[12914]
December 5, 2000
TO: ACCOUNTING/TREASURERS MEMBERS No. 35-00
CLOSED-END INVESTMENT COMPANY COMMITTEE No. 33-00
SEC RULES MEMBERS No. 79-00
RE: SEC ADOPTS AUDITOR INDEPENDENCE RULES
The SEC recently adopted proposals intended to modernize rules for determining
whether an auditor is independent in light of investments by auditors, and consulting services
provided by audit firms to their audit clients. The amendments 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. They also
identify certain consulting or non-audit services that impair the auditor’s independence. The
final rules enable accounting firms to cure certain inadvertent independence failures if they
have quality controls and satisfy other conditions. Finally, the amendments require companies,
including investment companies, to disclose in their annual proxy statement information
related to services provided by their auditor during the most recent fiscal year. The rule
amendments are effective February 5, 2001.
General Standard for Auditor Independence
Rule 2-01 of Regulation S-X sets forth qualifications of accountants practicing before the
Commission, including independence requirements. Rule 2-01(b) describes a general standard
under which the Commission will measure independence. The general standard indicates that
the Commission will not recognize an accountant as independent with respect to an audit client
if the accountant is not, or if a reasonable investor knowing all relevant facts and circumstances
would conclude that the accountant is not, capable of exercising objective and impartial
judgement on all issues encompassed within the accountant’s engagement.
The SEC originally proposed to supplement the general standard in rule 2-01(b) with
four governing principles for determining when an auditor lacks independence. The ICI and
other commenters suggested that the governing principles were too general and would be
difficult to apply to particular situations. In response, the SEC has removed the governing
principles from the final rule. However, the governing principles have been included in a
“preliminary note” to the final rule. The preliminary note indicates that the governing
principles are general guidance only and their application may depend on particular facts and
circumstances.
Specific Applications of the Independence Standard
Rule 2-01(c) sets forth a non-exclusive list of circumstances that are inconsistent with the
general independence standard. Paragraphs (c)(1) through (c)(5) address separately situations
in which an accountant is not independent of an audit client because of certain: (1) financial
2relationships, (2) employment relationships, (3) business relationships, (4) non-audit services, or
(5) contingent fees.
A. Financial Relationships
Under the rule an accountant is not independent if, at any point during the audit and
professional engagement period, the accountant has a direct financial interest or a material
indirect financial interest in the accountant’s audit client. For this purpose “accountant”
includes the accounting firm, covered persons1 in the firm, and their immediate family
members.2 Consistent with the original proposal, the final rule represents a liberalization from
prior restrictions that generally reached all partners in the firm, regardless of whether they had
any relationship to the audit client.
Consistent with the original proposal, the final rule limits investments in audit clients by
“non-covered” persons in the firm and their family members to not more than five percent. The
final rule provides that an accountant is not independent when any partner or professional
employee, any of his or her immediate family members, any close family member3 of a covered
person in the firm, or any group of these persons has filed a Schedule 13D or 13G indicating
beneficial ownership of more than five percent of an audit client’s equity securities.
The restrictions on investments in audit clients extend to certain affiliates of the audit
client. For example, an accountant cannot invest in an entity that has control over the audit
client, or over which the audit client has control, or which is under common control with the
audit client. As to investment companies, the restriction on investments in audit clients extends
to all entities in the investment company complex. Accordingly, when an audit client is an
entity that is part of an investment company complex, the accountant must be independent of
each entity in the investment company complex. This restriction is consistent with ISB No. 2 and
the original proposal.
1. Investment Company Complex
As proposed, the definition of investment company complex focused on investment
advisers and entities in a control relationship with the adviser, including entities under
common control with the adviser. The proposed definition was based on ISB No. 2, which
defines “mutual fund complex” as the mutual fund operation in its entirety, including all the
funds, the sponsor, its ultimate parent company, and their subsidiaries.
1 Covered person includes: (i) the audit engagement team; (ii) the chain of command; (iii) any partner, principal,
shareholder or managerial employee of the accounting firm who has provided ten or more hours of non-audit
services to the audit client for the period beginning on the date such services are provided and ending on the date the
accounting firm signs the report on the financial statements for the fiscal year during which those services are
provided, or who expects to provide ten or more hours on non-audit services to the audit client on a recurring basis;
and (iv) any other partner, principal, or shareholder from an office of the firm in which the lead audit engagement
partner primarily participates in connection with the audit.
2 Immediate family member means a person’s spouse, spousal equivalent and dependents.
3 Close family member means a person’s spouse, spousal equivalent, dependent, parent, nondependent child, and
sibling.
3Several commenters expressed concern that the proposed definition was too broad. For
example, all subsidiaries of the adviser’s parent company would be included in the investment
company complex, even if they engaged in a business unrelated to asset management. In
response, the final definition of investment company complex is more limited than the one
originally proposed. As adopted, the rule includes an entity under common control with the
adviser only if the entity provides services to an investment company in the investment
company complex.
Consistent with the original proposal, the definition of investment company complex
does not include sub-advisers whose role is primarily portfolio management and who provide
services pursuant to a subcontract with, or are overseen by, an investment adviser in the
complex.
2. Indirect Investments and the Investment Company Exception
The final rule indicates that an accountant is not independent when the accounting firm,
any covered person in the firm, any of his or her immediate family members or any group of the
above persons has any material indirect investment in the audit client. The original proposal
indicated that ownership of more than five percent of an entity that has an ownership interest in
the audit client constitutes a material indirect investment.
In response to comments the Commission eliminated the five percent threshold from the
final rule. Instead, the final rule describes material indirect investments in terms of the ability
of the accountant or the intermediary to exercise significant influence over the audit client.
In response to comments, the final rule includes an investment company exception
intended to ensure that accounting firm personnel can freely invest in diversified investment
companies (that are not audit clients or part of a related investment company complex) even if
the investment company owns shares in an audit client. The provision eliminates the need for
auditors to monitor whether, and to what degree, funds in which they invest hold securities
issued by audit clients.
3. Exception for Employee Compensation and Benefit Plans
In response to comments by the Institute, the final rules contain an exception to the
financial interest rules intended to allow broader participation by immediate family members of
auditors in employee compensation and benefit plans. The exception is available to immediate
family members (typically spouses) of covered persons, who are covered persons only by virtue
of being a partner in the same office as the lead audit engagement partner of, or a partner or
manager performing ten or more hours of non-audit services for, an audit client. Under the
exception, the spouse can invest in audit client funds through a 401(k) plan if audit client funds
are the only available option in the plan. If, however, the immediate family member has an
alternative in the 401(k) plan that does not involve investing in a fund complex for which the
person’s relative is a covered person, then the family member may not invest in the audit client.
B. Non-audit Services
The Commission’s original proposal identified ten non-audit services that, if provided to
an audit client, would compromise the auditor’s independence. The final rule identifies nine
4such services. The Commission eliminated expert services (e.g., rendering expert opinions for
an audit client in legal, administrative or regulatory filings or proceedings) from the list of
prohibited services. In addition, the final rule permits two of the nine services (i.e., financial
systems design and implementation, and internal audit outsourcing) to be performed under
limited circumstances.
1. Financial Systems Design and Implementation
Rather than prohibit these services, the final rule permits these services subject to
conditions intended to reduce the likelihood that the auditor will be placed in a position of
making, and then auditing, managerial decisions. Further, the final rule requires the company’s
annual proxy statement to disclose information related to the financial systems design services
provided by the auditor, as described below.
2. Internal Audit Outsourcing
Under the final rule, an auditor’s independence is impaired by performing more than
forty percent of the audit client’s internal audit work related to the internal accounting controls,
financial systems, or financial statements.4
3. Broker-dealer Services
The original proposal would have prohibited an accountant from designing an audit
client’s system for complying with broker-dealer or investment adviser regulations. In its
comment letter the Institute noted that investment advisers frequently hire their auditor to
design, implement, and test their systems intended to ensure compliance with the securities
laws, and that these types of consulting engagements do not give rise to the independence
concerns identified in the proposal. We are pleased to report that the Commission omitted the
prohibition on designing broker-dealer and investment adviser compliance systems from the
final rule.
C. Curing Independence Violations
Consistent with the original proposal, the final rule includes a limited exception
pursuant to which inadvertent violations of the independence rules will not disqualify the
accounting firm, if the firm maintains certain quality controls and satisfies certain other
conditions. The effect of this provision is that an accounting firm that has appropriate quality
controls will not be deemed to lack independence when an accountant did not know of the
circumstances giving rise to the impairment and, upon discovery, the impairment is quickly
resolved.
Proxy Disclosure Requirement
The proxy disclosure amendments adopted by the Commission require disclosure
regarding: (1) fees billed for services rendered by the principal accountant; (2) whether the audit
4 To limit the effect on small businesses, the final rule permits audit clients with less than $200 million in assets to
engage their auditor to perform more than forty percent of their internal audit functions.
5committee considered the compatibility of the non-audit services the company received from its
auditor and the independence of the auditor; and (3) the employment of leased personnel in
connection with the audit.
A. Disclosure of Fees
The final rule requires registrants to disclose the fees paid to the auditor for: (1) the
annual audit of the company’s financial statements, (2) financial information systems design
and implementation services, and (3) all other fees, including fees for tax-related services.
When disclosing fees for items (2) and (3) above, investment companies must disclose fees
billed for services rendered to the registrant, the registrant’s investment adviser (not including
any sub-adviser), and any entity controlling, controlled by, or under common control with the
adviser that provides services to the registrant.
B. Audit Committee Disclosure
The original proposal would have required companies to disclose in their proxy
statements whether, before each non-audit service was rendered, the audit committee
approved, and considered the effect on independence of such service. The final rule has been
modified to require disclosure only of whether the audit committee considered whether the
non-audit services provided are compatible with maintaining the accountant’s independence.
C. Leased Personnel
Issuers must disclose in their proxy statements the percentage of hours worked on the
audit engagement by persons other than the accountant’s full time permanent employees, if that
figure exceeds fifty percent.
Effective Date and Transition Rules
The new rules will become effective February 5, 2001. However, a transition period of
18 months is provided with respect to appraisal and internal audit services since these services
are currently permitted, subject to certain conditions. The rules grandfather contracts for the
provision of financial information systems design and implementation in existence at the
effective date under certain conditions. Companies must comply with the new proxy disclosure
requirements for proxy statements filed after February 5.
Gregory M. Smith
Director – Operations/
Compliance & Fund Accounting
Attachment
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Attachment (in .pdf format)