements, since the accounting
firm is retained by the audit committee, we share the view reflected in
Section 205 of the Sarbanes-Oxley Act and current auditing standards,
that the accounting firm has a responsibility to communicate certain
information to the audit committee. As discussed below, we are adopting
rules requiring that certain information be communicated by the
independent accountant to the audit committee. Some commenters \198\
believe that the Commission should require that these communications be
in writing. Others,\199\ however, disagree. We have not required that
the communication be in writing. We would expect, however, that such
communications would be documented by the accountant and the audit
committee. We believe that many of these communications currently are
being made as accountants fulfill their responsibilities under GAAS and
the securities laws.\200\
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\196\ See, e.g., letter from The Institute of Chartered
Accountants of Scotland, dated January 8, 2003; letter from Battelle
& Battelle, LLP, dated December 20, 2002; letter from Grant Thornton
LLP, dated January 13, 2003.
\197\ See, e.g., letter from Gelford Hochstadt Pangburn, PC,
dated January 3, 2003; letter from Ernst & Young LLP, dated January
6, 2003.
\198\ See, e.g., letter from Piercy Bowler Taylor & Kern, dated
January 7, 2003; letter from Robert G. Beard, undated; letter from
Eide Bailly LLP, dated January 8, 2003; letter from California
Public Employees' Retirement System, dated January 10, 2003; letter
from Lynn E. Turner, dated January 13, 2003.
\199\ See, e.g., letter from Computer Sciences Corporation,
dated January 13, 2003; letter from Sullivan & Cromwell LLP, dated
January 10, 2003; letter from America's Community Bankers, dated
January 13, 2003; letter from Deloitte & Touche LLP, dated January
10, 2003.
\200\ See, ``Audit Committee Disclosures,'' Release No. 34-
42266, Dec. 22, 1999.
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In describing the role and responsibilities of the audit committee,
Warren Buffett has stated that:
Their function * * * is to hold the auditor's feet to the fire.
And, I suggest * * * the audit committee ask [questions] of the
auditors [including]: if the auditor were solely responsible for
preparation of the company's financial statements, would they have
been prepared in any way differently than the manner selected by
management? They should inquire as to both material and non-material
differences. If the auditor would have done anything differently
than management, then explanations should be made of management's
argument and the auditor's response.\201\
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\201\ Warren Buffett, Comments during SEC ``Roundtable
Discussion on Financial Disclosure and Auditor Oversight,'' March 4,
2002.
Requiring that the accountants communicate information to the audit
committee will aid the audit committee in fulfilling its
responsibilities.
1. Critical Accounting Policies and Practices
Consistent with our proposal, we are establishing rules requiring
communication by accountants to audit committees of all critical
accounting policies and practices.\202\ In December 2001, we issued
cautionary advice regarding each issuer disclosing in the Management's
Discussion and Analysis \203\ section of its annual report
[[Page 6028]]
those accounting policies that management believes are most critical to
the preparation of the issuer's financial statements.\204\ The
cautionary advice indicated that ``critical'' accounting policies are
those that are both most important to the portrayal of the company's
financial condition and results and require management's most
difficult, subjective or complex judgments, often as a result of the
need to make estimates about the effect of matters that are inherently
uncertain.\205\ As part of that cautionary advice, we stated:
\202\ In this release, the terms ``critical accounting policies
and practices'' and ``critical accounting policies'' are used
interchangeably.
\203\ Item 303 of Regulation S-K, (17 CFR 229.303), which
requires disclosure about, among other things, trends, events or
uncertainties known to management that would have a material impact
on reported financial information.
\204\ Release No. 33-8040, Dec. 12, 2001, (66 FR 65013).
\205\ Id.
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Prior to finalizing and filing annual reports, audit committees
should review the selection, application and disclosure of critical
accounting policies. Consistent with auditing standards, audit
committees should be apprised of the evaluative criteria used by
management in their selection of the accounting principles and
methods. Proactive discussions between the audit committee and the
company's senior management and auditor about critical accounting
policies are appropriate.\206\
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\206\ Id. (footnotes omitted).
In May 2002, the Commission proposed rules to require disclosures
that would enhance investors' understanding of the application of
companies' critical accounting policies.\207\ The May 2002 proposed
rules cover (1) accounting estimates a company makes in applying its
accounting policies and (2) the initial adoption by a company of an
accounting policy that has a material impact on its financial
presentation. Under the first part of those proposed rules, a
``critical accounting estimate'' is defined as an accounting estimate
recognized in the financial statements (1) that requires the registrant
to make assumptions about matters that are highly uncertain at the time
the accounting estimate is made and (2) for which different estimates
that the company reasonably could have used in the current period, or
changes in the accounting estimate that are reasonably likely to occur
from period to period, would have a material impact on the presentation
of the registrant's financial condition, changes in financial condition
or results of operations. The May 2002 proposed rules outline certain
disclosures that a company would be required to make about its critical
accounting estimates. In addition, under the second part of the May
2002 proposed rules, a company would be required to make certain
disclosures about its initial adoption of accounting policies,
including the choices the company had among accounting principles.
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\207\ Release No. 33-8090, May 10, 2002, (67 FR 35620).
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Accountants and issuers should read and refer to the December 2001
Cautionary Guidance to determine the types of matters that should be
communicated to the audit committee under this rule. We are not
requiring that those discussions follow a specific form or manner, but
we expect, at a minimum, that the discussion of critical accounting
estimates and the selection of initial accounting policies will include
the reasons why estimates or policies meeting the criteria in the
Guidance are or are not considered critical and how current and
anticipated future events impact those determinations. In addition, we
anticipate that the communications regarding critical accounting
policies will include an assessment of management's disclosures along
with any significant proposed modifications by the accountants that
were not included.
2. Alternative Accounting Treatments
We recognize that the complexity of financial transactions results
in accounting answers that are often the subject of significant debate
between management and the accountants. Some commenters \208\ to the
proposed rules suggested that this rule be restricted to material
accounting alternatives. These commenters indicated that restricting
these communications will assist audit committee members by focusing
their attention on important accounting alternatives. One commenter
\209\ believes that only alternative treatments under GAAP that were
the subject of serious consideration and debate by the accountant and
management should be communicated to the audit committee.
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\208\ See, e.g., letter from Chamber of Commerce of the United
States of America, dated January 9, 2003; letter from Battelle &
Battelle LLP, dated December 20, 2002; letter from Eli Lilly and
Company, dated January 9, 2003; letter from Computer Sciences
Corporation, dated January 13, 2003; letter from
PricewaterhouseCoopers, dated January 8, 2003.
\209\ See, e.g., letter from Deloitte & Touche LLP, dated
January 10, 2003.
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We understand the concerns expressed and, accordingly, we have
clarified the final rule. Providing audit committees with information
on material accounting alternatives is consistent with the objectives
of the Act and will minimize the risk that audit committee members will
be distracted from material accounting policy matters by the numerous
discussions between the accountant and management on the application of
accounting principles to relatively small transaction or events.
Therefore, these rules require communication, either orally or in
writing, by accountants to audit committees of all alternative
treatments within GAAP for policies and practices related to material
items that have been discussed with management, including the
ramifications of the use of such alternative treatments and disclosures
and the treatment preferred by the accounting firm. This rule is
intended to cover recognition, measurement, and disclosure
considerations related to the accounting for specific transactions as
well as general accounting policies.
We believe that communications regarding specific transactions
should identify, at a minimum, the underlying facts, financial
statement accounts impacted, and applicability of existing corporate
accounting policies to the transaction. In addition, if the accounting
treatment proposed does not comply with existing corporate accounting
policies, or if an existing corporate accounting policy is not
applicable, then an explanation of why the existing policy was not
appropriate or applicable and the basis for the selection of the
alternative policy should be discussed. Regardless of whether the
accounting policy selected preexists or is new, the entire range of
alternatives available under GAAP that were discussed by management and
the accountants should be communicated along with the reasons for not
selecting those alternatives. If the accounting treatment selected is
not, in the accountant's view, the preferred method, we expect that the
reasons why the accountant's preferred method was not selected by
management also will be discussed.
Communications regarding general accounting policies should focus
on the initial selection of and changes in significant accounting
policies, as required by GAAS,\210\ and should include the impact of
management's judgments and accounting estimates, as well as the
accountant's judgments about the quality of the entity's accounting
principles. The discussion of general accounting policies should
include the range of alternatives available under GAAP that were
discussed by management and the accountants along with the reasons for
selecting the chosen policy. If an existing accounting policy is being
modified, then the reasons for the change also should be communicated.
If the accounting policy selected is not the accountant's preferred
policy, then we
[[Page 6029]]
expect the discussions to include the reasons why the accountant
considered one policy to be preferred but that policy was not selected
by management.
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\210\ See, AU Sec. 380.
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The separate discussion of critical accounting policies and
practices is not considered a substitute for communications regarding
general accounting policies, since the discussion about critical
accounting policies and practices might not encompass any new or
changed general accounting policies and practices. Likewise, this
discussion of general accounting policies and practices is not intended
to dilute the communications related to critical accounting policies
and practices, since the issues affecting critical accounting policies
and practices, such as sensitivities of assumptions and others, may be
tailored specifically to events in the current year, and the selection
of general accounting policies and practices should consider a broad
range of transactions over time.
3. Other Material Written Communications
We understand written communications between accountants and
management range from formal documents, such as engagement letters, to
informal correspondence, such as administrative items. We also
acknowledge that historically not all forms of written communications
provided to management have been provided to the audit committee. Our
rule is intended to implement Section 205 of the Sarbanes-Oxley Act,
which clarified the substance of information that should be provided by
accountants to audit committees to facilitate accountant and management
oversight by those committees.
The Sarbanes-Oxley Act specifically cites the management letter and
schedules of unadjusted differences as examples of material written
communications to be provided to audit committees. Examples of
additional written communications that we expect will be considered
material to an issuer include:
[sbull] Management representation letter; \211\
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\211\ See, SAS No. 85, ``Management Representations,'' AU Sec.
333.
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[sbull] Reports on observations and recommendations on internal
controls; \212\
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\212\ See, SAS 60, ``Communication of Internal Control Related
Matters Noted in an Audit,'' AU Sec. 325.
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[sbull] Schedule of unadjusted audit differences,\213\ and a
listing of adjustments and reclassifications not recorded, if any;
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\213\ See, SAS No. 89, ``Audit Adjustments,'' AU Sec. 333.
---------------------------------------------------------------------------
[sbull] Engagement letter; \214\ and
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\214\ See, SAS No. 83, ``Establishing an Understanding With the
Client,'' AU Sec. 310.
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[sbull] Independence letter.\215\
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\215\ See, SQCS No. 2, ``System of Quality Control for a CPA
Firm's Accounting and Auditing Practice,'' QC Sec. 20.
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These examples are not exhaustive, and accountants are encouraged
to critically consider what additional written communications should be
provided to audit committees.
4. Timing of Communications
Commenters \216\ generally agreed with our proposal that the
communications should occur prior to the filing of the issuer's
periodic annual report, although a commenter \217\ suggested that the
communications should occur throughout the period. The Act requires
that the communications be timely reported to the audit committee. For
purposes of the requirements of this provision, our rule specifies that
the communications between the accountant and the audit committee occur
prior to the filing of the audit report with the Commission pursuant to
applicable securities laws. As a result, these discussions will occur,
at a minimum, during the annual audit, but we expect that they could
occur as frequently as quarterly or more often on a real-time basis.
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\216\ See, e.g., letter from California Public Employees'
Retirement System, dated January 10, 2003; letter from Computer
Sciences Corporation, dated January 13, 2003; letter from American
Institute of Certified Public Accountants, dated January 9, 2003;
letter from PricewaterhouseCoopers, dated January 8, 2003.
\217\ See, e.g., letter from Lynn E. Turner, dated January 13,
2003.
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The timing of these communications is intended to occur before any
audit report is filed with the Commission pursuant to the securities
laws. We believe that this rule will ensure that these communications
occur prior to filing of annual reports and proxy statements, as well
as prior to filing registration statements and other periodic or
current reports when audit reports are included.
5. Investment Companies
The proposed rules would have required accountants to communicate
with an audit committee of an investment company all critical
accounting policies, alternative methodologies and other material
information before filing an audit report with the Commission. Although
commenters \218\ generally agreed that the information required to be
communicated was appropriate, the timing of such communications would
be problematic for investment companies. Commenters \219\ stated that
investment companies within an investment company complex frequently
have a common board of directors, but have staggered fiscal-year ends.
As a result, the proposed rules could require accountants to
communicate with audit committees as frequently as monthly. To
eliminate this burden, some commenters \220\ suggested these
discussions occur as infrequently as annually, with two commenters
\221\ suggesting updates for material changes. Another commenter \222\
suggested that we leave communication of these matters up to the
discretion of the investment company's audit committee and the
accountant.
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\218\ See, letter from The Vanguard Group, dated January 13,
2003; letter from Investment Company Institute, dated January 13,
2003; letter from PricewaterhouseCoopers, dated January 8, 2003.
\219\ See, e.g., letter from The Vanguard Group, dated January
13, 2003; letter from Investment Company Institute, dated January
13, 2003; letter from Ernst & Young, dated January 6, 2003.
\220\ See, letter from The Vanguard Group, dated January 13,
2003; letter from Investment Company Institute, dated January 13,
2003; letter from PricewaterhouseCoopers, dated January 8, 2003.
\221\ See, letter from Investment Company Institute, dated
January 13, 2003; letter from The Vanguard Group, dated January 13,
2003.
\222\ See, letter from Ernst & Young, dated January 6, 2003.
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We believe it is important to discuss critical accounting policies,
alternative methodologies, and other material information close to the
time when the audit report is filed. It is not our intention, however,
to have accountants communicate the same information to the audit
committee multiple times during the year. As adopted, the final rules
require the accountant to communicate to the audit committee of an
investment company annually, and if the annual communication is not
within 90 days prior to the filing, provide an update in the 90 day
period prior to the filing, of any changes to the previously reported
information.\223\
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\223\ The rule also would require communication of a description
of all non-audit services provided, including fees associated with
the services, to the investment company complex that were not
subject to the pre-approval requirements for investment companies as
discussed in Section II.D of this release.
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The adopted rules, in effect, would require an accountant of an
investment company complex where the individual funds have different
fiscal year ends to communicate the required information no more
frequently than four times during a calendar year. We believe this
should not place an undue burden on investment company audit committees
because many of the boards of directors
[[Page 6030]]
for investment companies meet on a quarterly basis.\224\
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\224\ Similarly, the accountant only would need to disclose
those non-audit services provided to the investment company complex
that they were engaged to perform during the intervening period
since their last communication, but for which pre-approval by the
investment company's audit committee was not required.
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H. Expanded Disclosure
To allow the issuer's investors to be better able to evaluate the
independence of the accountant, we believe that disclosures should be
made by issuers of the scope of services provided by its independent
public accountants. Section 202 of the Sarbanes-Oxley Act requires pre-
approval of all audit and non-audit services, with exceptions provided
for de minimis amounts under certain circumstances, as described in the
Act and in rules discussed previously in this release. The Sarbanes-
Oxley Act further requires disclosure in periodic reports of non-audit
services approved by the audit committee.
Current proxy disclosure rules require that a registrant disclose,
in the most recent fiscal year, the professional fees paid for both
audit and non-audit services to its principal independent accountant.
As a result of the requirements of Sarbanes-Oxley and partly in
response to public comment on the current proxy disclosures
requirements since their adoption in 2000, we proposed rules to change
both the types of fees that must be described and the number of years
for which the disclosures must be provided.\225\ The proposed rules
would have increased the disclosed categories of professional fees paid
for audit and non-audit services from three to four. The categories of
reportable fees proposed were: (1) Audit Fees, (2) Audit-Related Fees,
(3) Tax Fees, and (4) All Other Fees.\226\ The proposed disclosure
called for information to be provided for each of the two most recent
fiscal years, rather than just the most recent fiscal year. In
addition, we proposed that registrants be required to describe in
subcategories the nature of the services provided that are categorized
as audit-related fees and all other fees.
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\225\ See, proposed Item 9(e), Schedule 14A.
\226\ Previously, registrants were required to disclose only
``Audit Fees,'' ``Financial Systems Design and Implementation Fees''
and ``All Other Fees.''
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Our proposed changes to the proxy disclosure rules were intended to
clarify the categorization of services provided by the audit firm in
order to provide increased transparency for investors. Many commenters
\227\ favored the approach of our proposals, however, some commenters
\228\ requested clarification relating to the categorization of certain
types of services. For example, the discussion accompanying the
proposed rules stated that the ``tax fees'' category would capture all
services performed by professional staff in the independent
accountant's tax division. Thus, the proposed rules would have required
that the fees associated with the review by the tax partner of the tax
accrual during the audit be included within the ``tax services
category.'' However, as stated elsewhere in the proposing release, the
``audit services'' category should include services performed to
fulfill the accountant's responsibility under GAAS. Likewise, complex
accounting issues may require that the firm engage in consultation with
national office or other technical reviewers to reach an audit
judgment.
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\227\ See, e.g., letter from California Public Employees'
Retirement System, dated January 10, 2003; letter from The Business
Roundtable, dated January 13, 2003; letter from American Community
Bankers, dated January 13, 2003; letter from American Institute of
Certified Public Accountants, dated January 9, 2003; letter from
Financial Executives International's Committee on Corporate
Reporting, dated January 14, 2003.
\228\ See, e.g., letter from Eli Lilly and Company, dated
January 9, 2003; letter from KPMG, dated January 9, 2003; letter
from Deloitte & Touche, LLP, dated January 10, 2003.
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Some commenters \229\ generally agreed with the proposed categories
of services. Some,\230\ however, suggested modifications or
clarifications to the categories or reductions in the number of
categories. Additionally, some commenters suggested that the
disclosures should be provided for three years \231\ and others
suggested that they be provided for only one year.\232\
Our final rules retain the basic provisions of our proposals. In
response to the requests by commenters for clarification of the
categorization of services, we expect that all services performed to
comply with GAAS should be classified as ``audit services'' in
providing the disclosures. Certain services, such as tax services and
accounting consultations, may not be billed as audit services. However,
to the extent that such services are necessary to comply with GAAS, an
appropriate allocation of those fees may be included in the audit fee
category. We recognize, however, that some services may be difficult to
classify and we encourage issuers and their accountants to contact our
staff to discuss the appropriate classifications.
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\229\ See, e.g., letter from Ralph S. Saul, dated December 23,
2002; letter from Ernst & Young, dated January 6, 2003; letter from
Commercial Federal Corporation, dated January 13, 2003.
\230\ See, e.g., letter from Lynn E. Turner, dated January 13,
2003; letter from California Public Employees' Retirement System,
dated January 10, 2003; letter from Eli Lily and Company, dated
January 9, 2003; letter from American Bar Association, Sector of
Business Law, dated January 14, 2003.
\231\ See, e.g., letter from California Public Employees'
Retirement System, dated January 10, 2003; letter from California
Board of Accountancy, dated January 13, 2003; letter from Lynn E.
Turner, dated January 13, 2003.
\232\ See, e.g., letter from American Institute of Certified
Public Accountants, dated January 9, 2003; letter from Wells Fargo &
Company, dated January 13, 2003.
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Consistent with our proposal, we are adopting rules requiring
issuers to provide disclosures of fees paid to the independent
accountant segregated into the four previously-identified categories.
Additionally, other than for the audit category, the issuer is required
to describe, in qualitative terms, the types of services provided under
the remaining three categories. Also, consistent with our proposal,
this information is required for the two most recent years. Finally,
consistent with our proposal, this information must be provided either
in the issuer's proxy statement, or its periodic annual filing.
While the rules we are adopting continue to require issuers to
disclose fees paid to the principal accountant for audit services, we
are expanding the types of fees that should be included in this
category to include fees for services that normally would be provided
by the accountant in connection with statutory and regulatory filings
or engagements. In addition to including fees for services necessary to
perform an audit or review in accordance with GAAS,\233\ this category
also may include services that generally only the independent
accountant reasonably can provide, such as comfort letters, statutory
audits, attest services, consents and assistance with and review of
documents filed with the Commission.
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\233\ See also, Section 2(a)(2) the Sarbanes-Oxley Act which
defines the term ``audit.''
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We believe that the addition of a new category, ``Audit-Related
Fees,'' will enable registrants to present the audit fee relationship
with the principal accountant in a more transparent fashion. In
general, ``Audit-Related Fees'' are assurance and related services
(e.g., due diligence services) that traditionally are performed by the
independent accountant. More specifically, these services would
include, among others: employee benefit plan audits, due diligence
related to mergers and acquisitions, accounting consultations and
audits in connection with acquisitions, internal control reviews,
attest services that are not required by statue or regulation and
[[Page 6031]]
consultation concerning financial accounting and reporting standards.
We also believe it is appropriate to add transparency regarding a
second category of fees: ``Tax Fees.'' The review of a registrant's tax
returns and reserves is a task that often requires extensive knowledge
about the audit client. In many public companies, the fee for tax
services is substantial in relation to other services. We believe that
investors will benefit from being able to consider those fees
separately from the ``All Other Fees'' category. The ``Tax Fees''
category would capture all services performed by professional staff in
the independent accountant's tax division except those services related
to the audit as discussed previously. Typically, it would include fees
for tax compliance, tax planning, and tax advice. Tax compliance
generally involves preparation of original and amended tax returns,
claims for refund and tax payment-planning services. Tax planning and
tax advice encompass a diverse range of services, including assistance
with tax audits and appeals,\234\ tax advice related to mergers and
acquisitions, employee benefit plans and requests for rulings or
technical advice from taxing authorities.
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\234\ As discussed previously in this release an accountant's
independence is deemed to be impaired when representing the audit
client before a tax court, district court and U.S. federal court of
claims.
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The category of ``All Other Fees'' would remain unchanged from the
existing rule, except that to the extent that financial information
systems implementation and design exist they would be disclosed as a
component of ``All Other Fees.''
Consistent with our proposal, we also are requiring that the
information be provided for two periods so that investors will have
comparative information about the fees paid to the independent
accountant by the issuer.
As noted in our previous discussion about audit committee pre-
approval requirements, we have clarified the guidance on audit
committee pre-approval of services provided by the independent
accountant. Accordingly, the issuer must provide disclosure of the
audit committee's pre-approval policies and procedures. Additionally,
to the extent that the audit committee has applied the de minimis
exception discussed previously, the issuer must disclose the percentage
of the total fees paid to the independent accountant where the de
minimis exception was used. This information should be provided by
category.
We expect registrants to provide clear, concise and understandable
descriptions of the policies and procedures. Alternatively, registrants
could include a copy of those policies and procedures with the
information delivered to investors and filed with the Commission.
Either method should allow shareholders to obtain a complete and
accurate understanding of the audit committee's policies and
procedures. We expect the policies and procedures would address auditor
independence oversight functions in a prudent and responsible manner.
Additionally, these procedures would describe, if applicable, the
specific processes in place that monitor activities where the de
minimis exception is invoked.
Consistent with our proposal, we are requiring that the disclosures
be included in a company's annual report. However, because we believe
that this information is relevant to a decision to vote for a
particular director or to elect, approve or ratify the choice of an
independent public accountant, we are requiring that this disclosure be
included in a company's proxy statement on Schedule 14A or information
statement on Schedule 14C. Since the information is included in Part
III of annual reports on Forms 10-K and 10-KSB, domestic companies are
able to incorporate the required disclosures from the proxy or
information statement into the annual report.
Our intent is that this information be made available to investors
of all registrants. However, not all registrants are required to file
proxy statements. Thus, consistent with the provisions in the Act,
registrants that do not issue proxy statements are required to include
appropriate disclosures in their annual filing included in Form 10-K,
Form 10-KSB, 20-F, Form 40-F and Form N-CSR \235\ as appropriate. For
the reasons noted previously in this release, we are exempting asset-
backed issuers and unit investment trusts from these disclosure
requirements.
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\235\ We recently adopted Form N-CSR to be used by registered
management investment companies to file certified shareholder
reports with the Commission under the Sarbanes-Oxley Act of 2002.
---------------------------------------------------------------------------
With respect to investment companies, we proposed to require
investment companies to make disclosure that is similar to the
disclosure proposed for operating companies filing with the Commission.
The proposed rule required an investment company to disclose the audit
fees paid by the investment company to its accountant and the aggregate
fees paid for audit related, tax services, and other services to the
investment company's accountant by the investment company and its
investment adviser and any entity controlling, controlled by or under
common control with the adviser, that provides services to the
investment company. The proposed rule also required the disclosure of
the percentage, for each category presented, of fees which were subject
to: (1) Direct pre-approval; (2) pre-approval pursuant to policies and
procedures; and (3) pre-approval pursuant to the de minimis exception.
Lastly, the proposed rule would require these disclosures in the annual
report on proposed Form N-CSR and proxy and information statements.
Commenters \236\ generally raised several significant issues
related to the disclosure that would be required for investment
companies. Many commenters \237\ believed the fee disclosures should
only be required to be made for the services provided by the accountant
to the investment company registrant. One commenter \238\ suggested the
fees presented should be disclosed separately for those services
provided to the investment company directly and those provided to the
other entities in the investment company complex. Some commenters \239\
believed that only those fees required to be pre-approved by the
investment company's audit committee should be disclosed. Lastly, one
commenter \240\ expressed concern that providing percentage disclosure
by type of pre-approval method (i.e., direct, pursuant to policy and
procedures, or the de minimis exception) would imply that some of these
methodologies were improper.
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\236\ See, e.g., letter from Investment Company Institute, dated
January 13, 2003; letter from PricewaterhouseCoopers, dated January
8, 2003.
\237\ See, e.g., letter from KPMG, dated January 9, 2003; letter
from PricewaterhouseCoopers, dated January 8, 2003; letter from
Ernst & Young, dated January 6, 2003.
\238\ See, letter from Ernst & Young, dated January 6, 2003.
\239\ See, letter from PricewaterhouseCoopers, dated January 8,
2003; letter from Deloitte & Touche, dated January 10, 2003.
\240\ See, letter from Investment Company Institute, dated
January 13, 2003.
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After considering the comments, we do not believe that the fee
disclosures should be limited to only those fees paid directly by the
investment company registrant. We believe the fees paid by other
entities in the investment company complex can have a bearing on the
investment company accountant's independence. However, we are concerned
that the disclosures provide meaningful information to investors.
Consequently, we have determined to modify the proposed requirements.
Our final rule requires the investment company to disclose
separately those
[[Page 6032]]
audit and non-audit fees from services provided directly to the
investment company and those non-audit fees from services provided to
all other entities in the investment company complex where the services
were subject to pre-approval by the investment company's audit
committee. Like an operating company, the investment company would be
required to disclose the percentage of fees for each category of fees
that were pre-approved pursuant to the de minimis exception. The final
rules require disclosure of the total non-audit fees paid to the
accountant, regardless of whether those fees were pre-approved by the
investment company's audit committee, by the investment company, its
adviser, and any entity controlling, controlled by, or under common
control with the investment adviser that provides ongoing services to
the fund. The final rule also will require the investment company to
disclose if the audit committee has considered whether the provision of
non-audit services provided to the investment company's adviser and its
related parties that were not subject to the investment company audit
committee's pre-approval is compatible with maintaining the principal
accountant's independence.
These disclosure provisions are effective for periodic annual
filings for the first fiscal year ending after December 15, 2003. We
encourage issuers who have not previously issued their periodic annual
filings to adopt these disclosure provisions earlier.
I. International Impact
The Commission realizes that these rules will have an international
impact. It will affect foreign accounting firms that conduct audits of
both foreign private issuers and foreign subsidiaries and affiliates of
U.S. issuers. Through its participation in the International
Organization of Securities Commissions and bilateral meetings, and
through a roundtable held in Washington in December, the Commission has
made a concerted effort to obtain the views of the international
community of regulators, market participants and practitioners. Through
this process and public consultation, the Commission has received
valuable insight into various foreign regulatory regimes relating to
auditor independence, and detailed and specific comments on the
proposed rule.
The partner rotation requirements set forth in the proposed rule
were of particular concern to the international community. The
proposal, as mandated by the Act, called for the rotation of the lead
and concurring partners on a five-year basis. In addition, it precluded
these partners from returning to an audit of the same registrant for
five years. The proposal also applied the same rotation requirement to
all partners on the audit engagement team. Commentators noted that the
proposed requirements could have a particularly adverse impact in
foreign countries, especially in emerging countries, where there may be
a more limited pool of accountants and experts conversant in U.S. GAAP
and U.S. GAAS. Other commentators indicated that the proposed rotation
requirements would cause firms to rotate hundreds of partners in scores
of countries. The resulting widespread rotation would affect audit
quality adversely, and would be hard, if not impossible, to achieve
practically.
We are extending the partner rotation requirements beyond the lead
and concurring partners. However, taking into account these and other
comments, the rotation will not be applied as broadly as proposed. We
believe that partner rotation should be a function of the level of
responsibility for decisions on accounting and financial reporting
issues, and the level of interaction with senior management of an
issuer. Accordingly, under the final rule, the rotation requirement
will apply to partners that serve the client at the issuer or parent
level. It also will apply to the lead partner serving an issuer's
subsidiary whose revenues constitute 20% or more of the consolidated
assets or revenues of the parent. Partners serving subsidiaries whose
assets and revenues fall below the threshold are not subject to
rotation. The same is true for partners, other than lead partners,
serving subsidiaries above the threshold.
The international community also requested that the Commission
modify its approach to conflicts of interest resulting from employment
relationships. The Act requires a ``cooling off '' period of one year
before a member of the audit engagement team can work for a registrant
in certain key positions. Under the proposed rule, the restriction
applied with regard to employment by the issuer and its affiliates.
Some commentators stated that the rule should only apply to partners on
the audit engagement team. Commentators also indicated that extending
the requirement to apply with regard to key positions at the issuer and
its affiliates was overbroad, difficult to monitor, and possibly
impossible to control. Moreover, we have become aware that in certain
jurisdictions the labor law or jurisprudence would prohibit foreign
accounting firms from imposing restrictions on the future employment
opportunities of their personnel.
We agree that extending the requirement to the audit client might
be difficult to monitor particularly in situations where a member of
the audit engagement team begins employment with an affiliate of the
issuer. Further, we recognize that in certain foreign jurisdiction it
may be extremely difficult to comply with these requirements. In
response to the concerns raised, the cooling-off period will apply to
the lead, concurring partner or any other member of the audit
engagement team, unless exempted, who provides more than ten hours of
audit, review or attest services. The restriction on employment will
apply only with regard to key positions at the issuer. Members of the
audit engagement team, including those employed by a foreign accounting
firm, will be able to take positions with the subsidiaries or
affiliates of an issuer. They also may take key positions at the issuer
in certain circumstances and upon the approval of the audit committee
(or a similar body).
The Commission also has given consideration to comments regarding
foreign requirements with respect to the provision of appraisal and
valuation services. The Commission believes that the extension of these
services to audit clients raises concerns with respect to the auditor's
independence. The Commission is, therefore, eliminating some exemptions
previously provided in this area. However, we understand that laws and
regulations in certain foreign countries require auditors to provide
contribution-in-kind reports or valuation services. The Commission has
historically addressed conflicts between U.S. and foreign requirements
regarding non-audit services on an ad hoc basis. Commission staff has
previously afforded relief from proscriptions against appraisal and
valuation services where, among other things, the auditor and issuer
were able to demonstrate that the auditor was not providing an opinion
on the fairness of a given transaction. The Commission will continue to
take this ad hoc approach, and will continue to consider requests for
exemptive relief from foreign auditors.
Finally, several foreign commentators noted that a prohibition on
legal services could amount to a prohibition on the provision of tax
services by foreign accounting firms from particular jurisdictions. It
would appear that in certain jurisdictions tax services are defined as
legal services and can only be rendered by persons licensed to practice
law. The Commission is making clear that foreign accounting firms can
[[Page 6033]]
provide tax services, as appropriate, despite their local definition
and local licensing requirements.
The Commission is mindful of the fact that this rule may overlap
with foreign requirements designed to achieve auditor independence. The
Commission has taken foreign requirements into account, and afforded
accommodations to foreign accounting firms in a manner and to the
extent consistent with the spirit and intent of the Act. As the rule is
implemented, the Commission, as well as the PCAOB, will monitor its
international impact and continue to dialogue with its foreign
counterparts.
III. Paperwork Reduction Act
Certain provisions of our final amendments contain ``collection of
information'' requirements within the meaning of the Paperwork
Reduction Act of 1995 (``PRA'').\241\ We published a notice requesting
comment on the collection of information requirements in the proposing
release for the rule amendments, and we submitted these requirements to
the Office of Management and Budget (``OMB'') for review in accordance
with the PRA.\242\ The titles for the collection of information are:
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\241\ 44 U.S.C. 3501 et seq.
\242\ 44 U.S.C. 3507(d) and 5 CFR 1320.11.
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(1) ``Proxy Statements--Regulation 14A (Commission Rules 14a-1
through 14a-15 and Schedule 14A)'' (OMB Control No. 3235-0059);
(2) ``Information Statements--Regulation 14C (Commission Rules 14c-
1 through 14c-7 and Schedule 14C)'' (OMB Control No. 3235-0057);
(3) ``Form 10-K'' (OMB Control No. 3235-0063);
(4) ``Form 10-KSB'' (OMB Control No. 3235-0420);
(5) ``Form 20-F'' (OMB Control No. 3235-0288);
(6) ``Form 40-F'' (OMB Control No. 3235-0381);
(7) ``Regulation S-X'' (OMB Control No. 3235-0009); and
(8) ``Form N-CSR'' (OMB Control No. 3235-0570).
These regulations and forms were adopted pursuant to the Securities
Act, the Exchange Act and the Investment Company Act and set forth the
disclosure requirements for periodic reports, registration statements
and proxy and information statements filed by companies to ensure that
investors are informed. The hours and costs associated with preparing,
filing and sending these forms constitute reporting and cost burdens
imposed by each collection of information. An agency may not conduct or
sponsor, and a person is not required to respond to, a collection of
information unless it displays a currently valid OMB control number.
Compliance with the requirements will be mandatory. There will be no
mandatory retention period for the information disclosed, and responses
to the requirements will not be kept confidential.
Regulation S-X is the central repository for rules related to the
form and content of financial statements with the Commission.
Regulation S-X, however, does not direct registrants to file financial
statements or to collect financial data. Regulation S-X indicates what
should be in the financial statements and how financial statements
should be presented when they are required to be filed by other rules
and forms under the securities laws. Burden hours and costs associated
with the preparation of financial statements in accordance with
Regulation S-X are allocated to the rules or forms that require the
financial statements to be filed. Because Regulation S-X does not
require any information to be filed with the Commission, we previously
have assigned one burden hour to Regulation S-X for administrative
convenience to reflect the fact that this regulation does not impose
any direct burden on companies.
A. Summary of Amendments
1. Communication With Audit Committees
As required by Section 204 of the Sarbanes-Oxley Act, we are
amending Regulation S-X to require each public accounting firm
registered with the Board that audits an issuer's financial statements
to report to the issuer's or investment company's audit committee: (1)
All critical accounting policies and practices used by the issuer, (2)
all material alternative accounting treatments within GAAP that have
been discussed with management, including the ramifications of the use
of the alternative treatments and the treatment preferred by the
accounting firm, (3) other material written communications between the
accounting firm and management of the issuer such as any management
letter or schedule of ``unadjusted differences,'' and (4) in the case
of registered investment companies, all non-audit services provided to
certain entities in the investment company complex that were not pre-
approved by the investment company's audit committee. The required
reports need not be in writing but the report is required to be
presented to the audit committee before the auditor's report on the
financial statements is filed with the Commission.\243\
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\243\ See, Release No. 33-8040, Dec. 12, 2001 (66 FR 65013). In
this release the Commission provided cautionary advice regarding
disclosure about critical accounting policies. See also, Release No.
33-8098, May 10, 2002, (67 FR 35620). In this release the Commission
proposed rules to require disclosures that would enhance investors'
understanding of the application of companies' critical accounting
policies. The proposed disclosures would focus on accounting
estimates a company makes in applying its accounting policies and
the initial adoption by a company of an accounting policy that has a
material impact on its financial presentation.
---------------------------------------------------------------------------
2. Disclosures of Audit and Non-Audit Services
Item 9 of Schedule 14A requires the disclosure of certain
information regarding the registrant's relationship with the
independent auditor of the company's financial statements when there is
a solicitation relating to: (1) A meeting at which directors to the
company's board of directors are to be elected (or the solicitation of
consents or authorizations in lieu of such a meeting) or (2) the
election of the auditor, or the approval or ratification of the
company's selection of the auditor. We are amending paragraph (e) of
Item 9 to provide more detailed information regarding the categories of
fees paid by the registrant to the auditor and to inform investors
about the critical role that audit committees play in assuring the
auditor's independence. We believe that the disclosure will allow
investors to better assess an auditor's independence and certain
activities of an audit committee.
Item 9(e) previously required disclosure of fees billed by the
auditor in the last fiscal year, with the fees broken down into three
categories: audit fees, financial information systems design and
implementation fees, and all other fees. The final rules add disclosure
of two categories (tax fees and audit-related fees), while eliminating
one category (financial information systems design and implementation),
and require disclosure of one more past year of each of these fees.
Because these fees are already being disclosed, repeating the prior
year's disclosures for comparison purposes should not increase
significantly a registrant's compliance burden. In addition, breaking
tax fees and audit-related fees out of the ``all other'' category of
fees currently being disclosed should not result in any significant
incremental burden.
With respect to investment companies, the final rules also will
require disclosure of all non-audit fees paid to the investment
company's
[[Page 6034]]
accountant by any entity in the investment company complex and whether
the audit committee has considered those non-audit services in
evaluating the auditor's independence from the investment company.
Since these disclosures exist in some form currently, there should be
no significant incremental disclosure burden.
Under the final rules, registrants also will be required to
disclose any policies and procedures adopted by an audit committee to
be followed for pre-approval of services to be performed by the
accounting firm in the event that the audit committee does not
expressly pre-approve the particular engagements.\244\ In addition, the
final rules require registrants to disclose what percentage of fees in
each of the categories noted above (audit, audit-related, tax, and
other) relate to engagements for which the pre-approval requirement was
waived under the de minimis exception.\245\
---------------------------------------------------------------------------
\244\ 17 CFR 210.2-01(c)(7)(A) and (B).
\245\ 17 CFR 210.2-01(c)(7)(C).
---------------------------------------------------------------------------
Some companies that file Forms 10-K or 10-KSB are not subject to
the proxy disclosure requirements. These companies, therefore, now will
be required to present the required disclosures in the Form 10-K or 10-
KSB. Foreign private issuers that file Form 20-F and Canadian companies
that file Form 40-F generally are not subject to the proxy disclosure
requirements and, therefore, will be required to present the required
disclosures on Form 20-F or Form 40-F. Some investment companies do not
regularly file proxy or information statements. These investment
companies will, therefore, now be required to disclose this information
in the investment company's annual report on Form N-CSR.
B. Summary of Comment Letters and Revisions to Proposals
We requested comment on the PRA analysis contained in the proposing
release. Two commenters responded generally that they believed the
burden estimates seemed unrealistic.\246\ However, neither commenter
provided supporting data, revised burden hour estimates or other
information to support their views. One of these commenters believed
that the 25% allocation to outside professionals was unrealistically
low.\247\ As we have mentioned in many recent releases, we believe that
the allocation of 75% of the burden to internal staff and 25% of the
burden to outside professionals accurately reflects current practice
for proxy and information statements and annual reports for domestic
issuers.\248\ In particular, the disclosure requirements regarding
principal accountant's fees should involve information that already is
readily available to internal staff of the registrant. We have not
concluded that our burden hour estimates for purposes of the Paperwork
Reduction Act should be changed, although we will continue to monitor
registrant response to our burden hour estimates.
---------------------------------------------------------------------------
\246\ See, e.g., letter from Deloitte & Touche LLP, dated
January 10, 2003; letter from Lynn E. Turner, dated January 13,
2003.
\247\ See, e.g., letter from Deloitte & Touche LLP, dated
January 10, 2003.
\248\ See, e.g., Release No. 33-8098, May 10, 2002, (67 FR
35620); Release No. 33-8106, Jun. 17, 2002, (67 FR 42914); Release
No. 33-8124, Aug. 28, 2002, (67 FR 57276); Release No. 33-8128,
Sept. 5, 2002, (67 FR 58480); Release No. 33-8138, Oct. 22, 2002,
(67 FR 66208); Release No. 33-8144, Nov. 4, 2002, (67 FR 68054);
Release No. 34-46778, Nov. 6, 2002, (67 FR 69430); Release No. 33-
8154, Dec. 2, 2002, (67 FR 76780); Release No. 33-8160, Dec. 10,
2002, (67 FR 77594); and Release No. 33-8173, Jan. 8, 2003.
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In addition, we have made several revisions to the proposals.
However, we do not believe these changes will significantly change our
previous estimates of the burden on registrants from the amendments.
1. Communication With Audit Committees
We have made one change to the proposed rules concerning
communication with audit committees. We proposed rules that would have
required public accounting firms performing the audit for an issuer or
investment company to report to the audit committee of the issuer or
investment company, prior to the filing of such audit with the
Commission, all alternative treatments of financial information within
GAAP that have been discussed with management of the issuer or
investment company. In response to commenters, the final rules only
require reporting of material alternative treatments of financial
information within GAAP that have been discussed with management of the
issuer or investment company. This change should aid in focusing the
reports to audit committees on important matters and not dilute the
usefulness with discussion of less important matters. With respect to
investment companies, we have added a requirement to disclose all non-
audit services provided to the investment company complex that were not
pre-approved by the investment company's audit committee. However, we
are changing the requirement to discuss these matters from before each
filing, which could have been as frequent as monthly, to annually, with
an update, if necessary.
2. Disclosures of Audit and Non-Audit Services
We have made three minor changes in response to commenters'
concerns regarding the rules requiring disclosure of audit and non-
audit services. The first change clarifies the audit fee category to
specifically include services that normally are provided by the
accountant in connection with statutory and regulatory filings. The
second change relates to tax fees and specifies that registrants will
be required to describe each subcategory of services comprising the
fees disclosed under the ``tax fees'' category, similar to the
requirement for the ``audit-related fees'' category. Finally, the third
change relates to the requirement to disclose the percentage of audit
fees, audit-related fees, tax fees, and all other fees that were
approved by the audit committee. The proposed rule would have required
this disclosure for all fees derived from engagements that were: (1)
Approved by the issuer's or investment company's audit committee before
the accountant was engaged by the issuer or investment company, (2)
entered into pursuant to pre-approval policies and procedures
established by the audit committee of the issuer or investment company,
provided the audit committee was informed of each service, and (3) for
which the pre-approval requirement was waived under the de minimis
exception. The final rules will only require disclosure of the
percentage of audit fees, audit-related fees, tax fees, and all other
fees for which the pre-approval requirement was waived under the de
minimis exception.
With respect to investment companies, we have made three changes to
the rule. The first change requires the fund to disclose all non-audit
fees paid by entities in the investment company complex only to the
extent those non-audit services relate to the operations or financial
reporting of the investment company. The second change requires
investment companies to disclose the aggregate non-audit fees paid to
the auditor by any entity in the investment company complex. The third
change requires the investment company to disclose if the audit
committee has considered whether the provision of non-audit services by
the accountant to the investment company complex is compatible with
maintaining the accountant's independence.
[[Page 6035]]
C. Revisions to Reporting and Burden Estimates
1. Communication With Audit Committees
As discussed in the proposing release, we believe that GAAS
currently require discussions between the auditors and the audit
committee of significant unusual, controversial, or emerging accounting
policies, of the process used by management to select certain
estimates, and of disagreements with management over certain accounting
matters.\249\ We further believe that audit committees generally are
aware of management's letter making representations to the auditors,
which the auditor uses in completing the audit of the issuer's
financial statements.\250\ Audit committees also should be aware of
``unadjusted differences,'' \251\ if any, as a result of the enactment
of Section 401 of the Sarbanes-Oxley Act, which added Section 13(i) to
the Securities Exchange Act of 1934 (``Exchange Act'').\252\ Under new
Section 13(i) of the Exchange Act, therefore, there should be no
material ``unadjusted differences.'' In the case of investment
companies, we believe auditors already are reporting non-audit services
provided to the investment company complex annually and some routinely
provide more frequent updates at the request of the audit
committee.\253\ Because of these GAAS and legal provisions, we believe
that the final rules regarding auditor reports to audit committees will
not increase significantly the burden hours on accounting firms or
registrants.
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\249\ See, SAS 61, ``Communication with Audit Committees or
Others with Equivalent Authority and Responsibility,'' AU Sec. 380.
\250\ SAS No. 85, ``Management Representations,'' AU Sec. 333.
\251\ See, SAS No. 89, ``Audit Adjustments,'' AU Sec. 333.
\252\ Each financial report that contains financial statements,
and that is required to be prepared in accordance with (or
reconciled to) generally accepted accounting principles under this
title and filed with the Commission shall reflect all material
correcting adjustments that have been identified by a registered
public accounting firm in accordance with generally accepted
accounting principles and the rules and regulations of the
Commission.
\253\ See, Independence Standards Board, ``Independence
Discussions with Audit Committees,'' Independence Standard No. 1
(Jan. 1999).
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2. Disclosures of Audit and Non-Audit Services
While we have made some modifications to the proposals relating to
disclosure of audit and non-audit services, we do not believe these
changes will have a significant effect on the total amount of burden
hours for preparing the forms. Accordingly, we believe that our
estimates of the burden articulated in the proposing release have not
changed as a result of modifications contained in the final rules.
a. Proxy and Information Statements. We estimate that the
incremental disclosure changes would impose, on average, two additional
burden hours on each of the 7,661 filers of Schedule 14A, or an
aggregate 15,322 additional burden hours. We further estimate that
approximately 75% of the extra burden hours, or approximately 11,492
hours, would be expended by internal staff and the remaining 25%, or
3,830 hours, would be expended by outside professionals who are
retained by the filer. Assuming that outside professional costs would
be an average of $300 per hour, the aggregate annual professional costs
would be $1,149,000. Similarly, we estimate that these disclosures
would impose, on average, two additional burden hours on each of the
464 filers of Schedule 14C, or an aggregate 928 additional burden
hours. Using the same allocation of hours and cost estimate of
professional fees as for Schedule 14A, we estimate that 696 hours would
be expended by internal staff and the remaining 232 hours would be for
outside professional assistance, producing an outside professional cost
of $69,600.
b. Annual Reports on Form 10-K. We estimate that the incremental
disclosure changes will impose, on average, two additional burden hours
per year on each of the 8,484 filers of Form 10-K. 6,676 of those
filers, however, will provide the information under Schedule 14A and
209 of those filers would provide the information under Schedule
14C.\254\ The burden hours for the disclosure by these filers therefore
have been assigned to Schedule 14A and Schedule 14C, respectively. The
burden imposed on the remaining 1,599 filers is being assigned to Form
10-K. This results in 3,198 (2 hours x 1,599 filers) additional burden
hours for Form 10-K. We further estimate that approximately 75% of the
extra burden hours, or approximately 2,399 hours, will be expended by
internal staff and the remaining 25%, or 799 hours, will be expended by
outside professionals. Assuming that outside professional costs average
$300 per hour, the estimated aggregate annual professional costs are
$239,700.
---------------------------------------------------------------------------
\254\ These numbers are obtained by reviewing the number of
filers that filed a Form 10-K and Schedule 14A or Schedule 14C,
respectively, between October 1, 2001 and September 30, 2002.
---------------------------------------------------------------------------
c. Annual Reports on Form 10-KSB. We estimate that the incremental
disclosure changes will impose, on average, two additional burden hours
per year on each of the 3,820 filers of Form 10-KSB. 985 of those
filers, however, will provide the information under Schedule 14A and
255 of those filers will provide the information under Schedule 14C.
The burden hours for the disclosure by these filers have been assigned
to Schedule 14A and Schedule 14C, respectively. The burden imposed on
the remaining 2,580 filers is being assigned to Form 10-KSB. This
results in 5,160 (2 hours x 2,580 filers) additional burden hours. We
further estimate that approximately 75% of the extra burden hours, or
approximately 3,870 hours, will be expended by internal staff and the
remaining 25%, or 1,290 hours, will be expended by outside
professionals. Assuming that outside professional costs average $300
per hour, the estimated aggregate annual professional costs are
$387,000.
d. Annual Reports by Foreign Private Issuers on Form 20-F. We
estimate that the incremental disclosure changes will impose, on
average, two additional burden hours per year on each of the 1,194
filers of Form 20-F, or 2,388 additional burden hours. We further
estimate that approximately 25% of the extra burden hours, or
approximately 597 hours, will be expended by internal staff and the
remaining 75%, or 1,791 hours, will be expended by outside professional
costs associated with reviewing the disclosures because this form is
prepared by foreign private issuers who rely more heavily on outside
counsel for assistance. Assuming that outside professional costs
average $300 per hour, the estimated aggregate annual professional
costs are $537,300.
e. Reports by Certain Canadian Issuers on Form 40-F. We estimate
that the incremental disclosure changes will impose, on average, two
additional burden hours per year on each of the 134 filers of Form 40-
F, or 268 additional burden hours. Consistent with our treatment of
foreign private issuers filing Form 20-F, we further estimate that
approximately 25% of the extra burden hours, or approximately 67 hours,
will be expended by internal staff and the remaining 75%, or 201 hours,
will be expended by outside professionals. Assuming that outside
professional costs average $300 per hour, the estimated aggregate
annual professional costs are $60,300.
f. Form N-CSR. We estimate that the additional disclosure changes
will impose, on average, 1.5 additional burden hours per year on each
of the anticipated 3,700 filers of Form N--CSR. This results in 5,550
(1.5 hours x 3,700 filers) additional burden hours. We
[[Page 6036]]
estimate that the cost of these burden hours is $81 per hour, resulting
in aggregate internal costs of $449,550.\255\ Further, we estimate that
this additional disclosure will require 0.5 hours in professional
review by outside counsel at an average rate of $300 per hour,
resulting in an estimated aggregate annual outside professional costs
of $555,000.
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\255\ See, Securities Industry Association, Report on Management
& Professional Earnings in the Securities Industry 2002 (2002).
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IV. Cost--Benefit Analysis
We are sensitive to the costs imposed by and benefits derived from
our rules, and we have identified certain costs and benefits of these
rules. Additionally, certain of these costs are imposed by
Congressional mandate through the enactment of the Sarbanes-Oxley Act.
A. Background
The Sarbanes-Oxley Act was enacted on July 30, 2002. Title II to
that Act adds Sections 10A(g) through 10A(l) to the Securities Exchange
Act of 1934 (``Exchange Act'') and requires that the Commission, within
180 days of enactment, adopt rules to carry out each of those
sections.\256\
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\256\ Section 208(a) of the Sarbanes-Oxley Act of 2002.
---------------------------------------------------------------------------
The final rules:
[sbull] Revise the Commission's regulations related to the non-
audit services that, if provided to an audit client, would result in
the accounting firm being deemed to lack independence with respect to
the audit client; \257\
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\257\ See, Section 201 of the Sarbanes-Oxley Act.
---------------------------------------------------------------------------
[sbull] Require that an issuer's audit committee pre-approve all
audit and non-audit services provided to the issuer by the independent
accountant; \258\
---------------------------------------------------------------------------
\258\ See, Section 202 of the Sarbanes-Oxley Act.
---------------------------------------------------------------------------
[sbull] Prohibit certain partners on the audit engagement team from
providing audit services to the issuer for more than five or seven
consecutive years, depending on the partner's involvement in the audit
(smaller accounting firms may be exempted from this requirement); \259\
---------------------------------------------------------------------------
\259\ See, Section 203 of the Sarbanes-Oxley Act.
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[sbull] Prohibit an accounting firm from auditing an issuer's
financial statements if a person in a financial reporting oversight
role of that issuer had been a member of the accounting firm's audit
engagement team within the one-year period preceding the commencement
of audit procedures; \260\
---------------------------------------------------------------------------
\260\ See, Section 206 of the Sarbanes-Oxley Act.
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[sbull] Require that the auditor of an issuer's financial
statements report certain matters to the issuer's audit committee,
including ``critical'' accounting policies and practices used by the
issuer; \261\ and
---------------------------------------------------------------------------
\261\ See, Section 204 of the Sarbanes-Oxley Act.
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[sbull] Require disclosures to investors of information related to
audit and non-audit services provided by, and fees paid by the issuer
to, the auditor of the issuer's financial statements.\262\
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\262\ See, generally, Section 202 of the Sarbanes-Oxley Act;
Section 10A(i)(2) of the Exchange Act, 15 U.S.C. 78j-1(i)(2).
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In addition, under the final rules, an accountant will be deemed to
be not independent from an audit client if any ``audit partner''
receives compensation based directly on selling engagements to that
client other than audit, review, or attest services. We have narrowed
the final rule by exempting accounting firms with fewer than ten
partners and fewer than five audit clients from this provision.\263\
While many of the final rules respond directly to the provisions of
Title II of the Sarbanes-Oxley Act, certain of the rules go beyond the
specific provisions of the Act. These provisions include:
---------------------------------------------------------------------------
\263\ See, e.g., letter from U.S. Small Business
Administration's Office of Advocacy, January 13, 2002.
---------------------------------------------------------------------------
[sbull] Applying the partner rotation rules to additional ``audit
partners``;
[sbull] Applying the one-year cooling off period to persons in a
financial reporting oversight role with the issuer; and
[sbull] Prohibiting an accounting firm from compensating an audit
partner for directly selling non-audit services to an audit client.
B. Potential Benefits of the Final Rules
Potential benefits resulting from the final amendments include
increased investor confidence in the independence of accountants, in
the audit process, and in the reliability of reported financial
information. As discussed below, clearer auditor independence
regulations should provide investors with comfort that auditors are
placing the interests of investors over financial or personal
incentives. The final rules mandating that accountants communicate
certain matters to audit committees should benefit investors by
enhancing the opportunities for meaningful audit committee oversight of
the financial reporting process. Investors also will benefit from the
enhanced disclosure of the non-audit services provided by, and fees
paid to, the accounting firm that audits the company's financial
statements, and from better disclosure of the audit committee's role in
approving the provision of audit and non-audit services by the
accounting firm that audits the company's financial statements. We
believe that these factors could improve the efficiency of the markets
and result in a lower cost of capital.
1. Auditor Independence
The amendments are intended to facilitate the independence of the
accountant from management in the following ways:
[sbull] Providing clearer definition of the types of non-audit
services that would be deemed to impair an auditor's independence;
[sbull] Requiring that each engagement of the accountant to perform
audit or non-audit services for the company be pre-approved by the
audit committee, which serves as the representative of investors;
[sbull] Requiring the ``rotation'' of ``audit partners'' on the
audit engagement team to assure a periodic fresh look at the accounting
and auditing issues related to the issuer's financial statements;
[sbull] Providing that the accountant's independence would be
deemed to be impaired if an ``audit partner'' is compensated directly
for selling non-audit services or products to an audit client. This
provision should mitigate the concerns that an accountant might be
viewed as compromising accounting judgments in order not to jeopardize
the potential for increased income from the act of selling non-audit
services to the audit client; and
[sbull] Requiring a ``cooling off'' period between working on the
audit engagement team and joining the client in a ``financial reporting
oversight role'' in order to assure that personal relationships and the
new member of management's knowledge of the audit plan do not
negatively impact the audit process.
Strengthening auditor independence should provide investors with
more confidence that the accountants are playing their ``gatekeeper''
role related to companies'' financial reporting and provide further
assurance that the financial condition, results of operations, and cash
flows of companies are fairly reflected in their financial reports
thereby allowing public companies less costly access to the capital
markets.
The final rules specify that ``audit partners'' who are compensated
for cross-selling non-audit services are deemed to be not independent
with respect to the audit client. This will further enhance the
independence of the audit function since the audit partner's focus will
be on the conduct of the audit rather than on efforts to sell other
engagements to the audit client. The
[[Page 6037]]
danger inherent in compensating audit partners for cross-selling non-
audit services is that it might create a temptation for accountants to
compromise the quality of the audit in order to maintain their
relationship with management to whom they wish to cross-sell such
services.
2. Auditor Reports to Audit Committees
The final rules require that each public accounting firm registered
with the Board that audits an issuer's financial statements report
specified information to the issuer's audit committee, including: (1)
All critical accounting policies and practices used by the issuer, (2)
all material alternative accounting treatments within GAAP that have
been discussed with management, (3) other material written
communications between the accounting firm and management of the
issuer, such as any management letter or schedule of ``unadjusted
differences,'' and (4) in the case of registered investment companies,
all non-audit services provided to entities in the investment company
complex that were not pre-approved by the investment company's audit
committee.
The report by the Senate Committee on Banking, Housing, and Urban
Affairs on the bill that later became the foundation for the Sarbanes-
Oxley Act, in addressing the need for such reports from the accountant
to the audit committee, stated, in part:
The Committee believes that it is important for the audit
committee to be aware of key assumptions underlying a company's
financial statements and of disagreements that the auditor has with
management. The audit committee should be informed in a timely
manner of such disagreements, so that it can independently review
them and intervene if it chooses to do so in order to assure the
integrity of the audit.\264\
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\264\ Report of the Senate Committee on Banking, Housing, and
Urban Affairs, ``Public Company Accounting Reform and Investor
Protection Act of 2002,'' Senate Report 107-205, 107th Cong., 2d
Sess., at 21 (July 3, 2002).
Almost eight months before passage of the Sarbanes-Oxley Act, in
December 2001, we issued cautionary advice regarding the disclosure in
the Management's Discussion and Analysis \265\ section of its annual
report of those accounting policies that management believes are most
critical to the preparation of the issuer's financial statements.\266\
As part of that cautionary advice, we stated:
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\265\ Item 303 of Regulation S-K (17 CFR 229.303), which
requires disclosure about, among other things, trends, events or
uncertainties known to management that would have a material impact
on reported financial information.
\266\ Release No. 33-8040, Dec. 12, 2001, (66 FR 65013).
Prior to finalizing and filing annual reports, audit committees
should review the selection, application and disclosure of critical
accounting policies. Consistent with auditing standards, audit
committees should be apprised of the evaluative criteria used by
management in their selection of the accounting principles and
methods. Proactive discussions between the audit committee and the
company's senior management and auditor about critical accounting
policies are appropriate.\267\
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\267\ Id. (footnotes omitted).
Communications with the audit committee about such policies
facilitate the audit committee's oversight of the financial reporting
process. Investors should benefit by the audit committee being better
informed and, thus, in a position to better challenge what it may view
as non-typical, aggressive, or improper applications of GAAP used by
management to enhance or manipulate reports of the company's financial
results or financial condition.
3. Enhanced Disclosures About the Services Provided by Auditors to
Registrants
Investors will receive more detailed information about:
[sbull] Any policies and procedures adopted by an audit committee
for pre-approving audit and non-audit services provided by the
independent accountant,
[sbull] The fees paid by the registrant to the accountant in each
of the last two years for audit, audit-related, tax, and all other
services,\268\ and
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\268\ In the case of an investment company, the investors will
receive this information for the investment company registrant and
separately, for all other entities in the investment company complex
where the services were subject to pre-approval by the investment
company's audit committee.
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[sbull] The percentage of fees in each of those categories where
the audit committee used the de minimis exception.
These disclosures will provide greater transparency to investors of
certain aspects of the auditor-client relationship. Providing better,
more complete information in cases where non-audit services occur
allows investors to determine for themselves whether there are concerns
related to the auditor's independence. It also may allow investors to
ask more direct and useful questions of management and directors
regarding their decisions to engage the accountants for such services.
C. Potential Costs of the Final Rules
1. Auditor Independence
Changes in our auditor independence rules may impose costs on
accounting firms and on any issuers that engage, or would like to
consider engaging, the accountant of an issuer's financial statements
to perform non-audit services.
a. Non-audit services. According to the information available to
the staff in 2000, approximately 12,600 registrants did not purchase
any consulting services from the auditor of their financial statements,
and 4,100 registrants reported purchasing such services.\269\ Based on
the scrutiny that these services have received over the past year, the
Commission believes that the number of companies purchasing non-audit
services from their accountant might have decreased further.
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\269\ Id.; 65 FR at 43185.
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The current auditor independence rules state that the performance
of certain non-audit services will be deemed to impair an auditor's
independence. The final rules, in some cases, redefine those services
and add one more item, ``expert services,'' to the list of prohibited
services. These changes may impact the competitive markets for these
services. Audit clients are precluded from engaging their independent
accountants to perform services in the categories of bookkeeping
services, financial systems design and implementation services,
appraisal and valuation services, actuarial services, internal audit
outsourcing services, management functions, human resources, broker-
dealer, investment adviser or investment banking services, legal
services and expert services. These companies may incur costs from
having to use a separate vendor for such services resulting in the
possible loss of any benefits of having a single provider for both
audit and non-audit services. Companies also may incur costs in
locating a new vendor and developing a business relationship with that
vendor. In addition, companies may incur costs from not being able to
retain their preferred provider of non-audit services, if that
preferred provider is their independent accountant. The difference in
value between a preferred provider and a second choice may be
substantial, particularly if the preferred provider has relatively rare
service offerings or service offerings that are particularly well
suited to the needs of the company.
The final rules may cause accountants to lose one or more sources
of revenue because they will no longer be able to
[[Page 6038]]
sell certain non-audit services to their audit clients. Additionally,
accounting firms may incur additional costs to market these services
with non-audit clients as well as additional learning costs to
familiarize themselves with the operations of those non-audit clients.
Finally, to the extent that there exist economies of scope in the
provision of audit and non-audit services (as, for example, through the
use of shared knowledge management systems and other infrastructure)
and to the extent that the preclusion of certain non-audit services to
audit clients results in the exit of personnel who provide such
services from accounting firms, there may be an increase in the cost of
both audit and non-audit services.
We believe, however, that in view of the statements by the largest
four accounting firms, and others, that they no longer intend to
provide internal audit outsourcing services and financial system design
and implementation services to audit clients,\270\ the cost associated
with the adoption of the final rules may be limited. Also, to the
extent that the provision of non-audit services is merely redistributed
among the firms, there would be no net loss of revenue to public
accounting firms as a whole.
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\270\ Report of the Senate Committee on Banking, Housing, and
Urban Affairs, ``Public Company Accounting Reform and Investor
Protection Act of 2002,'' Senate Report 107-205, 107th Cong., 2d
Sess., at 18 (July 3, 2002). See also letter from HarborView
Partners LLC, dated December 4, 2002.
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b. Audit Committee Pre-approval of Services. Under the final rules,
all auditing and non-audit services to be provided by the independent
accountant must be pre-approved by the issuer or investment company's
audit committee.\271\ There may be incremental costs associated with
audit committees performing this function. Such costs might include
more frequent committee meetings, an increased workload on audit
committee members, and having the audit committee's legal counsel
review the audit committee's draft policies and procedures for engaging
the independent accountants for non-audit services. The increased
burden on audit committee members might result in the need to increase
their compensation, resulting in additional costs to issuers or
investment companies. Some of these costs may be mitigated by the
provisions in the Act and the final rules that allow the audit
committee to delegate to one or more audit committee members the
authority to grant pre-approvals of these services.\272\
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\271\ Section 301 of the Sarbanes-Oxley Act of 2002 requires the
Commission to direct the national securities exchanges and national
securities associations to prohibit the listing of any security of
an issuer that does not meet certain criteria, including having an
audit committee that performs certain functions. See Section 10A(m)
of the Exchange Act, 15 U.S.C. 78j-1(m), and Release No. 33-8173
(Jan. 8, 2003). The Sarbanes-Oxley Act defines ``audit committee''
to be ``(A) a committee (or equivalent body) established by and
amongst the board of directors of an issuer for the purpose of
overseeing the accounting and financial reporting processes of the
issuer and audits of the financial statements of the issuer; and (B)
if no such committee exists with respect to an issuer, the entire
board of directors of the issuer.'' Section 205(a) of the Sarbanes-
Oxley Act, which, among other things, adds Section 3(a)(58) to the
Exchange Act.
\272\ Section 202 of the Sarbanes-Oxley Act; Section 10A(i)(3)
of the Exchange Act, 15 U.S.C. 78j-1(i)(3).
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Inadvertent violations of the Act and the final rules that would
add to the costs of the rules also may be mitigated by the de minimis
exception to the pre-approval requirement.\273\ This exception applies
if: (1) The aggregate amount of the non-audit services is not more than
five percent of the total amount of revenues paid by the issuer to the
accountant during the fiscal year in which the non-audit services were
provided,\274\ (2) at the time of the engagement the issuer did not
recognize the services to be non-audit services, and (3) the services
are approved by the audit committee prior to the completion of the
audit.\275\
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\273\ Section 202 of the Sarbanes-Oxley Act; Section
10A(i)(1)(B) of the Exchange Act, 15 U.S.C. 78j-1(i)(1)(B).
\274\ In the case of an investment company, the five percent
threshold is calculated based on the services provided to the
investment company complex that were subject to the pre-approval
requirements for the investment company's audit committee.
\275\ Id.
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We also believe that as a result of the Commission's audit
committee disclosure requirements adopted in 1999,\276\ prior
disclosures related to the involvement of the audit committee in
recommending or approving changes in independent accountants and the
resolution of disagreements between management and the
accountants,\277\ and professional standards that require
communications between the accountant and the audit committee on
auditor independence and other issues,\278\ many companies currently
have audit committees that carefully evaluate the engagement of
accountants to perform non-audit services. Accordingly, we believe that
the incremental costs associated with these rules will not be
substantial.
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\276\ Item 306 of Regulation S-K (17 CFR 229.306), and Item 306
of Regulation S-B (17 CFR 228.306); see generally, Release No. 34-
42266, Dec. 22, 1999, (64 FR 73389). These disclosure requirements
are discussed supra, in Section II.C. of this release.
\277\ Item 4 of Form 8-K, 17 CFR 249.308 and Item 304 of
Regulation S-K, 17 CFR 229.304, which require disclosure of
``whether the decision to change accountants was recommended or
approved by: (A) Any audit or similar committee of the board of
directors, if the issuer has such a committee; or (B) the board of
directors, if the issuer has no such committee'' and ``whether any
audit or similar committee of the board of directors, or the board
of directors, discussed the subject matter of each of such
disagreements with the former accountant * * *.'' Item
304(a)(1)(iii)(A), (iii)(B), and (iv)(B). 17 CFR
229.304(a)(1)(iii)(A), (iii)(B) and (iv)(B). For small business
issuers, Item 304(a)(1)(iii) of Regulation S-B, 17 CFR
228.304(a)(1)(iii) requires disclosure of ``whether the decision to
change accountants was recommended or approved by the board of
directors or an audit or similar committee of the board of
directors.''
\278\ See, e.g., SAS No. 61, as amended by SAS No. 89 and No.
90, ``Communications With Audit Committees,'' AU Sec. 380;
Independence Standards Board, ``Independence Discussions with Audit
Committees,'' Independence Standard No. 1 (Jan. 1999).
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c. Rotation of Partners on the Audit Engagement. Under the final
rules, no ``audit partner'' will serve on an audit engagement team for
more than seven consecutive years, and the ``lead'' and ``concurring''
partners will be prohibited from serving for more than five consecutive
years. Current professional requirements state that the ``lead''
partner should be replaced at least once every seven years.\279\ The
proposed rules would have required any partner on the audit engagement
team of an issuer and its significant subsidiaries to rotate after five
years. Many commenters believed that the reach of the proposal was too
deep, particularly for individuals that have limited participation in
the audit. The final rules require fewer partners to rotate than under
the proposal. Under the final rules, the lead partner, who has primary
responsibility for the audit, along with the concurring partner, must
rotate after five years. Other audit partners at the issuer,\280\ or a
subsidiary of the issuer whose assets or revenues constitute 20% or
more of the consolidated assets or revenues of the issuer must rotate
after seven years. Accounting firms with fewer than five audit clients
and fewer than ten partners may be exempted from the partner rotation
requirements if the Board conducts a special review of each of the
firm's audit engagements for audit clients at least once every three
years. In total, the final rule expands the rotation requirements to
cover a greater number of partners than under the current professional
requirements.
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\279\ See, AICPA, SEC Practice Section, Requirements of Members,
at item e. The membership requirements are available online at
http://www.aicpa.org/members/div/secps/require.htm.
\280\ In the case of investment companies, other audit partners
would include all audit partners working on an investment company
registrant.
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A number of commenters expressed concern that under the proposed
rules many small accounting firms would be unable to meet the partner
rotation requirements and may be driven out of
[[Page 6039]]
business, potentially burdening the ability of smaller companies to
retain auditors and access the public markets. We have attempted to
mitigate this effect by providing an exemption for smaller accounting
firms in the final rules.\281\
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\281\ According to data provided by the SECPS, out of 767
accounting firms with audit clients, 462 firms are eligible for the
exemption from partner rotation.
---------------------------------------------------------------------------
Without the exemption, clients of many of the smaller accounting
firms would have to change auditors every five years because their
incumbent auditor would not be able to meet the partner rotation
requirements. This would have imposed marketing and client-specific
learning costs on the accounting firms and costs on clients to
familiarize the new accountant with their operations.
Costs associated with the periodic replacement of partners might
include more frequent company-specific training, conducted by both the
accounting firm and the audit client, as new partners join the audit
engagement team. For example, the new partners will need to learn the
company's accounting and financial reporting procedures, controls and
familiarize themselves with key personnel. The final rules also might
result in incremental costs related to some partners being required to
travel extensively, relocate from one part of the country to another,
or from one country to another.\282\
The costs related to these rules will vary based on the proximity
of an accounting firm's audit clients, the concentration of the firm's
practice within an industry, and the availability of partners to whom
the work may be redistributed, and similar factors. We note that these
costs may be passed on to issuers in the form of higher audit fees.
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\282\ For example, one commenter estimated that on certain large
engagements, the proposed rotation requirements would result in an
average annual incremental cost of $1,250,000; see, letter from
Deloitte & Touche LLP dated January 10, 2003. Another commenter
estimated the cost to be as much as $2,000,000 per year for large
registrants; see, letter from KPMG dated January 9, 2003.
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Had the proposed rules been adopted, another potential impact would
have been the impact on the specialization of accounting firms within
each industry. To minimize partners' costs of learning new businesses,
accounting firms have an incentive to specialize in certain industries.
This, potentially, could have had the effect of creating oligopolies
within each industry and could have adversely affected competition
among accounting firms.
d. One-Year Cooling Off Period. The final rules indicate that an
accounting firm is deemed to be not independent with respect to an
audit client if a former member of the audit engagement team is
employed by the issuer in a ``financial reporting oversight role''
unless the individual had not been a member of the audit engagement
team during the one year period preceding the initiation of the
audit.\283\
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\283\ In the case of investment companies, the cooling off
period would extend not only to positions at the investment company,
but also to positions at any entity in the investment company
complex that is directly responsible for the operations or financial
reporting of the investment company.
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Currently, when a former professional employee of an accounting
firm joins an audit client within one year of leaving the firm, and the
individual has significant interaction with the accounting firm's audit
engagement team, professional standards require the accounting firm to
perform procedures to assure that the individual's knowledge of, or
relationships with, the accounting firm do not adversely influence the
quality of the audit.\284\ These procedures include modifying the audit
plan to adjust for the risk that the individual would be able to
circumvent key aspects of the audit, and assuring that the people on
the audit engagement team have the stature and objectivity not to be
influenced by their former partner or co-employee and to have the
appropriate level of skepticism when evaluating the individual's
representations and views.
---------------------------------------------------------------------------
\284\ Independence Standards Board, ``Employment with Audit
Clients'' Independence Standard No. 3 (July 2000).
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Costs might occur, however, from the company being required to
delay the hiring, or not being able to hire, the individual that it
believes is the most qualified person to perform a ``financial
reporting oversight role'' at the company. This may add to recruitment
costs or result in less efficient operations. Such costs are difficult
to estimate and vary from one company to another. However, in response
to several commenters' concerns regarding the reach of the proposed
rules, the final rules limit the prohibitions based on the individual's
role on the audit engagement team. These costs might be ameliorated in
unusual circumstances due to the exception provided for emergency and
unusual circumstances.
e. Compensation. The final rules provide that an accountant is
deemed to be not independent with respect to an audit client if any
``audit partner'' earns or receives compensation in consideration of
directly selling engagements to provide any services to that client
other than audit, review or attest services. The final rules differ
from the proposed rules in three notable respects. First, the proposed
rules also would have provided that any accountant is not independent
with respect to an audit client if an audit partner earns or receives
compensation based on the selling or performance of engagements with an
audit client to provide any products or services other than audit,
review or attest services. The final rule applies only to compensation
based on the direct selling of engagements in the independence
determination. Second, several commenters noted that, as proposed, the
rules would have precluded a ``specialty'' partner from receiving
compensation when he or she sold services in his or her specialty area.
The final rules address this concern because they apply to ``audit
partners'' rather than all partners who are members of the audit
engagement team. Third, several commenters indicated the compensation
rules might be particularly difficult for smaller accounting firms. To
address this concern, the final rules include an exemption for
accounting firms with fewer than five audit clients and fewer than ten
partners.
Despite these revisions, the provision might affect the
compensation plans of those firms that currently reward audit partners
of the firm for selling non-audit services to their audit clients. The
final rules may result in those revenues being allocated to other
persons within the accounting firm. Absent this incentive, auditors may
be less inclined to inform issuers of ways to improve their performance
or condition through non-audit services. We do not expect, however,
that there would be any incremental costs to the firm or to the client.
2. Auditor Reports To Audit Committees
The final rules are identical to those proposed, with two
exceptions. The proposed rules would have required accounting firms to
report to audit committees all alternative accounting treatments within
GAAP that have been discussed with management, including the
ramifications of the use of the alternative treatments and the
treatment preferred by the accounting firm. The final rules only
require accounting firms to report material alternative treatments,
which should aid in focusing the reports to audit committees. The final
rules add a specific requirement related to investment companies that
requires auditors to disclose to the investment company's audit
committee all non-
[[Page 6040]]
audit fees paid to the accountant by any entity in the investment
company complex that was not subject to pre-approval by the investment
company's audit committee.
Because of existing GAAS and legal provisions,\285\ we believe that
the final rules regarding accountants' reports to audit committees will
not significantly increase costs for accounting firms or registrants.
Any such costs may arise from the timing of the communications,\286\
which must occur before the auditor's report is filed with the
Commission. We also believe limiting the reporting requirement to only
material alternative treatments will reduce unnecessary costs. The
required reports need not be in writing, but the report is required to
be presented to the audit committee before the auditor's report is
filed with the Commission.
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\285\ See, Item 303 of Regulation S-K, 17 CFR 229.303; Release
No. 33-8040 (Dec. 12, 2001); and SAS 61, ``Communication with Audit
Committees or Others with Equivalent Authority and Responsibility,''
AU Sec. 380.
\286\ An investment company's auditor will only be required to
communicate this information to the audit committee annually, unless
there have been changes from the previously-reported information and
the annual communication was completed more than 90 days prior to
the filing. This should reduce the cost for investment companies to
comply with this requirement.
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3. Enhanced Disclosures About the Services Provided by Auditors to
Registrants
The existing proxy disclosure rules require disclosure of all
professional fees billed by the principal auditor in the last fiscal
year, with the fees broken down into three categories: audit fees,
financial information systems design and implementation fees, and all
other fees. The final rules divide the disclosure into two more
categories--tax fees and audit-related fees--and add disclosure of one
more year of these fees while eliminating separate disclosure of fees
related to financial information systems design and
implementation.\287\ The final rules also require companies that do not
file proxy statements to file this information with the Commission in
their annual reports on Forms 10-K and 10-KSB, foreign private issuers
to file the information on Form 20-F, certain Canadian issuers to file
the information on Form 40-F, and registered management investment
companies to file the information on Form N-CSR.\288\
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\287\ In the case of investment companies, the investors will
receive this information for the investment company registrant and
separately, for all other entities in the investment company complex
where the services were subject to pre-approval by the investment
company's audit committee.
\288\ Form 10-K is the annual report that registrants file with
the Commission pursuant to Section 13 or 15(d) of the Exchange Act,
if no other annual reporting form has been prescribed. Small
business issuers may use abbreviated Form 10-KSB. A ``small business
issuer'' is an entity that (1) has revenues of less than
$25,000,000, (2) is a U.S. or Canadian issuer, (3) is not an
investment company, and (4) if a majority owned subsidiary, the
parent corporation is also a small business issuer. An entity is not
a ``small business issuer,'' however, if the aggregate market value
of its outstanding voting and non-voting common stock held by non-
affiliates is $25,000,000 or more. See, 17 CFR 240.12b-2. Registered
management investment companies would use Form N-CSR to file
certified shareholder reports with the Commission under the
Sarbanes-Oxley Act of 2002.
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Registrants also are required to disclose the audit committee's
policies and procedures for approval of services provided by the
accounting firm, and the percentage of fees in each of the four
categories noted above (audit, audit-related, tax, and all other) where
the audit committee used the de minimis exception to the pre-approval
requirements.\289\
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\289\ With respect to investment companies, the final rules also
will require disclosure of all non-audit fees paid to the investment
company's accountant by all entities in the investment company
complex, and whether the audit committee considered those non-audit
services in evaluating the auditor's independence with respect to
the investment company.
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Based on the staff's experience, we believe that the additional
disclosure contemplated by the final rules will require, on average,
approximately one-half of a page in a company's proxy statement or
annual report. Accordingly, we believe the additional printing costs
from these additional disclosures will be small.
Using estimates derived from our Paperwork Reduction Act analysis,
we estimate that the incremental impact of the disclosure changes will
result in a total cost of $5,862,400 for all affected filers. The
estimate is based on the burden hour estimates calculated under the
Paperwork Reduction Act. For purposes of the Paperwork Reduction Act,
we estimate that the additional disclosure will result in 26,678
internal burden hours and $2,999,400 in external costs. Assuming a cost
of $125/hour for in-house professional staff (and $40 per hour for
internal staff review for Form N-CSR), the total cost for the internal
burden hours would be $2,863,000.\290\ Hence the aggregate cost
estimate is $5,862,400 ($2,863,000 + $2,999,400).
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\290\ The $125/hour cost estimate is based on data obtained from
The SIA Report on Management and Professional Earnings in the
Securities Industry (Oct. 2001).
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4. Transition
In response to the concerns of several commenters, we are providing
a transition period for several of the requirements of the final rules.
A transition period helps to alleviate the immediate impact of any
costs and burdens that may be imposed on certain registrants and their
accounting firms. A transition period may even help reduce costs as
registrants and accounting firms will have additional time to adjust
their processes and procedures to the new requirements.
V. Consideration of Burden on Competition, and Promotion of Efficiency,
Competition, and Capital Formation
Section 23(a)(2) of the Exchange Act \291\ requires the Commission,
when adopting rules under the Exchange Act, to consider the anti-
competitive effects of any rule it adopts. In addition, Section 2(b) of
the Securities Act of 1933,\292\ Section 3(f) of the Exchange Act,\293\
and Section 2(c) of the Investment Company Act \294\ require the
Commission, when engaging in rulemaking that requires it to consider or
determine whether an action is necessary or appropriate in the public
interest, to consider whether the action will promote efficiency,
competition, and capital formation.
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\291\ 15 U.S.C. 78w(a)(2).
\292\ 15 U.S.C. 77b(b).
\293\ 15 U.S.C. 78c(f).
\294\ 15 U.S.C. 80a-2(c).
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The rules prohibit the independent accounting firm from providing
certain non-audit services for their audit clients. These rules,
therefore, could result in some companies seeking new accounting firms
for non-audit services permitted under our previous rules, but not
allowed under the Sarbanes-Oxley Act and the final rules. This may have
an impact on competition for those services, although to the extent the
new vendor is another accounting firm, the result may redistribute
services among firms rather than an increase or decrease in services.
The proposed rules may have disadvantaged smaller accounting firms
because of the partner rotation requirements, since smaller firms may
not have other partners available to continue providing audit services
to the client. We have modified the final rules to mitigate this
concern. Under the final rules, accounting firms with fewer than five
audit clients and fewer than ten partners may be exempted from the
audit partner rotation and compensation requirements.
One possible adverse impact on capital formation may come from
additional costs related to audit committees. Although the final rules
do
[[Page 6041]]
not require companies to have audit committees, many companies may
choose to establish such committees to facilitate the pre-approval
requirements of the rules. Additional costs may be associated with
forming such committees and, if necessary, recruiting and retaining
directors to serve on those committees. One commenter noted that the
costs to maintain audit committees may increase due to additional
meetings required, increased compensation for members due to the
increased time demands, and increased director's and officer's
insurance premiums due to increased liability of audit committee
members. While the rules may increase the number of meetings required
and the time demands of audit committee members, we believe a properly
functioning audit committee should enhance the quality and
accountability of the financial reporting process and help increase
investor confidence, which results in increased efficiency and
competitiveness of the U.S. capital markets.
Investors' confidence in the independence of auditors and in the
integrity of the financial information fuels our securities markets.
These rules are designed to bolster investor confidence in the
securities markets by strengthening auditor independence, improving the
transparency of the role of corporate audit committees, and enhancing
the reliability and credibility of financial statements of public
companies. Accordingly, on the whole, we believe the final rules will
promote capital formation and market efficiency.
VI. Final Regulatory Flexibility Act Analysis
This Final Regulatory Flexibility Act Analysis has been prepared in
accordance with 5 U.S.C. 603. It relates to revisions to Regulation S-X
and to Item 9 of Schedule 14A, and to Forms 10-K, 10-KSB, 20-F, 40-F
and N-CSR. The rules strengthen the Commission's requirements regarding
the independence of auditors, audit committee pre-approval of services
provided by the independent accountant and related disclosures, and
auditor communications with the audit committee.
A. Reasons for the Rule Amendments
The rules generally implement a congressional mandate. Some of the
amendments, although not specifically required by the statute, are
designed to implement the intent of the Sarbanes-Oxley Act. The rules
are intended to provide greater assurance to investors that independent
auditors are performing their public responsibilities.
The rules, in general:
[sbull] Revise the Commission's regulations related to the non-
audit services that, if provided to an audit client, will impair an
accounting firm's independence;
[sbull] Require that an issuer's audit committee pre-approve all
audit and non-audit services provided to the issuer by the auditor of
an issuer's financial statements;
[sbull] Prohibit certain partners on the audit engagement team from
providing audit services to the issuer for more than five or seven
consecutive years, depending on the partner's involvement in the audit,
except that certain small accounting firms may be exempted from this
requirement;
[sbull] Prohibit an accounting firm from auditing an issuer's
financial statements if certain members of management of that issuer
had been members of the accounting firm's audit engagement team within
the one-year period preceding the commencement of audit procedures;
[sbull] Require that the auditor of an issuer's financial
statements report certain matters to the issuer's audit committee,
including ``critical'' accounting policies used by the issuer; and
[sbull] Require disclosures to investors of information related to
audit and non-audit services provided by, and fees paid to, the auditor
of the issuer's financial statements.
[sbull] Provide that an accountant will not be independent from an
audit client if an audit partner received compensation based on selling
engagements to that client for services other than audit, review and
attest services, except that the rules exempt certain small accounting
firms from this requirement.
B. Objectives
Our objectives in implementing Title II of the Sarbanes-Oxley Act
are to increase investor confidence in the independence of auditors, in
the audit process, and in the reliability of reported financial
information. The rules accomplish these objectives by having: (1)
Clearer auditor independence regulations that will assure investors
that auditors are placing the interests of investors over financial or
personal incentives, (2) rules mandating that auditors communicate
certain matters to audit committees which should enhance the
opportunities for meaningful audit committee oversight of the financial
reporting process, and (3) enhanced disclosure of the non-audit
services provided by, and fees paid to, the accounting firm that audits
the company's financial statements and disclosure of the audit
committee policies for pre-approving the provision of non-audit
services by the accounting firm that audits the company's financial
statements. We believe that these factors will improve the efficiency
of the markets and result in a lower cost of capital.
C. Significant Issues Raised by Public Comment
Several commenters indicated that the partner rotation and
compensation rules might be particularly difficult for small accounting
firms to implement. They stated that if the rotation requirements were
applied to small accounting firms, many of these firms would be unable
to provide audit services to their public clients and would be forced
to give them up. They further suggested a number of accommodations for
small issuers and small firms including: exempting the firms based on
criteria such as number of partners, number of SEC clients, firm
revenue, or number of professional personnel; and exempting accountants
of small issuers as measured by revenue, assets, market capitalization
or profitability.
The U.S. Small Business Administration's Office of Advocacy
(``Advocacy'') was among the commenters recommending that the
Commission include a small firm exemption from the audit partner
rotation requirements. Advocacy stated that the exemption would ensure
that small issuers would not incur marked increases in audit costs. It
also expressed the concern that small issuers retaining the services of
accounting firms that previously were exempt from audit rotation
requirements may no longer be able to retain such firms if the firms
lose the exemption and decline to offer audit services as a result.
Advocacy asserted that if the small issuers then have to engage the
services of larger firms, the costs incurred by these companies would
increase due to the need of the new firms to familiarize themselves
with the issuers' industries and business practices. Advocacy further
stated that an effect of the elimination of small firms from the
competitive market for audit services and market consolidation would be
an increase in audit prices because of larger firms' gain in power over
pricing.
The final amendments provide an alternative application for small
accounting firms to address commenters' concerns. Under the final
rules, accounting firms with fewer than five audit clients that are
issuers and fewer than ten partners may qualify for the exemption from
partner rotation, but
[[Page 6042]]
the Board must conduct a special review of all of the firm's
engagements subject to the rule at least once every three years. This
special review should focus on the overall quality of the audit, and in
particular, the independence and competence of the key personnel on the
audit engagement teams. Additionally, accounting firms with fewer than
five audit clients that are issuers and fewer than ten partners are
exempt from the compensation requirements.
D. Small Entities Subject to the Rules
The rules affect smaller registrants and smaller accounting firms.
Exchange Act Rule 0-10(a) \295\ and Securities Act Rule 157 \296\
define a company to be a ``small business'' or ``small organization''
if it had total assets of $5 million or less on the last day of its
most recent fiscal year. We estimate that approximately 2,500
companies, other than investment companies, are small entities.
---------------------------------------------------------------------------
\295\ 17 CFR 240.0-10(a).
\296\ 17 CFR 230.157.
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For purposes of the Investment Company Act, Rule 0-10 \297\ defines
a ``small business'' as an investment company complex \298\ with net
assets of $50 million or less as of the end of its most recent fiscal
year. We estimate that approximately 225 investment companies meet this
definition.
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\297\ 17 CFR 270.0-10.
\298\ The definition of a ``small business'' also includes a
``unit investment trust'' and a ``business development company.''
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Our rules do not define ``small business'' or ``small
organization'' for purposes of accounting firms. The Small Business
Administration defines small business, for purposes of accounting
firms, as those with under $6 million in annual revenues. We have only
limited data indicating revenues for accounting firms, and we cannot
estimate the number of firms with less than $6 million in revenues that
practice before the Commission. We requested comment on the number of
accounting firms with revenue under $6 million. Advocacy provided
information indicating that a great majority of the 51,645 accounting
firms in the United States have less than $6 million in revenue.\299\
Advocacy noted that the U.S. Census does not classify the firms
according to revenue, but obtained average per-firm revenue through
publicly available IRS tax return information. According to Advocacy,
IRS data indicates that in 1998, there were 46,407 tax returns for
accounting firms organized as corporations.\300\ Advocacy concluded
that, of the firms captured by the IRS data, 99.18% (46,025) would
likely qualify as small businesses because they had less than $3
million in receipts, and a further 318 corporate filers were reported
to have an average of $5.7 million in receipts, indicating that the
majority of these firms also had less than $6 million in revenues.
Since fewer than 1,000 firms \301\ provide audit services to issuers,
it is uncertain how many of those firms qualify as small businesses.
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\299\ Advocacy cited recent U.S. Census Statistics. See, Bureau
Of The Census, U.S. Department Of Commerce, ``Statistics Of U.S.
Business,'' 1998 (NAICS Code 541211).
\300\ See, IRS, ``1998 Corporation Source Book Of Statistics Of
Income, Income Tax Returns of Active Corporations with Accounting
periods ended July 1998 Through June 1999,'' Minor Industry 541215
(1998).
\301\ Data provided by the SEC Practice Section of the AICPA.
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E. Reporting, Recordkeeping and Other Compliance Requirements
1. Auditor Independence
The vast majority of registrants are audited by one of the four
largest accounting firms, which clearly are not small entities.
Nonetheless, changes in the auditor independence regulations may impose
compliance requirements, recordkeeping and reporting requirements on
smaller accounting firms and on any smaller registrant that engages, or
would like to consider engaging, the auditor of an issuer's financial
statements to perform non-audit services.
(a) Non-audit services. These auditor independence rules state that
the performance of certain non-audit services will impair an auditor's
independence. The rules, in some cases, redefine the limits of those
non-audit services and add an additional item, ``expert services,'' to
the previous list of prohibited services. These changes could impact
the competitive markets for these services. In particular, the
Commission is withdrawing the specific exemption in the current rules
that allows audit clients with less than $200 million in total assets
to engage the auditors of their financial statements to perform
internal audit outsourcing services.\302\ Under these rules, small
issuers also are precluded from engaging the independent accountants to
perform services in the categories of financial systems design and
implementation services, appraisal and valuation services, actuarial
services, and others, that could have been performed under the previous
rules. Smaller registrants, therefore, may have to use a separate
vendor for such services. Smaller accounting firms may lose one or more
sources of revenue because they no longer will be able to sell certain
non-audit services to their audit clients.
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\302\ 17 CFR 210.2-01(c)(4)(v)(A).
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According to the information available to the staff in 2000,
however, approximately 12,600 registrants did not purchase any
consulting services from the auditor of their financial statements, and
4,100 registrants reported purchasing such services.\303\ Based on the
attention that non-audit services have received in the past year, the
Commission staff believes that the number of smaller registrants
purchasing non-audit services from their auditors, and the number of
smaller accounting firms providing a significant amount of non-audit
services to audit clients that are Commission registrants, might have
decreased. Also, to the extent non-audit services are merely
redistributed among the firms, there will be no net loss of revenue to
public accounting firms as a whole.
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\303\ Id.; 65 FR at 43185.
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(b) Audit Committee Pre-Approval of Services. Under the rules, all
audit and non-audit services to be provided by the auditor of an
issuer's financial statements must be pre-approved by the issuer's
audit committee.\304\ The definition of audit committee in the
Sarbanes-Oxley Act, which is cited in the rules, however, indicates
that if no such committee exists, the entire board of directors of the
issuer may perform this function.\305\ The rules, therefore, do not
require a small company to form an audit committee.
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\304\ In the case of investment companies, all non-audit
services provided by the auditor to an entity in the investment
company complex that relate to the operations or financial reporting
of the investment company must be pre-approved by the audit
committee of the investment company.
\305\ Section 301 of the Sarbanes-Oxley Act of 2002 requires the
Commission to direct the national securities exchanges and national
securities associations to prohibit the listing of any security of
an issuer that does not meet certain criteria, including having an
audit committee that performs certain functions. See, Section 10A(m)
of the Exchange Act, 15 U.S.C. 78j-1(m). The Sarbanes-Oxley Act
defines ``audit committee'' to be ``(A) a committee (or equivalent
body) established by and amongst the board of directors of an issuer
for the purpose of overseeing the accounting and financial reporting
processes of the issuer and audits of the financial statements of
the issuer; and (B) if no such committee exists with respect to an
issuer, the entire board of directors of the issuer.'' Section
205(a) of the Sarbanes-Oxley Act, among other things, adds Section
3(a)(58) to the Exchange Act.
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There are reasons to believe that many smaller entities currently
have audit committees.\306\ Any smaller entity that does not have such
a committee and forms one to facilitate operation of the rules,
however, will incur costs to establish such a committee and, if
necessary, to recruit and retain the required number of independent
[[Page 6043]]
directors. Smaller entities also may spend time and incur costs to
document the audit committee's activities in the areas covered by the
rules, including drafting and maintaining the audit committee's
policies and procedures related to engaging the auditor to perform non-
audit services. Moreover, small entities may incur costs in seeking the
help of outside experts, particularly outside legal counsel, in
drafting the audit committee's policies and procedures.
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\306\ See, e.g., NACD, 2001-2002 Public Company Governance
Survey (Nov. 2001).
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(c) Rotation of Partners on the Audit Engagement. Under the rules,
certain partners may not serve on an audit engagement team for more
than five or seven years, depending on the partner's involvement in the
audit. Current professional requirements state that the lead partner
should be replaced after serving in that capacity for seven years.\307\
The rules, therefore, require more partners to be rotated and the lead
partner to be rotated more frequently.
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\307\ See, AICPA, SEC Practice Section, Requirements of Members,
at item e. The membership requirements are available online at
http://www.aicpa.org/members/div/secps/require.htm. In its comment
letter, Advocacy stated its belief that there are approximately 460
audit firms in the United States providing audit services to 765
smaller reporting companies who are currently exempt from the AICPA
audit partner rotation requirements.
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Potential costs associated with the periodic replacement of
partners include more frequent company-specific training because new
partners joining the audit engagement team will need to learn the
company's accounting and financial reporting procedures, controls and
familiarize themselves with key personnel. The rules also may result in
incremental costs related to some partners being required to relocate.
In response to concerns expressed by commenters, the final rules
allow accounting firms with fewer than five audit clients and fewer
than ten partners to be exempted from the rotation requirement.
(d) One-Year Cooling Off Period. The rules deem an accounting firm
to be not independent with respect to an audit client if a former
member of the audit engagement team begins employment in a ``financial
reporting oversight role'' at that issuer if the individual had been a
member of the audit engagement team within the one-year period
preceding the initiation of the audit.\308\ A ``financial reporting
oversight role'' is a role in which a person is in a position to or
does influence the contents of financial statements or anyone who
prepares them.\309\ Such persons include directors, chief executive
officers, chief financial officers, chief accounting officers,
controllers, and others.
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\308\ In the case of investment companies, the cooling off
period extends not only to positions at the investment company, but
also to positions at any entity in the investment company complex
that is directly responsible for the operations or financial
reporting of the investment company.
\309\ See, Rule 2-01(f)(3)(ii) of Regulation S-X.
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A smaller registrant may incur costs from a delay in hiring, or not
being able to hire, the individual that it believes is the most
qualified person to perform a ``financial reporting oversight role'' at
the company. This may add to recruitment costs or less efficient
operations.
(e) Compensation. Under the rules, an accounting firm's
independence will be deemed to be impaired if any audit partner
receives compensation based on directly selling to an audit client
services other than audit, review and attest services. Thus, accounting
firms will have to discontinue compensating these individuals for
``cross-selling'' services.
Some smaller accounting firms may have a relatively small number of
partners, available to serve each client. Such firms may not have
personnel, other than the partner in charge of the smaller company's
audit with sufficient expertise to market and provide non-audit
services to that company. In recognition of the special issues
associated with smaller firms, the final rules provide that accounting
firms with fewer than five audit clients and fewer than ten partners
may be exempted from the compensation rule.
2. Auditor Reports to Audit Committees
Under the rules, each public accounting firm registered with the
Board that audits an issuer's financial statements must report to the
issuer's audit committee (1) all critical accounting policies and
practices used by the issuer, (2) all material alternative accounting
treatments within GAAP that have been discussed with management,
including the ramifications of the use of the alternative treatments
and the treatment preferred by the accounting firm, (3) other material
written communications between the accounting firm and management of
the issuer such as any management letter or schedule of ``unadjusted
differences,'' and (4) in the case of registered investment companies,
all non-audit services provided to entities in the investment company
complex that were not pre-approved by the investment company's audit
committee. The required reports need not be in writing, but must be
provided to the audit committee before the auditor's report on the
financial statements is filed with the Commission.\310\
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\310\ In the case of investment companies, the auditors are
required to discuss these matters with the audit committee annually,
with an update, if necessary.
---------------------------------------------------------------------------
GAAS currently require discussions between the auditors and the
audit committee of significant unusual, controversial, or emerging
accounting policies, of the process used by management to select
certain estimates, and of disagreements with management over certain
accounting matters. Further, audit committees generally are aware of
management's letter making representations to the auditors, which the
auditor uses in conducting the audit of the issuer's financial
statements, and the auditor's letters to management on reportable
conditions in internal controls and other matters. Also, due to
enactment of Section 401 of the Sarbanes-Oxley Act, all material
adjustments identified by the auditor should be reflected in the
issuer's financial statements and, therefore, there should be no
material ``unadjusted differences.'' In the case of investment
companies, we believe auditors already are reporting non-audit services
provided to the investment company complex annually and some routinely
provide more frequent updates at the request of the audit committee.
Because of these GAAS and legal provisions, we believe that
adoption of the rules regarding auditor reports to audit committees
will not significantly increase costs, including costs for smaller
accounting firms and smaller registrants. Some costs may be incurred,
however, to the extent communications are required before the auditor's
report is filed with the Commission.
3. Enhanced Disclosures About the Services Provided by Auditors to
Registrants
Currently, disclosure is required in proxy statements of the fees
billed in the most recent fiscal year under the categories of audit
fees, information systems design and implementation fees, and all other
fees.\311\ The rules require disclosure of the fees billed in each of
the two most recent years. The rules also add the categories of tax
fees and audit-related fees but eliminate separate disclosure of
information systems design and implementation from the current list of
categories of fees. The rules also require disclosure of
[[Page 6044]]
the percentage of fees in each category where the audit committee used
the de minimis exception to the pre-approval requirements. Finally, the
rules extend the disclosure requirements to all entities filing Forms
10-K, 10-KSB, 20-F, 40-F and N-CSR.\312\
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\311\ In the case of investment companies, the investors will
receive this information for the investment company registrant and
separately, for all other entities in the investment company complex
where the services were subject to pre-approval by the investment
company's audit committee.
\312\ Form 10-K is the annual report that registrants file with
the Commission pursuant to Section 13 or 15(d) of the Exchange Act,
if no other annual reporting form has been prescribed. Small
business issuers may use abbreviated Form 10-KSB. A ``small business
issuer'' is an entity that (1) has revenues of less than
$25,000,000, (2) is a U.S. or Canadian issuer, (3) is not an
investment company, and (4) if a majority owned subsidiary, the
parent corporation also is a small business issuer. An entity is not
a ``small business issuer,'' however, if the aggregate market value
of its outstanding voting and non-voting common stock held by non-
affiliates is $25,000,000 or more. See 17 CFR 240.12b-2. Registered
management investment companies use Form N-CSR to file certified
shareholder reports with the Commission.
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The rules require all entities filing Forms 10-K, 10-KSB, 20-F, 40-
F and N-CSR to include the disclosure either in the proxy or
information statement or, if the company is does not issue a proxy or
information statement, in Forms 10-K, 10-KSB, 20-F, 40-F or Form N-CSR.
The rules, therefore, may require smaller entities to spend additional
time and incur additional costs in preparing disclosures. Smaller
entities also may incur costs to set up procedures to monitor the
activities of the audit committee in order to collect and record the
information to be disclosed under the rules.
F. Agency Action To Minimize Effect on Small Entities and Significant
Alternatives
The Regulatory Flexibility Act directs us to consider significant
alternatives that would accomplish the stated objective, while
minimizing any significant adverse impact on small entities. In
connection with the amendments, we considered the following
alternatives:
[sbull] The establishment of differing compliance or reporting
requirements or timetables that take into account the resources of
smaller entities;
[sbull] The clarification, consolidation, or simplification of
compliance and reporting requirements under the rule for smaller
entities;
[sbull] The use of performance rather than design standards; and
[sbull] An exemption from coverage of the proposed amendments, or
any part thereof, for smaller entities.
We believe investors in both smaller companies and larger companies
want and benefit from the revisions to the auditor independence rules,
enhanced communications between the auditor and the audit committee,
and enhanced disclosures required by the rule.
We, nevertheless, have determined that the two specific exemptions
from the final rules for smaller accounting firms that are described
above are appropriate and consistent with the Sarbanes-Oxley Act.
VII. Codification Update
The Commission is amending the ``Codification of Financial
Reporting Policies'' announced in Financial Reporting Release No. 1
(April 15, 1982):
By amending Section 602 to add a new discussion at the end of that
section under the Financial Reporting Release Number (FR-68) assigned
to the adopting release and including the text in the adopting release
that discusses the final rules would be as presented in Section II of
this release.
The Codification is a separate publication of the Commission. It
will not be published in the Code of Federal Regulations.
VIII. Statutory Bases and Text of Amendments
We are adopting amendments to Rules 2-01 and 2-07 of Regulation S-
X, Item 9 of Schedule 14A, Forms 10-K, 10-KSB, 20-F and 40-F, Form N-
CSR and Exchange Act Rule 10A-2 under the authority set forth in
Schedule A and Sections 7, 8, 10, 19 and 28 of the Securities Act,
Sections 3, 10A, 12, 13, 14, 17, 23 and 36 of the Exchange Act,
Sections 5, 10, 14 and 20 of the Public Utility Holding Company Act of
1935, Sections 8, 30, 31 and 38 of the Investment Company Act of 1940,
Sections 203 and 211 of the Investment Advisers Act of 1940, and
Sections 3(a) and 208 of the Sarbanes-Oxley Act.
Text of Amendments
List of Subjects
17 CFR Part 210
Accountants, Accounting.
17 CFR Part 240
Broker-dealers, Issuers, Securities.
17 CFR Part 249
Reporting and recordkeeping requirements, Securities.
17 CFR Part 274
Investment companies, Reporting and recordkeeping requirements,
Securities.
In accordance with the foregoing, Title 17, Chapter II of the Code
of Federal Regulations is amended as follows:
PART 210--FORM AND CONTENT OF AND REQUIREMENTS FOR FINANCIAL
STATEMENTS, SECURITIES ACT OF 1933, SECURITIES EXCHANGE ACT OF
1934, PUBLIC UTILITY HOLDING COMPANY ACT OF 1935, INVESTMENT
COMPANY ACT OF 1940, INVESTMENT ADVISERS ACT OF 1940 AND ENERGY
POLICY AND CONSERVATION ACT OF 1975
1. The authority citation for Part 210 continues to read as
follows:
Authority: 15 U.S.C. 77f, 77g, 77h, 77j, 77s, 77z-2, 77z-3,
77aa(25), 77aa(26), 78c, 78j-1, 78l, 78m, 78n, 78o(d), 78q, 78u-5,
78w(a), 78ll, 78mm, 79e(b), 79j(a), 79n, 79t(a), 80a-8, 80a-20, 80a-
29, 80a-30, 80a-37(a), 80b-3, 80b-11 unless otherwise noted.
2. Section 210.2-01 is amended by:
a. Revising paragraph (c)(2)(iii);
b. Revising paragraph (c)(4);
c. Adding paragraph (c)(6);
d. Adding paragraph (c)(7);
e. Adding paragraph (c)(8);
f. Revising paragraph (e)(1);
g. Removing paragraph (e)(2);
h. Redesignating paragraph (e)(3) as (e)(2);
i. Revising paragraph (f)(1);
j. Revising paragraph (f)(3);
k. Revising paragraph (f)(7); and
l. Adding paragraph (f)(17).
The revisions and additions read as follows:
Sec. 210.2-01 Qualifications of accountants.
* * * * *
(c) * * *
(2) Employment relationships. * * *
(i) * * *
(ii) * * *
(iii) Employment at audit client of former employee of accounting
firm.
(A) A former partner, principal, shareholder, or professional
employee of an accounting firm is in an accounting role or financial
reporting oversight role at an audit client, unless the individual:
(1) Does not influence the accounting firm's operations or
financial policies;
(2) Has no capital balances in the accounting firm; and
(3) Has no financial arrangement with the accounting firm other
than one providing for regular payment of a fixed dollar amount (which
is not dependent on the revenues, profits, or earnings of the
accounting firm):
(i) Pursuant to a fully funded retirement plan, rabbi trust, or, in
jurisdictions in which a rabbi trust does not exist, a similar vehicle;
or
(ii) In the case of a former professional employee who was not a
partner, principal, or shareholder of the accounting firm and who has
been disassociated from the accounting firm
[[Page 6045]]
for more than five years, that is immaterial to the former professional
employee; and
(B) A former partner, principal, shareholder, or professional
employee of an accounting firm is in a financial reporting oversight
role at an issuer (as defined in section 10A(f) of the Securities
Exchange Act of 1934 (15 U.S.C. 78j-1(f)), except an issuer that is an
investment company registered under section 8 of the Investment Company
Act of 1940 (15 U.S.C. 80a-8), unless the individual:
(1) Employed by the issuer was not a member of the audit engagement
team of the issuer during the one year period preceding the date that
audit procedures commenced for the fiscal period that included the date
of initial employment of the audit engagement team member by the
issuer;
(2) For purposes of paragraph (c)(2)(iii)(B)(1) of this section,
the following individuals are not considered to be members of the audit
engagement team:
(i) Persons, other than the lead partner and the concurring
partner, who provided ten or fewer hours of audit, review, or attest
services during the period covered by paragraph (c)(2)(iii)(B)(1) of
this section;
(ii) Individuals employed by the issuer as a result of a business
combination between an issuer that is an audit client and the employing
entity, provided employment was not in contemplation of the business
combination and the audit committee of the successor issuer is aware of
the prior employment relationship; and
(iii) Individuals that are employed by the issuer due to an
emergency or other unusual situation provided that the audit committee
determines that the relationship is in the interest of investors;
(3) For purposes of paragraph (c)(2)(iii)(B)(1) of this section,
audit procedures are deemed to have commenced for a fiscal period the
day following the filing of the issuer's periodic annual report with
the Commission covering the previous fiscal period; or
(C) A former partner, principal, shareholder, or professional
employee of an accounting firm is in a financial reporting oversight
role with respect to an investment company registered under section 8
of the Investment Company Act of 1940 (15 U.S.C. 80a-8), if:
(1) The former partner, principal, shareholder, or professional
employee of an accounting firm is employed in a financial reporting
oversight role related to the operations and financial reporting of the
registered investment company at an entity in the investment company
complex, as defined in (f)(14) of this section, that includes the
registered investment company; and
(2) The former partner, principal, shareholder, or professional
employee of an accounting firm employed by the registered investment
company or any entity in the investment company complex was a member of
the audit engagement team of the registered investment company or any
other registered investment company in the investment company complex
during the one year period preceding the date that audit procedures
commenced that included the date of initial employment of the audit
engagement team member by the registered investment company or any
entity in the investment company complex.
(3) For purposes of paragraph (c)(2)(iii)(C)(2) of this section,
the following individuals are not considered to be members of the audit
engagement team:
(i) Persons, other than the lead partner and concurring partner,
who provided ten or fewer hours of audit, review or attest services
during the period covered by paragraph (c)(2)(iii)(C)(2) of this
section;
(ii) Individuals employed by the registered investment company or
any entity in the investment company complex as a result of a business
combination between a registered investment company or any entity in
the investment company complex that is an audit client and the
employing entity, provided employment was not in contemplation of the
business combination and the audit committee of the registered
investment company is aware of the prior employment relationship; and
(iii) Individuals that are employed by the registered investment
company or any entity in the investment company complex due to an
emergency or other unusual situation provided that the audit committee
determines that the relationship is in the interest of investors.
(4) For purposes of paragraph (c)(2)(iii)(C)(2) of this section,
audit procedures are deemed to have commenced the day following the
filing of the registered investment company's periodic annual report
with the Commission.
* * * * *
(4) Non-audit services. An accountant is not independent if, at any
point during the audit and professional engagement period, the
accountant provides the following non-audit services to an audit
client:
(i) Bookkeeping or other services related to the accounting records
or financial statements of the audit client. Any service, unless 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, including:
(A) Maintaining or preparing the audit client's accounting records;
(B) Preparing the audit client's financial statements that are
filed with the Commission or that form the basis of financial
statements filed with the Commission; or
(C) Preparing or originating source data underlying the audit
client's financial statements.
(ii) Financial information systems design and implementation. Any
service, unless 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, including:
(A) Directly or indirectly operating, or supervising the operation
of, the audit client's information system or managing the audit
client's local area network; or
(B) Designing or implementing a hardware or software system that
aggregates source data underlying the financial statements or generates
information that is significant to the audit client's financial
statements or other financial information systems taken as a whole.
(iii) Appraisal or valuation services, fairness opinions, or
contribution-in-kind reports. Any appraisal service, valuation service,
or any service involving a fairness opinion or contribution-in-kind
report for an audit client, unless 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.
(iv) Actuarial services. Any actuarially-oriented advisory service
involving the determination of amounts recorded in the financial
statements and related accounts for the audit client other than
assisting a client in understanding the methods, models, assumptions,
and inputs used in computing an amount, unless 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.
(v) Internal audit outsourcing services. Any internal audit service
that has been outsourced by the audit client that relates to the audit
client's internal accounting controls, financial systems, or financial
statements, for an audit client unless it is reasonable to conclude
that the results of these services will not
[[Page 6046]]
be subject to audit procedures during an audit of the audit client's
financial statements.
(vi) Management functions. Acting, temporarily or permanently, as a
director, officer, or employee of an audit client, or performing any
decision-making, supervisory, or ongoing monitoring function for the
audit client.
(vii) Human resources. (A) Searching for or seeking out prospective
candidates for managerial, executive, or director positions;
(B) Engaging in psychological testing, or other formal testing or
evaluation programs;
(C) Undertaking reference checks of prospective candidates for an
executive or director position;
(D) Acting as a negotiator on the audit client's behalf, such as
determining position, status or title, compensation, fringe benefits,
or other conditions of employment; or
(E) Recommending, or advising the audit client to hire, a specific
candidate for a specific job (except that an accounting firm may, 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).
(viii) Broker-dealer, investment adviser, or investment banking
services. Acting as a broker-dealer (registered or unregistered),
promoter, or underwriter, on behalf of an audit client, making
investment decisions on behalf of the audit client or otherwise having
discretionary authority over an audit client's investments, executing a
transaction to buy or sell an audit client's investment, or having
custody of assets of the audit client, such as taking temporary
possession of securities purchased by the audit client.
(ix) Legal services. Providing any service to an audit client that,
under circumstances in which the service is provided, could be provided
only by someone licensed, admitted, or otherwise qualified to practice
law in the jurisdiction in which the service is provided.
(x) Expert services unrelated to the audit. Providing an expert
opinion or other expert service for an audit client, or an audit
client's legal representative, for the purpose of advocating an audit
client's interests in litigation or in a regulatory or administrative
proceeding or investigation. In any litigation or regulatory or
administrative proceeding or investigation, an accountant's
independence shall not be deemed to be impaired if the accountant
provides factual accounts, including in testimony, of work performed or
explains the positions taken or conclusions reached during the
performance of any service provided by the accountant for the audit
client.
* * * * *
(6) Partner rotation. (i) Except as provided in paragraph
(c)(6)(ii) of this section, an accountant is not independent of an
audit client when:
(A) Any audit partner as defined in paragraph (f)(7)(ii) of this
section performs:
(1) The services of a lead partner, as defined in paragraph
(f)(7)(ii)(A) of this section, or concurring partner, as defined in
paragraph (f)(7)(ii)(B) of this section, for more than five consecutive
years; or
(2) One or more of the services defined in paragraphs (f)(7)(ii)(C)
and (D) of this section for more than seven consecutive years;
(B) Any audit partner:
(1) Within the five consecutive year period following the
performance of services for the maximum period permitted under
paragraph (c)(6)(i)(A)(1) of this section, performs for that audit
client the services of a lead partner, as defined in paragraph
(f)(7)(ii)(A) of this section, or concurring partner, as defined in
paragraph (f)(7)(ii)(B) of this section, or a combination of those
services, or
(2) Within the two consecutive year period following the
performance of services for the maximum period permitted under
paragraph (c)(6)(i)(A)(2) of this section, performs one or more of the
services defined in paragraph (f)(7)(ii) of this section.
(ii) Any accounting firm with less than five audit clients that are
issuers (as defined in section 10A(f) of the Securities Exchange Act of
1934 (15 U.S.C. 78j-1(f))) and less than ten partners shall be exempt
from paragraph (c)(6)(i) of this section provided the Public Company
Accounting Oversight Board conducts a review at least once every three
years of each of the audit client engagements that would result in a
lack of auditor independence under this paragraph.
(iii) For purposes of paragraph (c)(6)(i) of this section, an audit
client that is an investment company registered under section 8 of the
Investment Company Act of 1940 (15 U.S.C. 80a-8), does not include an
affiliate of the audit client that is an entity in the same investment
company complex, as defined in paragraph (f)(14) of this section,
except for another registered investment company in the same investment
company complex. For purposes of calculating consecutive years of
service under paragraph (c)(6)(i) of this section with respect to
investment companies in an investment company complex, audits of
registered investment companies with different fiscal year-ends that
are performed in a continuous 12-month period count as a single
consecutive year.
(7) Audit committee administration of the engagement. An accountant
is not independent of an issuer (as defined in section 10A(f) of the
Securities Exchange Act of 1934 (15 U.S.C. 78j-1(f))), other than an
issuer that is an Asset-Backed Issuer as defined in Sec. 240.13a-14(g)
and Sec. 240.15d-14(g) of this chapter, or an investment company
registered under section 8 of the Investment Company Act of 1940 (15
U.S.C. 80a-8), other than a unit investment trust as defined by section
4(2) of the Investment Company Act of 1940 (15 U.S.C. 80a-4(2)),
unless:
(i) In accordance with Section 10A(i) of the Securities Exchange
Act of 1934 (15 U.S.C. 78j-1(i)) either:
(A) Before the accountant is engaged by the issuer or its
subsidiaries, or the registered investment company or its subsidiaries,
to render audit or non-audit services, the engagement is approved by
the issuer's or registered investment company's audit committee; or
(B) The engagement to render the service is entered into pursuant
to pre-approval policies and procedures established by the audit
committee of the issuer or registered investment company, provided the
policies and procedures are detailed as to the particular service and
the audit committee is informed of each service and such policies and
procedures do not include delegation of the audit committees
responsibilities under the Securities Exchange Act of 1934 to
management; or
(C) With respect to the provision of services other than audit,
review or attest services the pre-approval requirement is waived if:
(1) The aggregate amount of all such services provided constitutes
no more than five percent of the total amount of revenues paid by the
audit client to its accountant during the fiscal year in which the
services are provided;
(2) Such services were not recognized by the issuer or registered
investment company at the time of the engagement to be non-audit
services; and
(3) Such services are promptly brought to the attention of the
audit committee of the issuer or registered investment company 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 of directors to
[[Page 6047]]
whom authority to grant such approvals has been delegated by the audit
committee.
(ii) A registered investment company's audit committee also must
pre-approve its accountant's engagements for non-audit services with
the registered investment company's investment adviser (not including a
sub-adviser whose role is primarily portfolio management and is sub-
contracted or overseen by another investment adviser) and any entity
controlling, controlled by, or under common control with the investment
adviser that provides ongoing services to the registered investment
company in accordance with paragraph (c)(7)(i) of this section, if the
engagement relates directly to the operations and financial reporting
of the registered investment company, except that with respect to the
waiver of the pre-approval requirement under paragraph (c)(7)(i)(C) of
this section, the aggregate amount of all services provided constitutes
no more than five percent of the total amount of revenues paid to the
registered investment company's accountant by the registered investment
company, its investment adviser and any entity controlling, controlled
by, or under common control with the investment adviser that provides
ongoing services to the registered investment company during the fiscal
year in which the services are provided that would have to be pre-
approved by the registered investment company's audit committee
pursuant to this section.
(8) Compensation. 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.
Any accounting firm with fewer than ten partners and fewer than five
audit clients that are issuers (as defined in section 10A(f) of the
Securities Exchange Act of 1934 (15 U.S.C. 78j-1(f))) shall be exempt
from the requirement stated in the previous sentence.
* * * * *
(e)(1) Transition and grandfathering. Provided the following
relationships did not impair the accountant's independence under pre-
existing requirements of the Commission, the Independence Standards,
Board, or the accounting profession in the United States, the existence
of the relationship on May 6, 2003 will not be deemed to impair an
accountant's independence:
(i) Employment relationships that commenced at the issuer prior to
May 6, 2003 as described in paragraph (c)(2)(iii)(B) of this section.
(ii) Compensation earned or received, as described in paragraph
(c)(8) of this section during the fiscal year of the accounting firm
that includes the effective date of this section.
(iii) Until May 6, 2004, the provision of services described in
paragraph (c)(4) of this section provided those services are pursuant
to contracts in existence on May 6, 2003.
(iv) The provision of services by the accountant under contracts in
existence on May 6, 2003 that have not been pre-approved by the audit
committee as described in paragraph (c)(7) of this section.
(v) Until the first day of the issuer's fiscal year beginning after
May 6, 2003 by a ``lead'' partner and other audit partner (other than
the ``concurring'' partner) providing services in excess of those
permitted under paragraph (c)(6) of this section. An accountant's
independence will not be deemed to be impaired until the first day of
the issuer's fiscal year beginning after May 6, 2004 by a
``concurring'' partner providing services in excess of those permitted
under paragraph (c)(6) of this section. For the purposes of calculating
periods of service under paragraph (c)(6) of this section:
(A) For the ``lead'' and ``concurring'' partner, the period of
service includes time served as the ``lead'' or ``concurring'' partner
prior to May 6, 2003; and
(B) For audit partners other than the ``lead'' partner or
``concurring'' partner, and for audit partners in foreign firms, the
period of service does not include time served on the audit engagement
team prior to the first day of issuer's fiscal year beginning on or
after May 6, 2003.
* * * * *
(f) * * *
(1) Accountant, as used in paragraphs (b) through (e) of this
section, means a registered public accounting firm, certified public
accountant or public accountant performing services in connection with
an engagement for which independence is required. References to the
accountant include any accounting firm with which the certified public
accountant or public accountant is affiliated.
* * * * *
(3)(i) Accounting 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.
(ii) Financial reporting oversight role means a role in which a
person is in a position to or does 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, or any equivalent position.
* * * * *
(7)(i) Audit engagement team means all partners, principals,
shareholders and professional employees participating in an audit,
review, or attestation engagement of an audit client, including audit
partners and all persons who consult with others on the audit
engagement team during the audit, review, or attestation engagement
regarding technical or industry-specific issues, transactions, or
events.
(ii) Audit partner means a partner or persons in an equivalent
position, other than a partner who consults with others on the audit
engagement team during the audit, review, or attestation engagement
regarding technical or industry-specific issues, transactions, or
events, who is a member of the audit engagement team who has
responsibility for decision-making on significant auditing, accounting,
and reporting matters that affect the financial statements, or who
maintains regular contact with management and the audit committee and
includes the following:
(A) The lead or coordinating audit partner having primary
responsibility for the audit or review (the ``lead partner'');
(B) The partner performing a second level of review to provide
additional assurance that the financial statements subject to the audit
or review are in conformity with generally accepted accounting
principles and the audit or review and any associated report are in
accordance with generally accepted auditing standards and rules
promulgated by the Commission or the Public Company Accounting
Oversight Board (the ``concurring or reviewing partner'');
(C) Other audit engagement team partners who provide more than ten
hours of audit, review, or attest services in connection with the
annual or interim consolidated financial statements of the issuer or an
investment company registered under section 8 of the Investment Company
Act of 1940 (15 U.S.C. 80a-8); and
(D) Other audit engagement team partners who serve as the ``lead
partner''
[[Page 6048]]
in connection with any audit or review related to the annual or interim
financial statements of a subsidiary of the issuer whose assets or
revenues constitute 20% or more of the assets or revenues of the
issuer's respective consolidated assets or revenues.
* * * * *
(17) Audit committee means a committee (or equivalent body) as
defined in section 3(a)(58) of the Securities Exchange Act of 1934 (15
U.S.C. 78c(a)(58)).
3. By adding Sec. 210.2-07 preceding General Instructions as to
Financial Statements to read as follows:
Sec. 210.2-07 Communication with audit committees.
(a) Each registered public accounting firm that performs for an
audit client that is an issuer (as defined in section 10A(f) of the
Securities Exchange Act of 1934 (15 U.S.C. 78j-1(f))), other than an
issuer that is an Asset-Backed Issuer as defined in Sec. 240.13a-14(g)
and Sec. 240.15d-14(g) of this chapter, or an investment company
registered under section 8 of the Investment Company Act of 1940 (15
U.S.C. 80a-8), other than a unit investment trust as defined by section
4(2) of the Investment Company Act of 1940 (15 U.S.C. 80a-4(2)), any
audit required under the securities laws shall report, prior to the
filing of such audit report with the Commission (or in the case of a
registered investment company, annually, and if the annual
communication is not within 90 days prior to the filing, provide an
update, in the 90 day period prior to the filing, of any changes to the
previously reported information), to the audit committee of the issuer
or registered investment company:
(1) All critical accounting policies and practices to be used;
(2) All alternative treatments within Generally Accepted Accounting
Principles for policies and practices related to material items that
have been discussed with management of the issuer or registered
investment company, including:
(i) Ramifications of the use of such alternative disclosures and
treatments; and
(ii) The treatment preferred by the registered public accounting
firm;
(3) Other material written communications between the registered
public accounting firm and the management of the issuer or registered
investment company, such as any management letter or schedule of
unadjusted differences;
(4) If the audit client is an investment company, all non-audit
services provided to any entity in an investment company complex, as
defined in Sec. 210.2-01 (f)(14), that were not pre-approved by the
registered investment company's audit committee pursuant to Sec. 210.2-
01 (c)(7).
(b) [Reserved]
PART 240--GENERAL RULES AND REGULATIONS, SECURITIES EXCHANGE ACT OF
1934
4. The authority citation for Part 240 continues to read, in part,
as follows:
Authority: 15 U.S.C. 77c, 77d, 77g, 77j, 77s, 77z-2, 77z-3,
77eee, 77ggg, 77nnn, 77sss, 77ttt, 78c, 78d, 78e, 78f, 78g, 78i,
78j, 78j-1, 78k, 78k-1, 78l, 78m, 78n, 78o, 78p, 78q, 78s, 78u-5,
78w, 78x, 78ll, 78mm, 79q, 79t, 80a-20, 80a-23, 80a-29, 80a-37, 80b-
3, 80b-4 and 80b-11, unless otherwise noted.
* * * * *
5. Section 240.10A-2 is added to read as follows:
Sec. 240.10A-2 Auditor independence.
It shall be unlawful for an auditor not to be independent under
Sec. 210.2-01(c)(2)(iii)(B), (c)(4), (c)(6), (c)(7), and Sec. 210.2-
07.
6. Section 240.14a-101 is amended by revising paragraph (e) of Item
9 to read as follows:
Sec. 240.14a-101 Schedule 14A. Information required in proxy
statement.
* * * * *
Item 9. Independent public accountants. * * *
* * * * *
(e)(1) Disclose, under the caption Audit Fees, the aggregate fees
billed for each of the last two fiscal years for professional services
rendered by the principal accountant for the audit of the registrant's
annual financial statements and review of financial statements included
in the registrant's Form 10-Q (17 CFR 249.308a) or 10-QSB (17 CFR
249.308b) or services that are normally provided by the accountant in
connection with statutory and regulatory filings or engagements for
those fiscal years.
(2) Disclose, under the caption Audit-Related Fees, the aggregate
fees billed in each of the last two fiscal years for assurance and
related services by the principal accountant that are reasonably
related to the performance of the audit or review of the registrant's
financial statements and are not reported under paragraph (e)(1) of
this section. Registrants shall describe the nature of the services
comprising the fees disclosed under this category.
(3) Disclose, under the caption Tax Fees, the aggregate fees billed
in each of the last two fiscal years for professional services rendered
by the principal accountant for tax compliance, tax advice, and tax
planning. Registrants shall describe the nature of the services
comprising the fees disclosed under this category.
(4) Disclose, under the caption All Other Fees, the aggregate fees
billed in each of the last two fiscal years for products and services
provided by the principal accountant, other than the services reported
in paragraphs (e)(1) through (e)(3) of this section. Registrants shall
describe the nature of the services comprising the fees disclosed under
this category.
(5)(i) Disclose the audit committee's pre-approval policies and
procedures described in 17 CFR 210.2-01(c)(7)(i).
(ii) Disclose the percentage of services described in each of
paragraphs (e)(2) through (e)(4) of this section that were approved by
the audit committee pursuant to 17 CFR 210.2-01(c)(7)(i)(C).
(6) If greater than 50 percent, disclose the percentage of hours
expended on the principal accountant's engagement to audit the
registrant's financial statements for the most recent fiscal year that
were attributed to work performed by persons other than the principal
accountant's full-time, permanent employees.
(7) If the registrant is an investment company, disclose the
aggregate non-audit fees billed by the registrant's accountant for
services rendered to the registrant, and to the registrant's investment
adviser (not including any subadviser whose role is primarily portfolio
management and is subcontracted with or overseen by another investment
adviser), and any entity controlling, controlled by, or under common
control with the adviser that provides ongoing services to the
registrant for each of the last two fiscal years of the registrant.
(8) If the registrant is an investment company, disclose whether
the audit committee of the board of directors has considered whether
the provision of non-audit services that were rendered to the
registrant's investment adviser (not including any subadviser whose
role is primarily portfolio management and is subcontracted with or
overseen by another investment adviser), and any entity controlling,
controlled by, or under common control with the investment adviser that
provides ongoing services to the registrant that were not pre-approved
pursuant to 17 CFR 210.2-01(c)(7)(ii) is compatible with maintaining
the principal accountant's independence.
Instruction to Item 9(e).
For purposes of Item 9(e)(2), (3), and (4), registrants that are
investment
[[Page 6049]]
companies must disclose fees billed for services rendered to the
registrant and separately, disclose fees required to be approved by the
investment company registrant's audit committee pursuant to 17 CFR
210.2-01(c)(7)(ii). Registered investment companies must also disclose
the fee percentages as required by item 9(e)(5)(ii) for the registrant
and separately, disclose the fee percentages as required by item
9(e)(5)(ii) for the fees required to be approved by the investment
company registrant's audit committee pursuant to 17 CFR 210.2-
01(c)(7)(ii).
* * * * *
PART 249--FORMS, SECURITIES EXCHANGE ACT OF 1934
7. The authority citation for Part 249 is amended by revising the
sectional authority for Sec. Sec. 249.220f, 249.240f, 249.310,
249.310b and 249.331 to read as follows:
Authority: 15 U.S.C. 78a et seq., unless otherwise noted.
Section 249.220f is also issued under secs. 3(a), 202, 208, 302,
306(a), 401(a), 401(b), 406 and 407, Pub. L. No. 107-204, 116 Stat.
745.
Section 249.240f is also issued under secs. 3(a), 202, 208, 302,
306(a), 401(a), 406 and 407, Pub. L. No. 107-204, 116 Stat. 745.
* * * * *
Section 249.310 is also issued under secs. 3(a), 202, 208, 302,
406 and 407, Pub. L. No. 107-204, 116 Stat. 745.
Section 249.310b is also issued under secs. 3(a), 202, 208, 302,
406 and 407, Pub. L. No. 107-204, 116 Stat. 745.
* * * * *
Section 249.331 is also issued under secs. 3(a), 202, 208, 302, 406
and 407, Pub. L. No. 107-204, 116 Stat. 745.
8. Amend Form 20-F (referenced in Sec. 249.220f) by adding Item
16C to read as follows:
Note: The text of Form 20-F does not, and this amendment will
not, appear in the Code of Federal Regulations.
Form 20-F
* * * * *
Item 16C. Principal Accountant Fees and Services.
(a) Disclose, under the caption Audit Fees, the aggregate fees
billed for each of the last two fiscal years for professional services
rendered by the principal accountant for the audit of the registrant's
annual financial statements or services that are normally provided by
the accountant in connection with statutory and regulatory filings or
engagements for those fiscal years.
(b) Disclose, under the caption Audit-Related Fees, the aggregate
fees billed in each of the last two fiscal years for assurance and
related services by the principal accountant that are reasonably
related to the performance of the audit or review of the registrant's
financial statements and are not reported under paragraph (a) of this
Item. Registrants shall describe the nature of the services comprising
the fees disclosed under this category.
(c) Disclose, under the caption Tax Fees, the aggregate fees billed
in each of the last two fiscal years for professional services rendered
by the principal accountant for tax compliance, tax advice, and tax
planning. Registrants shall describe the nature of the services
comprising the fees disclosed under this category.
(d) Disclose, under the caption All Other Fees, the aggregate fees
billed in each of the last two fiscal years for products and services
provided by the principal accountant, other than the services reported
in paragraphs (a) through (c) of this Item. Registrants shall describe
the nature of the services comprising the fees disclosed under this
category.
(e)(1) Disclose the audit committee's pre-approval policies and
procedures described in paragraph (c)(7)(i) of Rule 2-01 of Regulation
S-X.
(2) Disclose the percentage of services described in each of
paragraphs (b) through (d) of this Item that were approved by the audit
committee pursuant to paragraph (c)(7)(i)(C) of Rule 2-01 of Regulation
S-X.
(f) If greater than 50 percent, disclose the percentage of hours
expended on the principal accountant's engagement to audit the
registrant's financial statements for the most recent fiscal year that
were attributed to work performed by persons other than the principal
accountant's full-time, permanent employees.
Instructions to Item 16C.
1. You do not need to provide the information called for by this
Item 16C unless you are using this form as an annual report.
2. A registrant that is an Asset-Backed Issuer (as defined in Sec.
240.13a-14(g) and Sec. 240.15d-14(g) of this chapter) is not required
to disclose the information required by this Item.
* * * * *
9. Amend Form 40-F (referenced in Sec. 249.240f) by adding
paragraph (10) to General Instruction B to read as follows:
Note: The text of Form 40-F does not, and this amendment will
not, appear in the Code of Federal Regulations.
Form 40-F
* * * * *
General Instructions
* * * * *
B. Information To Be Filed on This Form
* * * * *
(10) Principal Accountant Fees and Services
(1) Disclose, under the caption Audit Fees, the aggregate fees
billed for each of the last two fiscal years for professional services
rendered by the principal accountant for the audit of the registrant's
annual financial statements or services that are normally provided by
the accountant in connection with statutory and regulatory filings or
engagements for those fiscal years.
(2) Disclose, under the caption Audit-Related Fees, the aggregate
fees billed in each of the last two fiscal years for assurance and
related services by the principal accountant that are reasonably
related to the performance of the audit or review of the registrant's
financial statements and are not reported under paragraph B.(10)(1) of
this Instruction. Registrants shall describe the nature of the services
comprising the fees disclosed under this category.
(3) Disclose, under the caption Tax Fees, the aggregate fees billed
in each of the last two fiscal years for professional services rendered
by the principal accountant for tax compliance, tax advice, and tax
planning. Registrants shall describe the nature of the services
comprising the fees disclosed under this category.
(4) Disclose, under the caption All Other Fees, the aggregate fees
billed in each of the last two fiscal years for products and services
provided by the principal accountant, other than the services reported
in paragraphs B.(10)(1) through B.(10)(3) of this Instruction.
Registrants shall describe the nature of the services comprising the
fees disclosed under this category.
(5)(i) Disclose the audit committee's pre-approval policies and
procedures described in paragraph (c)(7)(i) of Rule 2-01 of Regulation
S-X.
(ii) Disclose the percentage of services described in each of
paragraphs B.(10)(2) through B.(10)(4) of this Instruction that were
approved by the audit committee pursuant to paragraph (c)(7)(i)(C) of
Rule 2-01 of Regulation S-X.
(6) If greater than 50 percent, disclose the percentage of hours
expended on the principal accountant's engagement to audit the
registrant's financial statements for the most recent fiscal year that
were attributed to work performed by persons other than the principal
accountant's full-time, permanent employees.
[[Page 6050]]
Notes to Instruction B.(10)
1. You do not need to provide the information called for by this
Instruction B.(10) unless you are using this form as an annual report.
2. A registrant that is an Asset-Backed Issuer (as defined in Sec.
240.13a-14(g) and Sec. 240.15d-14(g) of this chapter) is not required
to disclose the information required by this Instruction B.(10).
* * * * *
10. Amend Form 10-K (referenced in Sec. 249.310) by:
a. Redesignating Item 16 of Part IV as Item 17 of Part IV, and
b. Adding new Item 16 to Part III.
The addition reads as follows:
Note: The text of Form 10-K does not, and this amendment will
not, appear in the Code of Federal Regulations.
Form 10-K
* * * * *
General Instructions
* * * * *
Annual Report Pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
* * * * *
Part III
* * * * *
Item 16. Principal Accountant Fees and Services.
Furnish the information required by Item 9(e) of Schedule 14A
(Sec. 240.14a-101 of this chapter).
(1) Disclose, under the caption Audit Fees, the aggregate fees
billed for each of the last two fiscal years for professional services
rendered by the principal accountant for the audit of the registrant's
annual financial statements and review of financial statements included
in the registrant's Form 10-Q (17 CFR 249.308a) or 10-QSB (17 CFR
249.308b) or services that are normally provided by the accountant in
connection with statutory and regulatory filings or engagements for
those fiscal years.
(2) Disclose, under the caption Audit-Related Fees, the aggregate
fees billed in each of the last two fiscal years for assurance and
related services by the principal accountant that are reasonably
related to the performance of the audit or review of the registrant's
financial statements and are not reported under Item 9(e)(1) of
Schedule 14A. Registrants shall describe the nature of the services
comprising the fees disclosed under this category.
(3) Disclose, under the caption Tax Fees, the aggregate fees billed
in each of the last two fiscal years for professional services rendered
by the principal accountant for tax compliance, tax advice, and tax
planning. Registrants shall describe the nature of the services
comprising the fees disclosed under this category.
(4) Disclose, under the caption All Other Fees, the aggregate fees
billed in each of the last two fiscal years for products and services
provided by the principal accountant, other than the services reported
in Items 9(e)(1) through 9(e)(3) of Schedule 14A. Registrants shall
describe the nature of the services comprising the fees disclosed under
this category.
(5)(i) Disclose the audit committee's pre-approval policies and
procedures described in paragraph (c)(7)(i) of Rule 2-01 of Regulation
S-X.
(ii) Disclose the percentage of services described in each of Items
9(e)(2) through 9(e)(4) of Schedule 14A that were approved by the audit
committee pursuant to paragraph (c)(7)(i)(C) of Rule 2-01 of Regulation
S-X.
(6) If greater than 50 percent, disclose the percentage of hours
expended on the principal accountant's engagement to audit the
registrant's financial statements for the most recent fiscal year that
were attributed to work performed by persons other than the principal
accountant's full-time, permanent employees.
Instruction to Item 16.
A registrant that is an Asset-Backed Issuer (as defined in Sec.
240.13a-14(g) and Sec. 240.15d-14(g) of this chapter) is not required
to disclose the information required by this Item.
* * * * *
11. Amend Form 10-KSB (referenced in Sec. 249.310b) by adding Item
16 to Part III to read as follows:
Note: The text of Form 10-KSB does not, and this amendment will
not, appear in the Code of Federal Regulations.
Form 10-KSB
* * * * *
Part III
* * * * *
Item 16. Principal Accountant Fees and Services.
Furnish the information required by Item 9(e) of Schedule 14A
(Sec. 240.14a-101 of this chapter).
(1) Disclose, under the caption Audit Fees, the aggregate fees
billed for each of the last two fiscal years for professional services
rendered by the principal accountant for the audit of the registrant's
annual financial statements and review of financial statements included
in the registrant's Form 10-Q (17 CFR 249.308a) or 10-QSB (17 CFR
249.308b) or services that are normally provided by the accountant in
connection with statutory and regulatory filings or engagements for
those fiscal years.
(2) Disclose, under the caption Audit-Related Fees, the aggregate
fees billed in each of the last two fiscal years for assurance and
related services by the principal accountant that are reasonably
related to the performance of the audit or review of the registrant's
financial statements and are not reported under Item 9(e)(1) of
Schedule 14A. Registrants shall describe the nature of the services
comprising the fees disclosed under this category.
(3) Disclose, under the caption Tax Fees, the aggregate fees billed
in each of the last two fiscal years for professional services rendered
by the principal accountant for tax compliance, tax advice, and tax
planning. Registrants shall describe the nature of the services
comprising the fees disclosed under this category.
(4) Disclose, under the caption All Other Fees, the aggregate fees
billed in each of the last two fiscal years for products and services
provided by the principal accountant, other than the services reported
in Items 9(e)(1) through 9(e)(3) of Schedule 14A. Registrants shall
describe the nature of the services comprising the fees disclosed under
this category.
(5)(i) Disclose the audit committee's pre-approval policies and
procedures described in paragraph (c)(7)(i) of Rule 2-01 of Regulation
S-X.
(ii) Disclose the percentage of services described in each of Items
9(e)(2) through 9(e)(4) of Schedule 14A that were approved by the audit
committee pursuant to paragraph (c)(7)(i)(C) of Rule 2-01 of Regulation
S-X.
(6) If greater than 50 percent, disclose the percentage of hours
expended on the principal accountant's engagement to audit the
registrant's financial statements for the most recent fiscal year that
were attributed to work performed by persons other than the principal
accountant's full-time, permanent employees.
Instruction to Item 16.
A registrant that is an Asset-Backed Issuer (as defined in Sec.
240.13a-14(g) and Sec. 240.15d-14(g) of this chapter) is not required
to disclose the information required by this Item.
* * * * *
[[Page 6051]]
PART 274--FORMS PRESCRIBED UNDER THE INVESTMENT COMPANY ACT OF 1940
12. The authority citation for Part 274 is amended by adding the
following citation in numerical order to read as follows:
Authority: 15 U.S.C. 77f, 77g, 77h, 77j, 77s, 78c(b), 78l, 78m,
78n, 78o(d), 80a-8, 80a-24, 80a-26, and 80a-29, unless otherwise
noted.
* * * * *
Section 274.128 is also issued under secs. 3(a), 202, 302, 406, and
407, Pub. L. No. 107-204, 116 Stat. 745.
13. By amending Form N-CSR (referenced in Sec. Sec. 249.331 and
274.128):
a. By revising General Instruction D; and
b. By adding Item 4.
The revision and addition read as follows:
Note: The text of Form N-CSR does not, and this amendment will
not, appear in the Code of Federal Regulations.
Form N-CSR
* * * * *
General Instructions
* * * * *
D. Incorporation by Reference
A registrant may incorporate by reference information required by
Items 4 and 10(a). No other Items of the Form shall be answered by
incorporating any information by reference. The information required by
Item 4 may be incorporated by reference from the registrant's
definitive proxy statement (filed or required to be filed pursuant to
Regulation 14A (17 CFR 240.14a-1 et seq.)) or definitive information
statement (filed or to be filed pursuant to Regulation 14C (17 CFR
240.14c-1 et seq.)) which involves the election of directors, if such
definitive proxy statement or information statement is filed with the
Commission not later than 120 days after the end of the fiscal year
covered by an annual report on this Form. All incorporation by
reference must comply with the requirements of this Form and the
following rules on incorporation by reference: Rule 10(d) of Regulation
S-K under the Securities Act of 1933 (17 CFR 229.10(d)) (general rules
on incorporation by reference, which, among other things, prohibit,
unless specifically required by this Form, incorporating by reference a
document that includes incorporation by reference to another document,
and limits incorporation to documents filed within the last 5 years,
with certain exceptions); Rule 303 of Regulation S-T (17 CFR 232.303)
(specific requirements for electronically filed documents); Rules 12b-
23 and 12b-32 under the Exchange Act (additional rules on incorporation
by reference for reports filed pursuant to Sections 13 and 15(d) of the
Exchange Act); and Rules 0-4, 8b-23, and 8b-32 under the Investment
Company Act of 1940 (17 CFR 270.0-4, 270.8b-23, and 270.8b-32)
(additional rules on incorporation by reference for investment
companies).
* * * * *
Item 4. Principal Accountant Fees and Services.
(a) Disclose, under the caption Audit Fees, the aggregate fees
billed for each of the last two fiscal years for professional services
rendered by the principal accountant for the audit of the registrant's
annual financial statements or services that are normally provided by
the accountant in connection with statutory and regulatory filings or
engagements for those fiscal years.
(b) Disclose, under the caption Audit-Related Fees, the aggregate
fees billed in each of the last two fiscal years for assurance and
related services by the principal accountant that are reasonably
related to the performance of the audit of the registrant's financial
statements and are not reported under paragraph (a) of this Item.
Registrants shall describe the nature of the services comprising the
fees disclosed under this category.
(c) Disclose, under the caption Tax Fees, the aggregate fees billed
in each of the last two fiscal years for professional services rendered
by the principal accountant for tax compliance, tax advice, and tax
planning. Registrants shall describe the nature of the services
comprising the fees disclosed under this category.
(d) Disclose, under the caption All Other Fees, the aggregate fees
billed in each of the last two fiscal years for products and services
provided by the principal accountant, other than the services reported
in paragraphs (a) through (c) of this Item. Registrants shall describe
the nature of the services comprising the fees disclosed under this
category.
(e)(1) Disclose the audit committee's pre-approval policies and
procedures described in paragraph (c)(7) of Rule 2-01 of Regulation S-
X.
(2) Disclose the percentage of services described in each of
paragraphs (b) through (d) of this Item that were approved by the audit
committee pursuant to paragraph (c)(7)(i)(C) of Rule 2-01 of Regulation
S-X.
(f) If greater than 50 percent, disclose the percentage of hours
expended on the principal accountant's engagement to audit the
registrant's financial statements for the most recent fiscal year that
were attributed to work performed by persons other than the principal
accountant's full-time, permanent employees.
(g) Disclose the aggregate non-audit fees billed by the
registrant's accountant for services rendered to the registrant, and
rendered to the registrant's investment adviser (not including any sub-
adviser whose role is primarily portfolio management and is
subcontracted with or overseen by another investment adviser), and any
entity controlling, controlled by, or under common control with the
adviser that provides ongoing services to the registrant for each of
the last two fiscal years of the registrant.
(h) Disclose whether the registrant's audit committee of the board
of directors has considered whether the provision of non-audit services
that were rendered to the registrant's investment adviser (not
including any sub-adviser whose role is primarily portfolio management
and is subcontracted with or overseen by another investment adviser),
and any entity controlling, controlled by, or under common control with
the investment adviser that provides ongoing services to the registrant
that were not pre-approved pursuant to paragraph (c)(7)(ii) of Rule 2-
01 of Regulation S-X is compatible with maintaining the principal
accountant's independence.
Instructions.
1. The information required by this Item 4 is only required in an
annual report on this Form N-CSR.
2. For purposes of paragraphs (b), (c), and (d), registrants that
are investment companies must disclose fees billed for services
rendered to the registrant and separately, disclose fees required to be
approved pursuant to paragraph (c)(7)(ii) of Rule 2-01 of Regulation S-
X. Registered investment companies must also disclose the fee
percentages as required by Item 4(e)(2) for the registrant and
separately, disclose the fee percentages as required by Item 4(e)(2)
for the fees required to be approved by the investment company
registrant's audit committee pursuant to paragraph (c)(7)(ii) of Rule
2-01 of Regulation S-X.
* * * * *
By the Commission.
Dated: January 28, 2003.
Jill M. Peterson,
Assistant Secretary.
[FR Doc. 03-2364 Filed 2-4-03; 8:45 am]
BILLING CODE 8010-01-P