ARNOLD & PORTER UPDATE

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1 ARNOLD & PORTER UPDATE Something Old; Something New Amendments to the SEC s Auditor Independence Rules March 2003 Just two years after adopting controversial and sweeping changes to its auditor independence rules in 2000, the Securities and Exchange Commission (the Commission ) was back at the drawing board at a January 22, 2003 open meeting at which the Commission adopted final rules on a range of auditor independence issues. These rules were mandated by Section 208 of the Sarbanes-Oxley Act of 2002 (the Act ), which required the Commission to write rules implementing most of Title II of the Act, Auditor Independence, within 180 days after enactment. Like the Commission s 2000 rules, the Act and the new rules specify certain non-audit services that, if provided by an accounting firm to an audit client during the professional engagement period, would impair independence. The new scopeof-services restrictions, in many respects, are similar to the old rules but, in other respects, sweep more broadly, although the new rules permit accounting firms to continue to provide a wide range of tax services to audit clients. The rules require audit committees to pre-approve all audit and permissible non-audit services provided by an issuer s financial statements auditor. The rules impose restrictions on relationships between auditors and their issuer audit clients, such as requiring the rotation of certain accounting firm partners and limiting the revolving door between audit firms and their clients. The rules also require enhanced disclosure of fees paid to the auditor and require disclosure of audit committee procedures for approving services. The Commission was bound by the Act to enact final rules to carry out the Act s independence provisions by the statutory deadline, but it also adopted generous transition and grandfathering rules to accommodate issuers and accounting firms in achieving compliance. The effective date for many of the rules is May 6, 2003, but some provisions do not apply for more than one year after that date. WASHINGTON 555 Twelfth Street, NW Washington, DC Fax NORTHERN VIRGINIA Suite Tysons Boulevard McLean, VA Fax NEW YORK 399 Park Avenue New York, NY Fax LOS ANGELES 44 th Floor 777 South Figueroa Street Los Angeles, CA Fax CENTURY CITY 17 th Floor 1900 Avenue of the Stars Los Angeles, CA Fax LONDON Tower Old Broad Street London EC2N 1HQ Fax DENVER Suite Seventeenth Street Denver, CO Fax arnoldporter.com

2 The rules are set forth as various amendments to Rule 2-01 of Regulation S-X, 17 CFR Part Qualifications of accountants and as new Rule In addition, new Securities and Exchange Act ( Exchange Act ) Rule 10A-2, 17 CFR A-2, provides that it shall be unlawful for an auditor not to be independent under specified provisions of the new rules. Thus, specified conduct that impairs independence also constitutes a separate violation of the Exchange Act. New disclosure rules amend relevant proxy and periodic disclosure forms for issuers and investment companies. New Audit Committee Responsibilities Pre-approval of Services from the Issuer s Auditor. Section 202 of the Act requires that all audit services and permissible non-audit services (except those qualifying for a de minimis exception) be pre-approved by the issuer s audit committee. Services provided under contracts in effect on May 6, 2003 are not subject to the pre-approval requirement although many audit committees already have adopted and implemented procedures for pre-approval. The pre-approval requirement is but one of a number of new audit committee responsibilities provided by the Act. The Act and the Commission s rules clearly contemplate that the audit committee, instead of management, will have the primary role of overseeing and approving the audit and non-audit engagements of the independent auditor. The good news is that the rules relating to pre-approval of services give audit committees substantial flexibility in carrying out these responsibilities. Under new Rule 2-01(c)(7), audit committees will utilize one of two alternative methods to pre-approve audit services and most non-audit services: (1) before the accountant is engaged by the issuer or its subsidiaries or the registered investment company or its subsidiaries to render an audit or non-audit service, the engagement may be approved by the issuer s or investment company s audit committee; or (2) alternatively, the engagement may be entered pursuant to pre-approval policies and procedures established by the audit committee, in which case the policies and procedures must be detailed as to the particular service, the audit committee must be informed of each service, and such policies and procedures may not include delegation of the audit committee s Exchange Act responsibilities to management. These conditions mean that the audit committee cannot simply pre-approve all permissible non-audit services, but must consider, at minimum, the particular category of service to be rendered. The release explains that pre-approval policies and procedures may, for example, delegate pre-approval to a member of the audit committee, who must report any pre-approval to the committee. Audit committees also may pre-approve a category of service well in advance of the rendering of the service; for example, they may approve certain audit and non-audit services at the time of the engagement for the coming year. The rules also provide a de minimis exception to the pre-approval requirements for non-audit services, if (1) all such services do not aggregate to more than five percent of total revenues paid by the audit client to the accountant in the fiscal year, (2) the services were not recognized as non-audit services at the time of the engagement, and (3) the services are promptly brought to the attention of the audit committee and approved prior to the completion of the audit by either the audit committee or a representative. the SEC s Auditor Independence Rules 2

3 Scope of non-audit services. Amended Rule 2-01(c)(4) provides that an accountant is not independent if, at any point during the audit and professional engagement period, the accountant provides any of ten specified non-audit services. In many respects, the listed services track the scope of services limitations in the old rule, but the text of the new rule and the adopting release must be read closely in order to identify what in some cases are slight, and in other cases more significant, changes in the existing limitations. The rule also adds a new category of prohibited services, expert services unrelated to the audit. The Commission recognized that audit clients may need a period of time to exit existing contracts and, therefore, the rules provide that services pursuant to contracts in existence on May 6, 2003 may be continued for up to one year, if they are in compliance with current independence requirements. If an accountant provides an audit client any of the first five non-audit services listed in Rule 2-01(c)(4): (i) bookkeeping services, (ii) financial information systems design and implementation, (iii) appraisal or valuation services, (iv) actuarial services, and (v) internal audit outsourcing, an accountant is deemed to be not independent 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. The release states that there is a rebuttable presumption that any of the five services are subject to audit procedures and the accounting firm has the responsibility to determine that a particular service will not be subject to audit procedures. Bookkeeping services are generally defined as maintaining or preparing the client s accounting records, preparing its financial statements filed with the Commission or that form the basis of financial statements filed with the Commission, or preparing or originating source data underlying the audit client s financial statements. Financial information systems design and implementation services are defined as (A) operating or supervising a client s information system or 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 (i.e., material ) to the audit client s financial statements or other financial information systems taken as a whole. To the extent the accounting firm designs or implements for an audit client a system that aggregates source data for the client as described under (B), above, the accounting firm would need to make an early evaluation of whether the data generated is material. An accounting firm would not be prohibited from working on hardware or software systems unrelated to the audit client s financial statements or accounting records. In addition, the release makes clear that this prohibition does not preclude the accountant from evaluating the internal controls of a system as it is being designed, implemented or operated or from making recommendations on internal control matters in conjunction with the design and implementation of a system by another service provider. Appraisal or Valuation Services, Fairness Opinions, or Contribution-in-kind Reports. Appraisal and valuation services include any process of valuing tangible or intangible assets or liabilities. Fairness opinions and contribution-in-kind reports involve the accounting firm s opinion on the adequacy of consideration in a transaction. The release states that the rules do not prohibit an accounting firm from providing such services for non-financial reporting, such as transfer pricing the SEC s Auditor Independence Rules 3

4 studies and other tax-only valuations. The release also states that it is permissible for a firm s valuation specialist to review work performed by the audit client or by a third party for the audit client. Actuarial Services. These services include any actuarially-oriented service involving the determination of amounts recorded in the audit client s financial statements and related accounts. However, an accountant would be permitted to assist a client in understanding the methods, models, assumptions, and inputs used in computing amounts. Internal Audit Outsourcing. These services include any internal audit service outsourced by the audit client that relates to the client s internal accounting controls, financial systems, or financial statements, but the release states that an auditor (1) may evaluate and make recommendations for improvements in controls, (2) may perform nonrecurring evaluations of discrete items or other programs that are not in substance the outsourcing of the internal audit function, and (3) may perform operational internal audits unrelated to the internal accounting controls, financial systems or financial statements. The rule defines the next three services listed management functions, human resources, and broker-dealer, investment adviser, or investment banking services in a manner substantially similar to the definitions in the old rule. Management Functions. These services are defined as acting as a director, officer, or employee of an audit client, or performing any decision-making, supervisory, or ongoing monitoring function for the client. The release states that designing and implementing internal accounting and risk management controls would be a prohibited management function, whereas accountants may continue to assess and recommend improvements in the design and implementation of internal controls and risk management controls and conduct an agreed-upon procedures engagement or provide attest services related to the company s internal controls. Human Resources. These are services related to seeking out or conducting reference checks of candidates for managerial, executive or director positions with the audit client, engaging in testing programs, acting as the audit client s negotiator or recommending the hiring of a specific candidate for a specific job. Broker-Dealer, Investment Adviser or Investment Banking Services. These services involve acting as a broker-dealer (registered or unregistered), promoter, or underwriter on behalf of an audit client, making investment decisions or otherwise having discretionary authority over the client s investments, executing orders for the client or having custody of the audit client s assets. There is likely to be further action by the Commission with respect to the ninth service listed, (ix) legal services, in order to address special issues of foreign accounting firms. The last service, (x) expert services, also may require further illumination by the Commission as accounting firms and issuers seek to understand the scope of the term. Legal Services. The rule provides that an accounting firm would not be independent of the audit client if the accounting firm provides any service to the client under circumstances in which the service could be provided only by someone licensed, admitted, or otherwise qualified to practice the SEC s Auditor Independence Rules 4

5 law in the jurisdiction in which the service is provided. The old rule applied only to services in which the service provider would have to be admitted to practice before the courts of a U.S. jurisdiction. The release acknowledges that some foreign jurisdictions require a law license for performance of tax work and states, 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 apply. The release states that the Commission will consider this factor in determining whether the service will impair independence. It is likely that the Commission or its Office of Chief Accountant will be asked to provide more definitive guidance on this subject in the future. Expert Services. The Act went beyond the list of non-audit services in the Commission s 2000 rule and added expert services unrelated to the audit as a prohibited non-audit service. The release acknowledges that, while virtually all services provided by an accountant may be perceived to be expert services, the prohibition in the rule would apply only to those services that involve advocacy in proceedings and investigations... and does not apply to other permitted non-audit services, such as tax services. The rule defines expert services as providing an expert opinion or other expert service for the audit client or the 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. However, the auditor is permitted to provide factual accounts, including in testimony, of work performed and to explain[] positions taken or conclusions reached during the performance of any service provided by the accountant for the audit client. Thus, the prohibition is triggered by the intended purpose of the auditor s engagement. If the auditor undertakes procedures approved or requested by the audit committee to search for fraud and report on the findings, it is not prohibited under the rule. However, the rule would prohibit an auditor s engagement by the client or the client s lawyers to provide forensic accounting services in connection with its defense to a Commission action or other litigation. Tax Services. Section 201 of the Act provides that an accounting firm may provide an audit client any non-audit service, including tax services, that is not described [in the list of non-audit services in that section] only if the activity is approved in advance by the audit committee of the issuer. This awkward formulation of language in the Act stimulated considerable debate as to whether and how the Commission could limit the provision of tax services by rule. Wide-ranging questions posed by the Commission in its proposing release added to the confusion. Since the scope of tax services is not addressed in the text of the rule (except with respect to fee disclosure), the language of the release is critical to establishing the parameters of permissible and impermissible tax services. Fortunately, the adopting release more clearly establishes these parameters than the proposing release. 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 pre-approval required under the rules. The release further states, [M]erely labeling a service as a tax service will not necessarily eliminate its potential to impair independence. In a footnote to this statement, the release states that it would not be appropriate to provide a prohibited service, such as a broker-dealer service, and argue that it is permissible because the service has tax implications. The release the SEC s Auditor Independence Rules 5

6 states that representing a client before a tax court, district court or federal court of claims would impair independence. In addition, the release admonishes audit committees to 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 not be supported by the Internal Revenue Code or regulations. Thus, court appearances on behalf of clients and the promotion of tax shelters are off limits, as are services that clearly are a prohibited service but which may have tax implications. While the release is not a model of clarity, the discussion of permissible tax services, the identification of specific tax services that would impair independence, other references to tax services in the release (e.g., the statement above that the prohibition on expert services does not apply to tax services) and the broad language related to tax fee disclosure, discussed below, suggest a wide range of tax services that may be provided to audit clients without impairing an auditor s independence, and a more narrow area of tax services that may not be provided. Fee and Pre-Approval Disclosure. Under the old rules, issuers are required to disclose fees paid to their auditor for the most recent fiscal year in three categories: audit services, financial information systems design and implementation, and all other services. The new rules require disclosure of fees paid for the two most recent fiscal years in four categories: audit, audit related, tax, and all other fees. These provisions are effective for periodic annual filings for the first fiscal year ending after December 15, The Commission has encouraged issuers to adopt the provisions earlier. Audit Fees. The rule describes this category as fees for services that are normally provided by the accountant in connection with statutory or regulatory filings or engagements. The release describes audit services broadly, to include services performed to fulfill the accountant s responsibility under Generally Accepted Auditing Standards and that generally only the independent accountant can reasonably provide. As an example, the release notes that, where a tax partner is involved in reviewing the tax accrual that appears in the company s financial statements, that is a necessary part of the audit and constitutes an audit service. The release explains that allocation of fees for a particular service may be appropriate in certain circumstances (e.g. between tax and audit). Thus, to be an audit service, a service must be normally provided in connection with a required filing, necessary to comply with GAAS, or a service that generally only the independent accountant reasonably can provide. Audit-related Fees. The rule describes this category as fees for services by the principal accountant that are reasonably related to the performance of the audit or review of the financial statements that are not disclosed under audit fees. These services are described in the release as including assurance and related services (e.g. due diligence services) that traditionally are performed by the independent accountant. These 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 statute or regulation and consultation concerning financial accounting and reporting standards. the SEC s Auditor Independence Rules 6

7 Tax Fees. This category captures all services performed by the professional staff in the accountant s tax division, except fees related to the audit. These include fees for tax compliance ( preparation of original and amended tax returns, claims for refund and tax payment-planning services ), tax planning and tax advice (encompassing a diverse range of services, including assistance with tax audits and appeals, tax advice related to mergers and acquisitions, employee benefit plans and requests for rulings or technical advice from taxing authorities. ) All Other Fees. This category includes any fees not reported under the above three categories. The rules also require disclosure of the percentage of services in each category that were approved under the de minimis exception to the pre-approval requirements. In addition, the audit committee s policies and procedures for pre-approval of services must be disclosed in the annual report. Communications with Audit Committees. New rules implementing Section 204 of the Act require the auditor to report to the audit committee on three specific issues discussed below. The Act requires that the information be reported timely ; the rule requires that the reports be made prior to the filing of an audit report with the Commission, including the annual report and proxy statement and any other periodic or current report when an audit report is included. 17 CFR Critical Accounting Policies and Practices. The release points to cautionary advice issued by the Commission in December 2001, indicating that critical accounting policies are those most important to the portrayal of the company s financial condition and results and require management s most difficult, subjective or complex judgments. The release also states that the auditors should report to the audit committee on critical accounting estimates, those which require the registrant to make assumptions about matters that are highly uncertain at the time the accounting estimate is made and for which different estimates that the company reasonably could have used, or changes in the estimates 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 operation. Alternative Accounting Treatments. The auditor must report all alternative treatments within Generally Accepted Accounting Principles for policies and practices related to material items that have been discussed with management, including (1) the ramifications of the use of such alternative disclosures and treatments, and (2) the treatment preferred by the accounting firm. Other Material Written Communications. The rule requires the accounting firm to report other material written communications between the firm and management, such as any management letter or schedule of unadjusted differences. If the audit client is an investment company, the rule also requires that the auditor report to the audit committee all non-audit services provided to any entity in the investment company complex that were not pre-approved by the investment company s audit committee. the SEC s Auditor Independence Rules 7

8 Employment Relationships. Section 206 of the Act prohibits an accounting firm from performing an audit for an issuer if the CEO, controller, CFO, CAA or any person serving in an equivalent position, was employed by the firm and participated in any capacity in the audit of the issuer during the one-year period preceding the date of the initiation of the audit. New Rule 2-01(c)(2)(iii)(B) sweeps more broadly than the Act s requirement and applies to persons who are in a financial reporting oversight role at the issuer, which is defined to mean 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 a person would be a member of the board or other governing body, CEO, CFO, CAA, COO, president, general counsel, controller, director of internal audit, director of financial reporting, treasury, or any equivalent position. The rule grandfathers existing employment relationships and does not apply to employment relationships that commenced at the issuer prior to May 6, The rule provides that an accounting firm is not independent with respect to an issuer if an individual (1) is employed by the issuer in a financial reporting oversight role (or, with respect to an investment company, employed in such a role by the investment company or by another entity in the complex in such a role related to the operations and financial reporting of the investment company) and (2) was 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 individual. Audit procedures are deemed to have commenced the day following the filing of the annual report for the previous period. The rule excepts persons other than the lead or concurring partner if they provide 10 or fewer hours of service, individuals employed by the issuer as a result of a business combination (subject to certain conditions) and individuals employed due to certain emergency situations. Note that these rules are in addition to existing rules applicable to issuer employees having financial relationships with the issuer s auditor. Partner Rotation. With the goal of bringing a fresh look to the audit engagement, the rules go beyond the requirement in Section 203 of the Act for lead and concurring partner rotation. New Rule 2-01(c)(6) provides for time out for various partners on the audit as follows: An audit partner serving as the lead audit partner (the audit partner having primary responsibility for the audit or review) or the concurring or review partner (the partner providing a second level of review) must leave the audit engagement after five consecutive years and may not return to the audit team for five years. Other audit engagement team partners who have responsibility for decision-making on significant matters affecting the financial statements or who maintain regular contact with management or the audit committee and who provide more than 10 hours of audit, review or attest services in connection with the annual or interim consolidated financial statements must leave the audit engagement after seven consecutive years and may not return for two years. the SEC s Auditor Independence Rules 8

9 Audit engagement team members who serve as the lead partner in connection with any audit or review related to the annual or interim financial statements of a subsidiary whose assets or revenues constitute 20% or more of the assets or revenues of the issuer s respective consolidated assets or revenues also are subject to the seven consecutive year on/ two year off requirement. The rotation requirement does not apply to a partner who consults with others on the engagement regarding technical or industry-specific issues. Small accounting firms (with fewer than five audit clients and fewer than 10 partners) are exempt, as long as the new Public Company Accounting Oversight Board conducts periodic reviews of their audit engagements. The rule also has special provisions relating to audit clients that are part of investment company complexes. The rotation requirement for lead partners will be effective for the first fiscal year beginning after May 6, 2003 and for concurring partners as of the end of the second fiscal year. For other partners, and for all partners with foreign accounting firms, the rules are effective as of the beginning of the first fiscal year after May 6, 2003, but the service that counts against time served begins on that date. Compensation. Although the Act did not include provisions relating to audit partner compensation, new Rule 2-01(c)(8) provides that an accountant is not independent if, during the audit and professional engagement period, any partner earns or receives compensation based upon the partner procuring engagements with the audit client for services other than audit, review, or attest services. Any accounting firm with ten or fewer partners or five or fewer issuer clients is exempt from the rule. The rule does not apply to compensation earned during the fiscal year of the accounting firm that includes May 3, * * * * * This memorandum is only a general summary of certain provisions of the Sarbanes-Oxley Act and related SEC rules and should not be construed as providing legal advice. If you have any questions about the Act, please feel free to call Marti Cochran ( ), Richard E. Baltz ( ), Penny Somer-Greif ( ) or your Arnold & Porter attorney. the SEC s Auditor Independence Rules 9