Strengthening the Commission's Requirements Regarding Auditor Independence

Client Alert


To:   Our Clients and Friends
From:   Olshan Grundman Frome Rosenzweig & Wolosky LLP
Date:   May 6, 2003
Re:   Strengthening the Commission's Requirements Regarding Auditor Independence


On January 28, 2003, the Securities and Exchange Commission (the "SEC") issued final rules relating to auditor independence, pursuant to Section 208(a) of the Sarbanes-Oxley Act (the "Act").  [1]  The new rules augment existing auditor independence requirements for accounting firms that audit public companies and are based on the concept that an auditor's independence is compromised if it performs management functions, audits its own work or acts as an advocate for its client.  Consistent with these general principles, the new rules limit and clarify the scope of non-audit services that accounting firms may provide to their public company audit clients.

Auditor Independence

Generally, accountants are prohibited from providing other non-audit services if their independence would be impaired under the general principles set forth in Rule 2-01(b) of Regulation S-X.   In addition to this general principle, the new SEC rules, in conjunction with Section 201(a) of the Act, promulgate a non-exclusive list of prohibited non-audit services for audit clients: [2]

  1. Bookkeeping or other services related to the accounting records or financial statements of the audit client [3];
  2. Financial information systems design and implementation services;
  3. Appraisal or valuation services, fairness opinions or contribution-in-kind reports;
  4. Actuarial services;
  5. Internal audit outsourcing services;
  6. Management functions and human resources services [4];

  7. Broker dealer, investment adviser or investment banking services;

  8. Legal and expert services unrelated to the audit [5];

  9. Any other service that the Public Company Accounting Oversight Board determines by regulation to be impermissible.

A limited exemption exists for provision of the first five categories of services listed above, so long as it would be reasonable to conclude that such services will not be subject to audit procedures during the audit of the given company's financial statements.  The SEC also reiterated its traditional position that an accounting firm may provide tax services to its audit clients, so long as these services do not fall into an otherwise prohibited category.

Audit Committee Pre-Approval of Services

An audit committee is now required to pre-approve all audit and permitted non-audit services. [6]  Such an approval may be obtained by traditional methods of approval or rendered implicitly pursuant to detailed pre-approval policies and procedures established by the audit committee, provided that such policies and procedures do not represent the delegation to management of audit committee duties.  The rules also contain a de minimis exception for certain non-audit services provided that the following conditions are met:

  • the aggregate fee for all exempted non-audit services is equal to no more than five percent of the total fees paid to the auditor during the fiscal year;
  • the services were not recognized as non-audit services at the time of the engagement; and
  • the services are promptly brought to the attention of the audit committee and approved by the audit committee prior to the completion of the audit.

Audit Committee Communications

Each public accounting firm that audits a company's financial statements must now communicate the following items to the audit committee prior to filing an audit report with the SEC:

  • all critical accounting policies and practices used by the company; [7]
  • alternative GAAP accounting treatments for material items that have been discussed with management (including the ramifications of the use of the alternative treatment and the auditor's preferred treatment); and
  • all material communications between the auditors and the company's management, including (1) management representation letters, (2) reports on observations and recommendations on internal controls, (3) schedules of unadjusted audit differences and listings of adjustments and reclassifications that were not recorded, (4) engagement letters and (5) independence letters.

Additional Disclosure Requirements

Each company must disclose either in its proxy statement or periodic annual filing fees paid to its principal independent auditor for the two most recent fiscal years. The fees must be separated into audit fees, audit-related fees, tax fees and all other fees.  Each company must provide a description of the services provided under each fee category, with the exception of audit fees.  Each company must also disclose in its proxy statement or periodic annual filing audit committee pre-approval policies and procedures and, if applicable, the percentage of fees paid subject to the de minimis exception discussed above.

Cooling-Off Period

The new rules impose a one-year cooling off period before the lead partner, the concurring partner or any other member of an audit engagement team who provided more than 10 hours of audit services during an annual audit period may be employed by a company in a financial oversight role.  For purposes of the rule, audit procedures are deemed to have commenced for the current audit engagement period the day after the prior year's periodic report is filed with the SEC and to have concluded when the current year's periodic annual report is filed with the SEC.  The cooling off period would have run if the accounting firm has completed one annual audit subsequent to when an individual was a member of the audit engagement team.

Audit Partner Rotation

The lead partner and the concurring partner on an audit engagement team are now required to rotate off the engagement after five years and subsequently wait five years prior to returning to the engagement. All other "audit partners" (as defined in the rules) on an audit engagement are required to rotate after no more than seven years and wait two years prior to returning to the engagement.

No Compensation for Cross-Selling Non-Audit Services

Accounting firms are now precluded from offering financial incentives to accountants for selling non-audit services to audit clients, because an accounting firm is not considered independent with respect to an audit client if any audit partner earns or receives compensation based on selling services to that client other than audit, review or attest services.8

The final rules on auditor independence become effective May 6, 2003.  Complicated transition periods are provided for as follows:

  • the prohibition on providing non-audit services that were formerly permissible will apply as of one year after the effective date of the rules, provided that during the one year transition period such services are being performed pursuant to a contract in existence on the effective date of the rules;
  • the pre-approval rules apply to all services the contracts for which are entered into after the effective date (contracts for non-audit services that were entered into prior to the effective date must be completed by the first anniversary of the effective date);
  • the rules relating to audit committee communication are effective on the effective date;
  • the "cooling-off" period for former audit team members joining an audit client is effective with respect to employment relationships that begin after the effective date;
  • the rotation requirements applicable to the lead partner are effective for the first fiscal year ending after the effective date of the rules (and time served as lead partner prior to the effective date is included in determining when rotation must occur);
  • 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 (and time served as concurring partner prior to the effective date is included in determining when rotation must occur);
  • the rotation requirements for other audit partners and for all partners of foreign accounting firms are effective as of the first day of the first fiscal year beginning after the effective date (and in determining the time served, that first fiscal year will be the first year of service); and
  • the compensation restrictions are effective for compensation earned or received in any fiscal year of an accounting firm following the fiscal year that includes the effective date.
  • the additional disclosure provisions relating to annual reports and proxy statements are effective for periods ending after December 15, 2003.


These are only brief descriptions of the SEC's new rules.  This memorandum provides general information only and does not constitute legal advice that may be applied to any particular situation.  Please contact the Partners in our Corporate Department for further advice and assistance.

[1] See the SEC's website at

[2] Although many of these prohibited non-audit services were prohibited under existing rules, the new rules eliminate many exceptions that formerly permitted auditors to perform certain of these services for audit clients.

[3] Bookkeeping services are defined to include (i) maintaining or preparing the audit client's records; (ii) preparing financial statements that are filed with the SEC or the information that forms the basis of financial statements filed with the SEC; or (iii) preparing or originating source data underlying the audit client's financial statements.

[4] This prohibition and the prohibition regarding financial information systems design and implementation do not prevent an auditor from diagnosing, assessing and recommending to audit committees and management ways in which its audit clients' internal and risk management controls can be improved or strengthened.

[5] This prohibition does not prevent an auditor from performing internal investigations or forensic or fact finding engagements, nor does it prevent an auditor from assisting the audit committee in fulfilling its responsibilities to conduct its own investigation of a potential accounting impropriety.

[6] A company's audit committee may delegate its pre-approval duties to one or more members of the audit committee, provided that the delegates are independent members of the company's board of directors.

[7] Auditors and companies should refer to the SEC's December 2001 Cautionary Guidance regarding disclosures of critical accounting policies in MD&A to determine the types of matters that should be communicated under the rules.

[8] This rule does not apply to non-audit or specialty partners.

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