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U.S. Securities and Exchange Commission

Speech by SEC Staff:
Remarks before the 2004 AICPA National Conference on Current SEC and PCAOB Developments


Edmund W. Bailey

Senior Assistant Chief Accountant
U.S. Securities and Exchange Commission

Washington, D.C.
December 6, 2004

As a matter of policy, the Securities and Exchange Commission disclaims responsibility for any private publication, or statement of any SEC employee or Commissioner. This speech expresses the author's views and does not necessarily reflect those of the Commission, the Commissioners, or other members of the Staff.


Good afternoon. My name is Ed Bailey and I am the Senior Assistant Chief Accountant in the Professional Practice Group of the Office of the Chief Accountant. Like all my colleagues on this stage, I would like to remind you that my comments do not necessarily reflect the views of the Commission, the Commissioners, or other members of the staff. My primary area of responsibility in the Professional Practice Group is auditor independence. However, I also worked on the development of the Commission's rules under Section 404 of the Sarbanes-Oxley Act and on reviewing the auditing standard for the audit and reporting on internal controls over financial reporting.

With limited time, my comments will focus on current independence issues and on just a few subjects that I believe will be of particular interest to all of you. These subjects are:

  • Auditor Independence
    • Who is Responsible
    • Frequently Asked Questions
  • Board of Directors Relationships with Auditors
  • Other Independence Initiatives

Esmeralda Rodriguez, Associate Chief Accountant and Nancy Salisbury, Professional Accounting Fellow in our group, together with the PCAOB representatives, will address in a later break-out session issues related to reporting and auditing on Internal Control over financial reporting and the Frequently Asked Questions related to the Commission's rules and the PCAOB's auditing standard. I would encourage those interested in these topics to attend that session.

Auditor Independence - who is responsible?

Rule 2-01 of Regulation S-X contains the rules in the Commission's 2000 release "Revision of the Commission's Auditor Independence Requirements" and the 2003 release "Strengthening the Commission's Requirement Regarding Auditor Independence". These rules are intended to assure investors that auditors are qualified and independent of their audit clients both in fact and in appearance. The rules set forth restrictions on financial interest, employment, and business relationships between an accountant and an audit client and restrictions on an accountant providing certain non-audit services to any audit client; as well as the prohibition of contingent fees engagements. Further, there are rules regarding partner rotation, the cooling-off period when a covered person accepts a position with an issuer and audit committee administration of the engagement including pre-approval of services provided by the principal auditor. The Commission stated in the 2003 release:

"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 and that, as required by Congress, are audited by independent auditors."

Public companies have a responsibility to ensure that the auditors of the financial statements are independent. Regulation S-X sets forth the form and content of and requirements for financial statements required to be filed with the Commission. Ensuring auditor independence is as an important a requirement as ensuring that revenues and expenses are properly reported and classified. Management, the Board of Directors and the Board's Audit Committee have a shared responsibility to ensure that the auditors of the company's financial statements are independent. If the auditor's independence is impaired then the company has not satisfied the requirement to file financial statements audited by an independent accountant. Discovery of an independence issue at the last minute can adversely affect an otherwise timely filing and can be financially detrimental to the company. There is not only the possibility of having to have the financial statements re-audited but also of an adverse market reaction to the non-compliance with Regulation S-X. A company should have policies and procedures in place to ensure its auditor is and remains independent. Ensuring auditor independence is a responsibility of both the auditor and the company. The 2003 Rules place a direct responsibility on audit committees to oversee the auditor's independence. When independence questions are raised with the staff, we often ask about the audit committee's investigation, their analysis of the facts and circumstances and their conclusions as to the audit firm's independence.

Auditor Independence - Frequently Asked Questions

The staff is expanding and updating our Frequently Asked Questions (FAQ's) on the Application of the Rules on Auditor Independence which is expected to be issued shortly. The new FAQ's will address additional clarity on partner rotation, on audits of financial statements filed with the Commission as required by Rules 3-05 and 3-09 of Regulation S-X, on prohibited indemnification language in engagement letters and on independence issues related to investments by private equity investment funds sponsored by public companies. The new consolidated FAQ's on Auditor Independence will also represent a comprehensive document, where all independence FAQ's, including both the 2000 and 2003 FAQ's, are presented in relevant categories and identified by the date they were issued. The staff plans to continue updating and maintaining this document so that you can find in one place all up-to-date FAQ's related to Auditor Independence.

Just a brief comment on Indemnification language; the staff has been advised that there has been appearances of indemnification language appearing in audit engagement letters for SEC registrants. When an accountant seek immunity from liability such conditions induce departures from objectivity and impartiality, consequently, the accountant cannot be recognized as independent.

Board of Directors Relationships with Auditors

Rule 2-01(c)(3) on business relationships says that an accountant is not independent if at any point during the audit and the professional engagement period the accounting firm or any person in the firm has any direct or material indirect business relationship with, among others, directors or substantial stockholders of the company. Boards of Directors have oversight responsibility for the company, its management and its auditors. The rules of the national stock exchanges require the Board of Directors of each listed company to consist of a majority of independent directors, and each member of the audit committee to be independent with respect to the company and its management. These rules also address the audit committee's responsibility to select and oversee an issuer's independent accountant. The independence rules on business relationships specifically prohibit Directors from having direct or material indirect business relationships with auditors.

Other Independence Initiatives

It is only reasonable to question, following my remarks whether the Commission is considering another revision of the auditor independence rules. I'm not aware of any new auditor independence initiatives at the Commission. I presume, though, that you are aware of the PCAOB's Roundtable on Auditor Independence and Tax Services that was held last July and the related PCAOB discussions during its latest Standards Advisory Group meetings. Also, I refer you to an article in the November 22, 2004, Financial Times, "Regulators close to plan on audit and tax links," which refers to PCAOB activity. To quote the article, "no formal discussion about the tax rules have been made by the PCAOB but an initial draft has been completed and the regulators may next month finalize a document for public consideration."


In a recent speech by Chairman, Donaldson, he noted:

"The SEC and others like us can set the rules and define independence - but legal definitions can only go so far. And our free market, democratic system will gradually erode, and inevitably suffer grievous harm, if remedial efforts are not undertaken and endorsed by a broad cross-section of our business and financial communities."

When companies and auditors achieve and maintain a reputation for auditor independence and engender trust in our financial reporting process is not, in the final analysis, up to the Commission or the PCAOB. It is up to the individuals running businesses and the CPAs doing their daily work of auditing financial statements. Management must recognize that having a critical and objective review of their financial statements and internal controls is not just a statutory requirement - it is good business. Auditors must recognize that the very existence of their profession will depend not only on the quality of their work but also on whether investors believe they have exercised free and independent judgment when they performed their audits. We will provide guidance, but you must turn that guidance into a way of life.

Thank you.


Modified: 12/06/2004