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U.S. Securities and Exchange Commission

Speech by SEC Staff:
Current SEC Developments:
Independence "Matters"

Remarks by

Lynn E. Turner

Chief Accountant
Office of the Chief Accountant
U.S. Securities & Exchange Commission

28th Annual National Conference on Current SEC Developments

December 6, 2000

The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or statement by any of its employees. The views expressed herein are those of Mr. Turner and do not necessarily reflect the views of the Commission, the Commissioners, or other members of the Commission's staff.


Good morning. It is a pleasure to have the opportunity to speak to you again at this conference. I appreciate the remarks made by Art and the efforts of the ISB.

As many know well, the process of working towards an effective but workable final auditor independence rule has been a long, and often difficult one. Along the way, there have been some heartfelt differences of opinion on how best to handle certain issues. The Commission's staff has heard the specific concerns of thousands, including all of the Big 5 firms and the AICPA, and the final rule reflects, to a great extent, their concerns. I want to commend Jim Schiro of PricewaterhouseCoopers and Phil Laskawy of Ernst & Young for their leadership throughout this process, as well as the three other Big 5 firms, the AICPA and others in the profession for their willingness to come to the table and work through the issues. I firmly believe that the final rule strikes a balance that serves the interests of America's investors while remaining flexible and adaptable for the unforeseen changes in tomorrow's marketplace.

America's accounting firms have established a proud heritage of excellence through the years, fulfilling a mandate established in 1933 to provide investors with information that is both comprehensive and reliable. Yet, competitive pressures and an imperfect self-regulatory presence gave rise to a need to address both perceived and actual conflicts of interest. Furthermore, recent events, news stories, and the business desires of public accounting firms to be able to invest in certain companies, have their clients invest in their own public offerings, and practice law, in addition to concerns over the culture and controls within the firms, raise significant public policy issues that require serious consideration. Accordingly, the Commission proposed changes to our auditor independence requirements in response to these developments. We received thoughtful and constructive input from a broad spectrum of interested parties. That input, which included almost 3,000 comment letters and written and oral testimony during four days of public hearings (about 35 hours of testimony from over 100 witnesses) helped us to better understand the sincere and strongly-held views on all sides, and to shape final rules.

The final rules, among other things,

  • significantly reduce the number of audit firm employees and their family members whose investments in audit clients are attributed to the auditor for purposes of determining the auditor's independence;

  • shrink the circle of family and former firm personnel whose employment impairs an auditor's independence;

  • identify certain non-audit services, that, if provided by an auditor to a public company audit client, impairs the auditor's independence. These prohibitions do not extend to services provided to non-audit clients.

Additionally, the final rules provide accounting firms with a limited exception from being deemed not independent for certain inadvertent independence impairments if they have sufficient quality controls and satisfy other conditions. Finally, most public companies will be required to disclose in their annual proxy statements, among other things, certain information related to non-audit services provided by their auditor.

But most importantly, the new rules will provide investors greater confidence and trust in the integrity and objectivity of the audits they rely on.

I would like to take a few minutes to further discuss a few specific provisions in the final rule. These areas include legal services, affiliates of the accounting firm and business relationships, contingent fees, fairness opinions, the term significant influence, quality controls and proxy disclosures.

Legal Services

Fundamentally, a conflict exists between the role of an independent auditor and that of an attorney. The auditor's charge is to examine objectively and report, regardless of the impact on the client, while the attorney's fundamental duty is to advance the client's interest. This conflict has been recognized by the U.S. Supreme Court and professional legal organizations. Our rule recognizes this and provides that an auditor's and firm's independence would be impaired if an auditor provides to its audit client a service for which the person providing the service must be admitted to practice before the courts of a U.S. jurisdiction. To be clear, this standard covers all services that require the person providing the service to be a licensed attorney. That is, the rule does not apply only to appearance in court or solely to litigators. It also applies to attorneys who give clients legal advice and preparing legal opinions. Further, pursuant to Rule 2-01(b), when a mutuality of interest exists or where advocacy relationships that are not currently commonplace arise in the future in the accountancy profession, they will be scrutinized by the staff. Additionally, as clearly documented in the adopting release, legal services provided outside of the United States to registrants raise serious concerns - any variation from the guidance in the adopting release will be deemed to impair an auditor's independence. I encourage firms to maintain an open line of communication with the staff on independence issues. By addressing potential independence issues in advance, the risk of not having an independent audit can be mitigated. Timely discussions can prevent otherwise unpleasant situations where the Commission, firm or registrant are placed in a box from which there is no escape.

Affiliate of the Accounting Firm and Business Relationships

One of the more controversial definitions in our proposed rule was "affiliate of the accounting firm." In sum, we understood that the proposed definition was believed to be overbroad and would affect the current business arrangements of some organizations. After careful consideration, the Commission decided not to adopt a separate definition of "affiliate of the accounting firm." Rather, the Commission concluded that retaining the existing base of guidance is appropriate. While the Commission had hoped to further clarify the standards in this area, the Commission did not want to create unintended consequences that commenters suggested would arise through application of the proposed definition. Affiliate issues related to the accounting firm are relatively new and include, among potential others, alternative practice structures, joint venture arrangements, business relationships other than in the normal course of business and spin-offs.

As the Commission has noted in the Codification of Financial Reporting in the past, joint ventures, limited partnerships, investments in supplier or customer companies, leasing interests and sales by the accountant of items other than professional services are examples of business relationships auditors have been, and will continue to be, precluded from having with their audit clients. In a letter the Commission issued to Arthur Andersen in 1989, the Commission stated,

"The Commission has recognized that certain situations, including those in which accountants and their audit clients have joined together in a profit-sharing venture, create a unity of interest between the accountant and client. In such cases, both the revenue accruing to each party ...and the existence of the relationship itself create a situation in which to some degree the auditor's interest is wedded to that of its client. That interdependence impairs the auditor's independence, irrespective of whether the audit was in fact performed in an objective, critical fashion. Where such a unity of interests exists, there is an appearance that the auditor has lost the objectivity and skepticism necessary to take a critical second look at management's representations in the financial statements. The consequence is a loss of confidence in the integrity of the financial statements."

To date, the staff has dealt these questions relative to affiliates of an audit firm individually by analyzing the situation in light of all facts and circumstances. As a result, over the years, letters have been issued by the staff describing known specific affiliations. These letters have been incorporated into the adopting release via footnotes 489 and 491. I expect that affiliate relationships will continue to develop and anticipate that the staff will closely monitor these relationships. As affiliations are contemplated, the staff is available for necessary up front consultations, but intend to strictly apply the Commission's rules and guidance.

Contingent Fees

The final rule defines a contingent fee as any fee established for the provision of any service or product pursuant to an arrangement in which no fee will be charged unless a specified finding or result is attained, or in which the amount of the fee is otherwise dependent upon the finding or result of such service or product, including commissions and similar payments. In the last couple of years, the staff has become aware of more situations where firms are developing very aggressive and questionable fee arrangements. Please understand that contingent fee arrangements are no longer the big pink elephant in the middle of the room that no one will talk about - they will be thoroughly evaluated by the staff. As the release notes, the staff will look closely to determine whether a fee, such as those labeled "value added" or "performance based," is in fact or substance a contingent fee, such as where there are side letters or other evidence that ties the fee to the success of the services rendered. For example, an auditor might undertake a study of certain types of client's expenditures in order to identify greater amounts of qualifying expenses that would result in greater income tax credits. Fees for such services might be based on a percentage of the tax credits generated, or a base fee plus a percentage of tax credits generated over a pre-determined based amount. In that case, the accounting firm's economic benefit will be greater if the tax credits are maximized. Because this interest is inconsistent with acting independently in assessing the accuracy of the impact on the income tax accounts and financial statements of those tax credits, those kinds of fee arrangements are prohibited under the final rule.

Fairness Opinions

Fairness opinions continue to be a concern of the staff. Situations where an accountant issues a fairness opinion or similar report in connection with a transaction involving an audit client have been and will continue to be questioned by the staff. While the new rule provides limited situations where fairness opinions may be permitted, the implied mutuality of interest severely limits the situations where such services may be provided by the auditor. The staff has agreed to an engagement whereby the auditor performs specified procedures as set forth in a letter to the Italian Consob, which is on our website at www.sec.gov.

Significant Influence

In our adopting release the Commission discussed, among other things, its belief that a significant influence test sets a proper baseline threshold for audit client affiliation because, under the equity method of accounting, it results in the marriage of financial information between audit client and the entity influenced by, or influencing, the financial or operating policies of the audit client. In applying this test the Commission referred to the principles in Accounting Principle Board ("APB") No. 18. Application of this test should encompass the financial as well as the non-financial measures of the bulletin such as, representation on the board of directors, participation in key policy decision, material inter-company transactions, interchange of personnel or other means.

Quality Controls

Included in the new rule is a limited exception that may apply to situations where an accountant's independence becomes impaired inadvertently. An example of such a violation would be where a family member makes a prohibited investment and the covered person is not aware of the investment. If the accounting firm maintains specified quality controls and satisfies other conditions, the accounting firm's independence may not be impaired as a result of the inadvertent violation. This limited exception applies only to the firm; therefore, the individual will still be subject to the possibility of enforcement action. I would add that with respect to assessing the quality control systems of firms, we anticipate that the work performed by the POB pursuant to the Look-back amnesty program as well as the peer reviews conducted under the oversight of the POB will provide support for compliance by the firms pursuant to this provision.

With respect to foreign associated or sister firms, to qualify for the limited exception, quality control systems that provide reasonable assurance that the firm and its employees do not lack independence are required immediately. Foreign firms that are associated with accounting firms with more than 500 SEC audit clients have been provided with additional time, through December 31, 2002, to comply with more extensive quality control system requirements outlined in the final rule. This accommodation was made as a result of logistical and practical implementation issues that we understand may arise in the course of establishing these automated systems.

Proxy Disclosures

The Commission has long been recognized as a disclosure oriented agency. Disclosure requirements related to our independence rulemaking are informative and concise. The three main areas of enhanced disclosure are: 1) disclosure regarding fees billed for services rendered by the principal accountant; 2) disclosure regarding whether the audit committee considered the compatibility of non-audit services the company received from its auditor and the independence of the auditor; and 3) disclosure regarding the employment of leased personnel in connection with the audit. The first two items are more likely to affect all public companies, whereas the third item will only affect public companies whose auditors are part of an alternative practice structure.

Companies are required to comply with the new proxy disclosures for all statements filed with us after the effective date, which is February 5, 2001. Generally, information about auditor fees is readily available to registrants through communications required of SECPS members and ISB No. 1 and their internal accounting systems. Based on the existing requirements and comments received by many of the firms, I suspect that this information is already on the agenda of many audit committees. Fees paid to the principal accountant are to be broken into three distinct categories. The categories include fees for: 1) the audit and review of the Company's annual and quarterly financial statements; 2) information technology consulting; and 3) all other services. The amount disclosed as the audit and review fees should be just that - this category should not be loaded up with other unrelated items that are not rendered as part of the audit or review process, such as billings for allowable internal audit services, due diligence or other services performed with respect to a registration statement. Situations may exist where companies want to provide additional details of the fees included in each of the above captions - we are not opposed to such disclosures.

Bright Lines

Application of these rules will be easier in some respects and more difficult in others. However, clear lines have been drawn in areas where independence will be impaired. The staff, as always, is more than willing to meet and discuss issues that are not otherwise defined or clear. But we do not want to find ourselves faced with the need for another amnesty program and violations of the new rules will be dealt with appropriately. Too often we find that there has been an independence violation and are then asked to waive the requirements of the rules, or that the firm be given a period to "cure" the problem in the future. With adequate quality controls, including ongoing training, monitoring and a substantive disciplinary mechanism, the staff expects that the rules will be complied with. If the rules are violated, unless covered by the inadvertent violation exception, independence will be deemed to be impaired. For example, if a partner or manager provides ten hours of non-audit services to an audit client then he or she is a covered person. Auditors and registrants need not ask for a waiver if a person puts in 11 hours. If a covered person has a prohibited financial interest such as a checking account, or a former partner has an immaterial capital balance and is employed by an audit client, then independence will be deemed to be impaired. The rules are clear and the staff does not intend to grant no action relief where clear lines have been drawn.

I would like to touch on the impact of the new independence rules with regard to audit committees and to briefly discuss the impact of the ISB's recently issued exposure draft.

Audit Committees

Over the past year, the role and importance of the audit committee has been enhanced through regulatory requirements and professional reporting requirements. We hope the practices set forth in the Report of the Blue Ribbon Committee on Improving the Effectiveness of Audit Committees, as well as the new rules adopted by the stock exchanges, the accounting profession and the Commission will contribute to an improvement in the quality of financial reporting in our capital markets. I would encourage you to discuss with your client's audit committees, not only the recommendations of the Blue Ribbon Committee, but also the Best Practices set forth in its Report. These practices are set forth in five principles which address the oversight role and responsibility of the audit committee, including the need to oversee both the internal and external audit functions, ensure independent communication with the internal and external auditors, engage in a robust, candid, and probing discussion of the quality of the Company's financial reporting and disclosure practices, and adopt measures to ensure the outside auditor's objectivity.

I also strongly encourage audit committees to seriously consider the recommendations of the Panel on Audit Effectiveness, commonly referred to as the O'Malley Panel. Included in these recommendations are:

  1. The audit committee should obtain each year from management, a report on the effectiveness of the Company's internal controls,

  2. Audit committees should pre-approve non-audit services provided by the independent auditor, and

  3. In making the determination of what non-audit services should be approved, the audit committee should consider the following ten factors which are designed to determine if the service has an impact not only on how investors will perceive an auditor's independence, but also on how the services affect audit quality:

    1. Whether the service is being performed principally for the audit committee.

    2. The effects of the service, if any, on audit effectiveness or on the quality and timeliness of the entity's financial reporting process.

    3. Whether the service would be performed by specialists (e.g., technology specialists) who ordinarily also provide recurring audit support.

    4. Whether the service would be performed by audit personnel, and if so, whether it will enhance their knowledge of the entity's business and operations.

    5. Whether the role of those performing the service would be inconsistent with the auditors' role (e.g., a role where neutrality, impartiality and auditor skepticism are likely to be subverted).

    6. Whether the audit firm personnel would be assuming a management role or creating a mutual or a conflict of interest with management.

    7. Whether the auditors, in effect, would be "auditing their own numbers."

    8. Whether the project must be started and completed very quickly.

    9. Whether the audit firm has unique expertise in the service.

    10. The size of the fee(s) for the non-audit service(s).

These factors expand on the four basic independence principles set forth by the Commission. The Commission has also discussed these factors in its release and I strongly urge you to review its comments. I also urge each and every audit committee to seriously consider the factors as they evaluate a specific non-audit service provided by the independent auditor.

Our final rule does not impose any new legal requirements on audit committees. While the rule may serve to direct the attention of audit committees to the potential for independence issues arising from non-audit services, any action taken by audit committees will be business judgments. Nonetheless, the rule should help audit committees carry out their existing responsibilities by codifying the key legal requirements that may bear on audit committee's exercise of their business judgment.

In a letter to the SECPS, ISB Chairman William Allen stated:

"[I}n asking itself whether a fact or relationship is material in this setting the auditor may not rely on its professional judgment that such fact or relationship does not constitute an impairment of independence. Rather the auditor is to ask, in its informed good faith view, whether the members of the audit committee who represent reasonable investors, would regard the fact in question as bearing upon the board's judgment of auditor independence."

The Commission has indicated that it agrees with Chairman Allen's comment. Additionally, as indicated in its adopting release, the Commission believes that audit committees, as well as management, should engage in active discussions of independence-related issues with the outside auditors. As with discussions over the quality and acceptability of management's judgments, audit committees can be useful in considering whether assertions of independence rest on conservative or aggressive readings of the independence rules.

Conceptual Framework

Finally, no speech on independence matters could be complete without some mention of the Independence Standards Board ("ISB"). The ISB was established in 1997, and I want to take just a moment to commend the ISB members for their service over the last three years.

The ISB members are all intelligent, extremely successful people and their deliberations had an obvious impact on the Commission's decisions about our new rule. The professional members of the ISB have given generously of their time and shown remarkable objectivity in light of the potential impact some of the issues could have on their firms. The public members participate on the Board out of a sense of public service and they also have given their extremely valuable time to gain an understanding of the issues and to seek answers to the difficult questions brought before them.

During our public hearings, the public members of the ISB expressed their support for our rulemaking on non-audit services, even though it is obvious from their personal careers that they thrive on taking on challenging projects. They did it because they thought that if the SEC, instead of the ISB, performed the rulemaking then the issues would reach a broader audience and there would be a more active public debate. Additionally, the SEC could directly address the significant policy issues involved, and investors might have more confidence in the result if the decisions were made by an agency with four impartial commissioners, rather than from a board with mixed professional and public members. All of the ISB members should be commended.

When the SEC assisted in establishing the ISB, however, the SEC indicated that it would look to this organization to provide independence guidance to public companies but it would not abdicate its responsibility with regard to independence regulations. This was clear during our recent action to amend the Commission's rule and has been the reason for our close oversight of the ISB since its inception.

In that vein, we are following the ISB's recent Conceptual Framework Exposure Draft. Let me mention just a few points that I think a fair reading of the SEC's recent auditor independence release would indicate would have to be part of any conceptual framework, if it was to be supported by the Commission.

First, a conceptual framework for auditor independence must focus not only on the fact of auditor independence but also on the appearance of independence. The Supreme Court has emphasized the importance of the link between investor confidence in the securities markets and the appearance of auditor's independence. The Court stated,

"The SEC requires the filing of audited financial statements to obviate the fear of loss from reliance on inaccurate information, thereby encouraging public investment in the Nation's industries. It is therefore not enough that financial statements be accurate; the public must also perceive them as being accurate. Public faith in the reliability of a corporation's financial statements depends on the public perception of the outside auditor as an independent professional.... If investors were to view the auditor as an advocate for the corporate client, the value of the audit function itself might well be lost."1

The accounting profession has long embraced the need for auditors to not only be, but also to appear to be, independent. Statement on Auditing Standards No. 1 states,

"Public confidence would be impaired by evidence that independence was actually lacking, and it might also be impaired by the existence of circumstances which reasonable people might believe likely to influence independence... Independent auditors should not only be independent in fact, they should avoid situations that may lead outsiders to doubt their independence."2

Witnesses at the Commission's hearings on the auditor independence rule strongly endorsed the need for auditors to maintain the appearance of independence from audit clients. Paul Volcker, former Chairman of the Federal Reserve Board, in response to a question about investors' perceptions of a conflict of interest when auditors provide non-audit services, said, "The perception is there because there is a real conflict of interest. You cannot avoid all conflicts of interest, but this is a clear, evident, growing conflict of interest...."

John Whitehead, former co-chairman of Goldman Sachs and a member of numerous audit committees testified,

"Financial statements are at the very heart of our capital markets. They're the basis for analyzing investments. Investors have every right to be able to depend absolutely on the integrity of the financial statements that are available to them, and if that integrity in any way falls under suspicion, then the capital markets will surely suffer if investors feel they cannot rely absolutely on the integrity of those financial statements."

I could go on with quotes from institutional investors such as TIAA CREF and CalPERS, and from many others. The message coming out of those hearings was very clear; the appearance of independence not only matters, it is the oxygen that keeps our profession alive.

The second factor that the staff would look for in any conceptual framework is a basis for establishing definitive rules that will enhance investors' confidence both in the auditor's ability to make unbiased decisions during the audit process and in the credibility of audited financial statements. The staff has serious doubts that the "threats and safeguards" approach discussed in the ISB's conceptual framework ED can accomplish this objective. In the auditor independence release, the Commission stated,

"We are concerned, however, that a `safeguards' approach, which is dependent on a firm's self-analysis and self-reviews, will not provide a definitive standard. In our view independence is better assured by consistent and uniform rules, rather than by rules that rely on the auditor's assessment of the extent of its own self-interest. Furthermore, it has been our experience that the existence of safeguards or quality controls alone does not ensure compliance with even the most basic independence regulations."3

A third factor that the staff would look for in a conceptual framework for auditor independence is rulemaking based on research into investors' views of the issues. When the Commission first endorsed the ISB in Financial Reporting Release No. 50, it noted that this was one of its primary ambitions for the Board. While some research has been performed for the ISB, many more research proposals have not been pursued. And, perhaps most disappointing, the ISB exposure draft does not make use of the Commission's recent hearings. With almost four days of testimony from over 100 witnesses, and thousands of comment letters, the Commission's rulemaking record contains perhaps the most extensive record ever compiled about investors' views of auditor independence issues. That record must not be lost or ignored; it should be examined carefully by accountants, academia, regulators and, particularly, by those setting the independence standards for the profession.

The staff believes that auditor independence is really about only one thing - investor confidence in the numbers and in the markets. The need for auditors to maintain the appearance of independence from their audit clients, a firm basis for definitive and credible rules, and sound research of investors' views, are vital to achieving that sense of confidence. I believe that guidance which does not unequivocally protect investors or that relies on a threats and safeguards approach is not viable or workable.

In the Commission's release, four basic principles are discussed that will serve as guidance and framework for auditors, registrants and the staff in analyzing independence issues.

A conceptual framework that fails to adequately address the concepts in those four principles as well the appearance concept based on a reasonable investor knowledgeable of all the relevant facts falls short of the mark. While the staff continues to follow the work of the ISB on a conceptual framework, we think its current exposure draft has not hit the bulls-eye.


In closing, we need to remember that the principles of America's accounting profession serve not only as the auditor's guide, but more importantly, they give the auditor's work its relevance. These principles establish a covenant with investors: a covenant that says the auditor will remain inquisitive, skeptical, and rigorous; that he or she will remain free from a web of entanglements or arrangements that threaten his or her objectivity; that with the auditor's stamp, the numbers speak the truth.

1 United States v. Arthur Young and Co., 465 US 805, 819 n. 15 (1984) (emphasis in original).

2 SAS No. 1; AU § 220.03.

3 Release No. 33-7919; FR 56 (Nov. 21, 2000), at section IV.D.2.