The Modernization of the Rules Governing the Independence of the Accounting Profession
November 15, 2000
The Commission will consider the adoption of rules that modernize the requirements for auditor independence primarily in three areas:
|(1)||investments by auditors or their family members in audit clients;|
|(2)||employment relationships between auditors or their family members and audit clients; and|
|(3)||the scope of services provided by audit firms to their audit clients.|
- The rules would significantly reduce the number of audit firm employees and their family members whose investments in, or employment with, audit clients would impair an auditor's independence.
- They would also identify certain non-audit services that, if provided to an audit client, would impair an auditor's independence. The proposals would not extend to services provided to non-audit clients.
- A limited exception would be provided to an accounting firm for inadvertent independence violations if the firm has quality controls in place and the violation is corrected promptly.
- Companies would disclose in their annual proxy statements certain information about non-audit services provided by their auditors during the last fiscal year.
Four PrinciplesThe proposing release articulated four principles by which to measure an auditor's independence. An accountant is not independent when the accountant
|(1)||has a mutual or conflicting interest with the audit client,|
|(2)||audits his or her own firm's work,|
|(3)||functions as management or an employee of the audit client, or|
|(4)||acts as an advocate for the audit client.|
Many commenters expressed concern that the principles may cast too wide a net and affect services that would not impair an auditor's independence. The staff, accordingly, has recommended to the Commission that the four principles be taken out of the rule itself and be incorporated into a preliminary note and used as general guidance.
Financial RelationshipsThe adopted rules in the area of financial relationships would be similar to the proposed rules. They would narrow significantly the circle of people whose investments trigger independence concerns. Today, many partners in firms that do not work on the audit of a client, as well as their spouses and families, are restricted from investments in a firm's audit clients. The rules the Commission considers today would limit such restrictions to principally those who work on the audit or can influence the audit.
Employment RelationshipsAdopted substantially as proposed, the employment relationship rules would greatly narrow the scope of people within audit firms whose families would be affected by the employment restrictions necessary to maintain independence. The rules also identify the positions, namely those in which a person can influence the audit client's accounting records or financial statements, which would impair an auditor's independence if held by a "close family member" of the auditor.
Business RelationshipsConsistent with existing rules, independence would be impaired if the accountant or any covered person has a direct or material indirect business relationship with the audit client, other than providing professional services.
General Standard for Auditor IndependenceThe rule is based on the widely endorsed principle that an auditor must be independent in fact and appearance. While some commenters stated that an appearance-related standard departs from current Commission rule, the Commission, courts and the profession have long recognized the importance of the appearance of independence.
The staff, however, was mindful of the concern that an appearance standard would be subjectively applied. The final rule articulates that an auditor's independence is impaired either when the accountant is not independent "in fact" or when, in light of all relevant facts and circumstances a reasonable investor would conclude that the auditor would not be capable of acting without bias. The objective "reasonable investor" standard is a common construct in securities laws.
Non-Audit ServicesThe rules identify nine non-audit services that are deemed inconsistent with an auditor's independence. Seven of the nine services are already restricted by the AICPA, SECPS or SEC. As such, much of the Commission's rule proposal sought to codify existing restrictions. Commenters expressed concern that the proposal went beyond the scope of the current prohibitions. In response, the rules the staff recommends the Commission adopt today would closely track the current language found in the existing prohibitions.
- Bookkeeping or Other Services Related to the Audit Client's Accounting Records or Financial Statements. Paralleling closely the current prohibition on bookkeeping, an audit firm could not maintain or prepare the audit client's accounting records or prepare the audit client's financial statements that are either filed with the Commission or form the basis of financial statements filed with the Commission. Exceptions include providing services in emergency situations, provided the accountant does not undertake any managerial actions or make any managerial decisions. Exceptions also include bookkeeping for foreign divisions or subsidiaries of an audit client, provided certain conditions exist.
- Financial Information Systems Design and Implementation. The auditor cannot operate or supervise the operation of the client's IT systems. However, the auditor could provide IT consulting services provided certain criteria are met. These criteria include that management
(1) acknowledges to the auditor and audit committee management's responsibility for the clients system of internal controls,
(2) identifies a person within management to make all management decisions with respect to the project,
(3) makes all the significant decisions with respect to the IT project,
(4) evaluates the adequacy and results of the project, and
(5) does not rely on the accountant's work as the primary basis for determining the adequacy of its financial reporting system.
The issuer would also disclose the total amount of fees for IT services received from its auditor. The prohibition does not include services an accountant performs in connection with the assessment, design, and implementation of internal accounting controls and risk management controls.
- Appraisal or Valuation Services or Fairness Opinions. The final rule would not ban all valuation and appraisal services. Its restrictions apply only where it is reasonably likely that the results of any valuation or appraisal would be material to the financial statements, or where the accountant would audit the results.
- Actuarial Services. Closely tracking the SECPS prohibition on actuarial services, actuarial-oriented advisory services would be limited only when they involve the determination of insurance company policy reserves and related accounts. Certain types of actuarial services could be performed if the audit client uses its own actuaries or third party actuaries to provide management with the primary actuarial capabilities, management accepts responsibility for actuarial methods and assumptions, and the accountant does not render actuarial services to an audit client on a continuous basis.
- Internal Audit Services. An audit firm would be allowed to perform up to 40 percent (measured in terms of hours) of an audit client's internal audit work. The rule would not restrict internal audit services regarding operational internal audits unrelated to accounting controls, financial systems, or financial statements. The rule would provide an exception for smaller businesses by excluding companies with less than $200 million in assets. Providing any internal audit services for an audit client, however, would be contingent on management taking responsibility for and making all management decisions concerning the internal audit function.
- Management Functions. Consistent with current SEC rules, an auditor's independence would be impaired when the accountant acts, temporarily or permanently, as a director, officer, or employee of an audit client, or performs any decision-making, supervisory, or ongoing monitoring function for the audit client.
- Human Resources. Closely paralleling the SECPS rules, an auditor would not be able to recruit, act as a negotiator on the audit client's behalf, develop employee testing or evaluation programs, or recommend, or advise that the audit client hire, a specific candidate for a specific job. An accounting firm could, 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.
- Broker-Dealer Services. Consistent with current AICPA rules, an auditor could not serve as a broker-dealer, promoter or underwriter of an audit client's securities.
- Legal Services. An auditor could not provide any service to an audit client under circumstances in which the person providing the service must be admitted to practice before the courts of a U.S. jurisdiction.
Affiliate ProvisionsThe proposed rule contained a definition of an "affiliate of an accounting firm" that many commenters felt might affect accounting firms' joint ventures with companies that are not their audit clients and the continuation of small firm alliances -- relationships that traditionally have not been thought to impair an accountant's independence. After considering these comments, the staff has recommended that the definition in the proposed rule not be adopted. Instead, the Commission would continue to analyze these situations under existing guidance.
An "affiliate of an audit client" would be defined to be any entity that can significantly influence, or is significantly influenced by, the audit client, provided the equity investment is material to the entity or the audit client. "Significance influence" generally is presumed when the investor owns 20% or more of the voting stock of the investee. The significant influence test is used because under GAAP it is the trigger that causes the earnings and losses of one company to be reflected in the financial statements of another company.
Contingent Fee ArrangementsThe rules reiterate that an accountant cannot provide any service to an audit client that involves a contingent fee.
Quality ControlsThe rules provide a limited exception from independence violations to the accounting firm, if certain factors are present:
- The individual did not know the circumstances giving rise to his or her violation.
- The violation was corrected promptly once the violation became apparent.
- The firm has quality controls in place that provide reasonable assurance that the firm and its employees maintain their independence. For the largest public accounting firms, the basic controls must include, among others, written independence policies and procedures, automated systems to identify financial relationships that may impair independence, training, internal inspection and testing, and a disciplinary mechanism for enforcement.
Proxy Disclosure RequirementCompanies would disclose in their annual proxy statements the fees for audit, I/T consulting and all other services provided by their auditors during the last fiscal year.
Companies will also state whether the audit committee has considered whether the provision of the non-audit services is compatible with maintaining the auditor's independence.
Lastly, the registrant would be required to disclose the percentage hours worked on the audit engagement by persons other than the accountant's full time employees, if that figure exceeded 50 percent. This requirement responds to recent moves by some accounting firms to sell their practices to financial services companies. The partners or employees often become employees of the financial services firm. The accounting firm then leases assets, namely auditors, back from those companies to complete audit engagements. In such cases, most of the auditors who work on an audit are employed elsewhere unbeknownst to the public.