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Update on Auditor Independence from the Corporate Perspective

(December 2004, Public Company Materials)

December 31, 2004

Audit committees of public companies, as you know, are required to police the independence of outside auditors. To this end, audit committees must approve in advance all audit, audit-related and permissible non-audit services to be rendered by their companies’ outside auditors, but may adopt appropriately detailed pre-approval policies and procedures relating to non-audit services.1 Resolution of the question whether auditors' provision of tax services to corporate audit clients impairs auditor independence has been particularly difficult for audit committees, because neither Congress (in the Sarbanes-Oxley Act of 2002) nor the Securities and Exchange Commission (“SEC”) has furnished clear guidance on distinguishing permissible tax services from those which, if rendered by a company’s outside auditor, might prevent the company from filing the requisite, independently audited financial statements. Two types of tax services have raised particular concern – aggressive and potentially abusive tax-shelter products (in some cases created and marketed to audit clients by registered public accounting firms), and personal tax and financial planning advice to senior management of audit clients.

Corporate audit committees should be advised immediately of the following separate, but related regulatory initiatives in the area of auditor independence, one of which relates to tax services subject to such committees’ prior approval (whether on an ad hoc basis or pursuant to properly crafted pre-approval procedures). First, the Public Company Accounting Oversight Board ("PCAOB") recently published proposed rules that would ban specific types of tax services deemed to impair the independence of outside auditors of public companies. Second, the SEC accounting staff separately issued a set of updated Frequently Asked Questions (“FAQs”) relating to auditor independence and disclosure of audit and non-audit fees in proxy statements.  

We begin with a discussion of the highlights of the SEC staff's newly revised auditor independence FAQ's from an audit committee’s perspective. We then turn to the PCAOB's proposed rules focusing on auditor tax services (available at http://www.pcaobus.org/Rules_of_the_Board/Documents/Docket_017/Release2004-015.pdf) (“PCAOB Release”), which are subject to notice, comment and final SEC action – the public comment period expires February 14, 2005. Together, these initiatives signal the intent of the two regulatory bodies to work cooperatively in the area of auditor independence.2

Updated SEC FAQs on Auditor Independence

The SEC staff recently revised certain, previously-issued FAQs, and added new FAQs, to its Auditor Independence FAQs (Dec. 13, 2004), available at http://www.sec.gov/info/accountants/ocafaqaudind121304.htm. The updated FAQs:
  • address disclosure regarding fees paid to the company's independent auditor –

    o clarifying that audit fees to be disclosed in response to Item 9(e)(1) of Schedule 14A should be fees that are billed, or expected to be billed, by the auditor of the company's financial statements for the two most recently completed fiscal years and the review of financial statements for any interim periods within that time frame. The pertinent FAQ makes clear that the company has an obligation to ask the auditor for the amount to be billed for audit fees, and include that amount in its proxy statement disclosure, if the company has not received the auditor's bill prior to filing the proxy statement. The fees disclosed under Items 9(e)(2) – (e)(4) of Schedule 14A (audit-related fees, tax fees and all other fees) should include amounts billed for services provided during the most recent fiscal year, even if the auditor did not bill the company until after the end of that fiscal year. [Question 2 of "Fee Disclosures"];
    o providing guidance on the location of fee disclosures (required by Item 9(e) of Schedule 14A) in the proxy statement. In this FAQ, the SEC staff expresses the view that companies may include fee disclosures with the information required to be disclosed regarding the company's audit, nominating and compensation committees, including the audit committee's report, as prescribed by Item 7(d) of Schedule 14A, or with the information regarding the independent auditor called for by Item 9(a) through (d) of Schedule 14A. The SEC staff makes clear its view, however, that the safe harbor covering disclosure pursuant to Item 7(d)(3) and the safe harbor covering disclosure required in the audit committee report pursuant to Items 306(a) and (b) of Regulation S-K do not cover the fee disclosures even if accompanying such information. [Question 5 of "Fee Disclosures"]; and
    o clarifying that where there has been a change of accountants during the year, the company should disclose only the fees paid to the auditor who provides the opinion on the company's financial statements for that fiscal year. [Question 6 of "Fee Disclosures"];
  • reiterate the SEC's longstanding position that an auditor's independence will be deemed impaired when that auditor and its audit client, directly or indirectly through an affiliate, enter into an agreement of indemnity that seeks to provide immunity to the auditor for his or her negligent acts. Moreover, this FAQ states that an auditor's independence would be impaired if the engagement letter between the auditor and the company includes a clause stating that the company will release, indemnify or hold the auditor harmless from liability and costs resulting from knowing misrepresentations by management. [Question 4 of "Other Matters"];
  • address issues arising from the partner rotation requirements [Questions 7 – 10 of "Audit Partner and Partner Rotation"];
  • address the definition of "associated entities" for purposes of identifying affiliates of an accounting firm [Question 1 of "Other Matters"];
  • reiterate guidance regarding business relationships between an auditor and its auditor client that may be deemed to impair independence as codified in SEC rules [Question 2 of "Other Matters"];
  • provide guidance regarding the scope of the SEC's auditor independence requirements with respect to auditors whose reports are filed with the SEC on financial statements of entities other than the issuer. In this regard, the SEC staff states that the auditor independence rules apply to audits of financial statements required by SEC rules, except for those required by Rule 3-05 of Regulation S-X (Financial Statements of Businesses Acquired or to Be Acquired), Rule 3-14 of Regulation S-X (Special Instructions for Real Estate Operations to be Acquired) and Item 310(c) of Regulation S-B (Financial Statements of Businesses Acquired or to Be Acquired), and Item 310(e) of Regulation S-B (Special Instructions for Real Estate Operations to be Acquired). [Question 3 of "Other Matters"]; and
  • clarify the requirement that the entire audit of an issuer must be conducted by independent auditors. In order for the principal auditor to rely on, and make reference to, the report of the auditor of a subsidiary or equity method investee, that auditor must also be independent under SEC rules. The SEC staff takes the position that the principal auditor in this situation bears primary responsibility for determining and confirming compliance with the SEC’s auditor independence rules. [Question 9 of “Audit Partner and Partner Rotation”].

PCAOB Rule Proposals Regarding Auditor Independence: the Provision of Tax Services, including Audit Committee Pre-Approval of Tax Services, and Contingent Fee Arrangements

Tax Services and Planning

With respect to tax services and planning, the PCAOB rule proposals would deem an auditor's independence to be impaired if he or she provided the following tax services to an audit client –
  • tax planning or advice with respect to potentially abusive tax transactions (e.g., listed transactions or confidential transactions under Treasury regulations);
  • tax services related to planning or opining on a transaction based on an aggressive interpretation of applicable tax laws and regulations; and
  • tax compliance and planning services for senior officers that oversee the company's financial reporting, including the company’s directors, chief executive officer, chief financial officer, chief operating officer, general counsel, chief accounting officer, controller, director of internal audit, director of financial reporting, treasurer or any equivalent position – regardless of formal title.

The rule proposals would not prohibit routine tax return preparation and tax compliance, general tax planning and advice, international assignment tax services and employee personal tax services, unless that employee is a senior officer playing a financial reporting oversight role within the company (noted above). Note that all these permissible tax services are subject to audit committee pre-approval (except as to those employees who pay for their own tax services and who are not involved in any way in overseeing financial reporting; the PCAOB recommends, however, that auditors consider the necessity of notifying the audit committee of any otherwise permissible tax services paid for by executive officers of the company).

Audit Committee Pre-Approval of Tax Services

The rule proposals would enhance the effectiveness of Sarbanes-Oxley’s audit committee pre-approval requirement in the area of tax services. Specifically, an auditor seeking audit committee pre-approval of such services must:
  • provide certain information to the audit committee, e.g., detailed documentation of the nature and scope of the proposed tax service and, if the auditor receives fees or other consideration from a third party in connection with the promotion or marketing of a tax transaction, disclosure regarding any compensation arrangement or other agreement (such as a referral agreement, a referral fee or fee-sharing arrangement) between the auditor or the auditor's affiliate and any such third party based on promoting or marketing a tax transaction;
  • discuss with the audit committee the potential effects of the provision of such services on the auditor's independence; and
  • document the auditor's discussion with the audit committee.

Although the proposals are subject to public notice and comment, as well as final SEC approval, we recommend that audit committees request the foregoing information from their companies’ outside auditors as soon as otherwise would be demanded by such committees’ existing procedures for evaluating auditor independence. As the PCAOB observed, the relevant rule proposal “is intentionally silent as to when a registered public accounting firm should provide the required information about a proposed tax service to an audit committee, because, under the SEC’s 2003 independence rules, audit committees themselves may have policies that establish a procedure and schedule for audit committee review of non-audit services, including tax services[,]”3 in lieu of advance approval of each such service on a case-by-case basis.

Auditor Independence and Contingent Fees

The rule proposals would, if adopted by the PCAOB and approved by the SEC, impose a prohibition against contingent fee arrangements between auditors and their corporate clients. The term "contingent fee" would be defined broadly by the PCAOB to cover the aggregate amount of compensation for any service provided either by the auditor or an affiliate, including any payment, service, or promise of other value, taking into account any rights to reimbursements, refunds, or other repayments that could modify the amount received in a manner that renders it contingent on a finding or result.

Contingent fee arrangements are already banned by Rule 2-01 of the SEC’s Regulation S-X, as recently underscored by the SEC Chief Accountant in a letter to the AICPA.4 Both the PCAOB’s proposal and Rule 2-01 generally establish an exception to this prohibition where the fees are determined by courts or other public authorities and not dependent on a finding or result. However, the PCAOB’s proposed rule would beyond the SEC’s rule to exclude tax matters entirely from this exception. In other words, the PCAOB is proposing to eliminate application of this exception to tax services performed by the outside auditor.

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        Please do not hesitate to get in touch with your contact at Weil, Gotshal & Manges if you have any questions regarding these issues, or if we can be of further assistance to you.

  1. Note that the audit committee must approve specifically, in advance, any proposals from the company’s outside auditor to provide services relating to the company’s internal control over financial reporting covered by Section 404 of the Sarbanes-Oxley Act of 2002. It makes no difference in this regard how the particular service is described for purposes of fee disclosures required in proxy statements of U.S. companies (or in absence of proxy filing obligation, annual reports on Form 10-K) and, for non-U.S. companies filing SEC reports, in annual reports on Form 20-F. See Question No. 3 of the PCAOB Staff’s Questions and Answers (June 23, 2004), available at http://www.pcaobus.org/Standards/Staff_Questions_and_Answers/Auditing_Internal_Control_over_Financial_Reporting_2004-06-23.pdf.
  2. See “SEC Chief Accountant Welcomes PCAOB Involvement in Independence Standards-Setting,” SEC Press Release No. 2004-169 (Dec. 14, 2004), available at http://www.sec.gov/news/press/2004-169.htm (“Although the Commission historically has adopted its own rules and interpretations regarding auditor independence issues – and will continue to provide companies and audit committees with guidance on independence issues – [SEC Chief Accountant] Nicolaisen stated that he looks forward to the PCAOB fulfilling its role and becoming the primary standard-setter and source of guidance to auditors on these issues.”).
  3. PCAOB Release, above, quoting text accompanying footnote 88.
  4. Letter from Donald T. Nicolaisen, Chief Accountant, OCA, SEC, to Bruce P. Webb, Chair, Professional Ethics Executive Committee, AICPA, dated May 21, 2004, available at http://www.sec.gov/info/accountants/staffletters/webb052104.htm.

Copyright 2004, Weil, Gotshal & Manges LLP, http://www.weil.com. All rights reserved. Quotation with attribution is permitted. This Memorandum provides information of a general nature only, and should not be taken or used as legal advice in specific situations requiring careful consideration of all relevant facts and circumstances.
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