[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
------------------------------------------------------------------------
2003                      March 16, 2003........  April 5, 2004
2004                      April 6,..............  2004 March 10, 2005
2005                      March 11, 2005........  March 30, 2006
------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \69\ SAS No. 55, ``Consideration of Internal Control in a 
Financial Audit,'' AU Sec.  319.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    \113\ American Institute of Certified Public Accountants 
(AICPA), Division for CPA Firms SEC Practice Section Peer Review 
Manual, 1978.
---------------------------------------------------------------------------

    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).
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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\
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \168\ See, letter from KPMG, LLP, dated January 9, 2003.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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)).
---------------------------------------------------------------------------

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.
---------------------------------------------------------------------------

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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    \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)].
---------------------------------------------------------------------------

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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    \207\ Release No. 33-8090, May 10, 2002, (67 FR 35620).
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \210\ See, AU Sec.  380.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \211\ See, SAS No. 85, ``Management Representations,'' AU Sec.  
333.
---------------------------------------------------------------------------

    [sbull] Reports on observations and recommendations on internal 
controls; \212\
---------------------------------------------------------------------------

    \212\ See, SAS 60, ``Communication of Internal Control Related 
Matters Noted in an Audit,'' AU Sec.  325.
---------------------------------------------------------------------------

    [sbull] Schedule of unadjusted audit differences,\213\ and a 
listing of adjustments and reclassifications not recorded, if any;
---------------------------------------------------------------------------

    \213\ See, SAS No. 89, ``Audit Adjustments,'' AU Sec.  333.
---------------------------------------------------------------------------

    [sbull] Engagement letter; \214\ and
---------------------------------------------------------------------------

    \214\ See, SAS No. 83, ``Establishing an Understanding With the 
Client,'' AU Sec.  310.
---------------------------------------------------------------------------

    [sbull] Independence letter.\215\
---------------------------------------------------------------------------

    \215\ See, SQCS No. 2, ``System of Quality Control for a CPA 
Firm's Accounting and Auditing Practice,'' QC Sec.  20.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

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.
---------------------------------------------------------------------------

    \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.''
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \233\ See also, Section 2(a)(2) the Sarbanes-Oxley Act which 
defines the term ``audit.''
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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:
---------------------------------------------------------------------------

    \241\ 44 U.S.C. 3501 et seq.
    \242\ 44 U.S.C. 3507(d) and 5 CFR 1320.11.
---------------------------------------------------------------------------

    (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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

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.
---------------------------------------------------------------------------

    \255\ See, Securities Industry Association, Report on Management 
& Professional Earnings in the Securities Industry 2002 (2002).
---------------------------------------------------------------------------

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\
---------------------------------------------------------------------------

    \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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    [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.
---------------------------------------------------------------------------

    [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.
---------------------------------------------------------------------------

    [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\
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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:
---------------------------------------------------------------------------

    \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\
---------------------------------------------------------------------------

    \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
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    [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.
---------------------------------------------------------------------------

    \269\ Id.; 65 FR at 43185.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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).
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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).
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

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).
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \297\ 17 CFR 270.0-10.
    \298\ The definition of a ``small business'' also includes a 
``unit investment trust'' and a ``business development company.''
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

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.
---------------------------------------------------------------------------

    \302\ 17 CFR 210.2-01(c)(4)(v)(A).
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \303\ Id.; 65 FR at 43185.
---------------------------------------------------------------------------

    (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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \306\ See, e.g., NACD, 2001-2002 Public Company Governance 
Survey (Nov. 2001).
---------------------------------------------------------------------------

    (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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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