[15603]
January 31, 2003
TO: ACCOUNTING/TREASURERS MEMBERS No. 7-03
CLOSED-END INVESTMENT COMPANY MEMBERS No. 10-03
COMPLIANCE ADVISORY COMMITTEE No. 8-03
SEC RULES MEMBERS No. 13-03
SMALL FUNDS MEMBERS No. 5-03
RE: SEC ADOPTS AUDITOR INDEPENDENCE RULES
As directed by Section 208(a) of the Sarbanes-Oxley Act, the Securities and Exchange
Commission recently adopted rules intended to strengthen auditor independence
requirements.1 These rules (1) expand the types of non-audit services that, if provided to an
audit client, impair an accounting firm’s independence, (2) require that an issuer’s audit
committee pre-approve all audit and non-audit services provided by the auditor, (3) require
partners to rotate off the audit engagement team after a five or seven year period, (4) prohibit
members of an audit engagement team from accepting certain employment positions with audit
clients for a one-year period, (5) require the auditor to report certain matters to the issuer’s
audit committee, including “critical” accounting policies, (6) require disclosure of the types of
services provided by, and fees paid to, the independent accountant, and (7) prohibit audit
partners from receiving compensation for “cross-selling” non-audit services to audit clients.
The final rules reflect many of the Institute’s comments on the proposed rules.2
The rules will be effective 90 days after publication in the Federal Register (the “Effective
Date”). The rules contain various transition periods, during which existing relationships will
not impair an accountant’s independence. Those elements of the recently adopted rules that are
of most significance to investment companies are summarized below.
I. Employment Relationships – One Year “Cooling Off” Period
The Commission originally proposed that employment of a former audit engagement
team member in a financial reporting oversight role at any entity in the investment company
1 SEC Release No. 33-8183; 34-47265; 35-27642; IC-25915; IA-2103 (January 28, 2003) (“Release”). A copy of the
Release is available on the SEC’s website at http://www.sec.gov/rules/final/33-8183.htm.
2 See Memorandum to Accounting/Treasurers Members No. 3-03, Closed-End Investment Company Members No. 5-
03, SEC Rules Members No. 8-03, Small Funds Members No. 2-03, dated January 15, 2003.
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complex during the one-year period after completion of the last audit would impair the
independence of the accounting firm with respect to the audit client. As adopted, an accounting
firm would not be independent if a former audit engagement team member3 is employed in a
financial reporting oversight role with the registered investment company, or any entity in the
investment company complex that is responsible for the financial reporting or operations of the
registered investment company, or any other registered investment company in the same
investment company complex. The final rule prohibits employment for a one-year period in
positions at an investment company complex that would allow a former audit engagement
team member to bring undue influence over the audit process of an investment company. The
final rule recognizes that certain positions may exist at an entity in the investment company
complex that would be considered financial reporting or oversight positions, but that those
positions have no direct influence on the financial reporting or operations of an investment
company. The final rule would not disqualify an audit firm if the former audit engagement
team member is employed in such a position.
The rule is effective for employment relationships that commence after the Effective
Date.
II. Non-Audit Services
Consistent with the Commission’s original proposal, the final rules prohibit audit firms
from providing ten categories of non-audit services to their audit clients. These services
include: (1) bookkeeping; (2) financial information systems design and implementation; (3)
appraisal or valuation services; (4) actuarial services; (5) internal audit outsourcing; (6)
management functions; (7) human resources functions; (8) broker-dealer, investment adviser or
investment banking services; (9) legal services; and (10) expert services.
The Release makes clear that designing and implementing internal accounting control
and risk management systems impair the accountant’s independence. However, accountants
may evaluate the design, implementation or operation of these systems, and make
recommendations for their improvement, as part of an audit or attest service.
The Release indicates that an accounting firm can provide tax services to its audit clients
without impairing the firm’s independence. These services can include tax compliance, tax
planning, and tax advice. However, the Release also indicates that certain tax services would
impair the accountant’s independence, such as representing an audit client before a tax court.
In addition, the Release urges audit committees to scrutinize carefully the retention of the
accountant in a transaction initially recommended by the accountant, the sole business purpose
of which may be tax avoidance.
Recognizing that audit clients may need a period of time to exit existing contracts, the
rules provide that until 12 months after the Effective Date, provision of non-audit services will
not impair an accountant’s independence provided those services are pursuant to contracts in
existence on the Effective Date.
3 The final rule provides that persons, other than the lead and reviewing partner, who provide ten or fewer hours of
audit, attest, or review services during the period are not considered members of the audit engagement team.
3
III. Partner Rotation
The Commission originally proposed that all partners on the audit engagement team
must rotate after five years of service and that they be subject to a five-year “time-out” period.
The final rules apply the five-year rotation and five-year time-out requirements to only the lead
and reviewing partner. Other “audit partners” on the engagement team must rotate after seven
years and are subject to a two-year time out period. Audit partners for this purpose include
partners on the audit engagement team who have responsibility for decision-making on
significant auditing, accounting, and reporting matters that affect the issuer’s financial
statements or who maintain regular contact with management and the audit committee.
Under the proposed rule, a partner performing audit, review, or attest services for any
entity in the investment company complex could only do so if they if they had not served five
consecutive years on any entity in the complex. The rotation requirement would have extended
to specialized partners, such as tax partners, that work on significant aspects of the audit.
Partners affected by the rotation requirement would have had to remain off any engagement in
the investment company complex for a period of five years. The final rule as adopted by the
Commission prohibits the rotation of partners between different investment companies in the
same complex. However, the final rule does not prohibit accountants from rotating to other
entities in the investment company complex. The final rule contains a provision that would
allow audit partners auditing multiple investment companies in the same investment company
complex to audit each investment company for five or seven complete fiscal years, as
appropriate.4
The final rules contain transition provisions for the rotation requirements. The rotation
requirements applicable to the lead partner are effective for the first fiscal year ending after the
Effective Date. In determining when the lead partner must rotate, time served in the capacity of
lead partner prior to the effective date of the rules is included.5 The rotation requirements for
the concurring partner are effective as of the end of the second fiscal year after the Effective
Date.6 For other partners covered by the rules, the rules are effective as of the beginning of the
first fiscal year after the Effective Date. However, in determining the time served, that first
fiscal year will constitute the first year of service for such partners.
IV. Audit Committee Administration of the Audit Engagement
Consistent with the Commission’s original proposal, the final rules require that the audit
committee pre-approve all permissible non-audit services provided to the investment company
and all audit, review or attest engagements required under the securities laws. All
4 For purposes of calculating five consecutive years of service, audits of registered investment companies with
different fiscal-year ends that are performed in a continuous 12-month period count as a single consecutive year.
5 For example, for a lead partner serving a calendar year audit client, if 2003 was that partner’s fifth, sixth or seventh
year as lead partner for that audit client, he would be able to complete the current year’s audit and must rotate off for
the 2004 engagement.
6 For example, a concurring partner for a calendar year audit client, where 2003 was his fourth or greater year in that
role, would be able to serve in that capacity for the 2004 audit before being subject to rotation.
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engagements must be either: (1) pre-approved by the audit committee; or (2) entered into
pursuant to pre-approval policies and procedures established by the audit committee.
The Commission’s original proposal also would have required the investment
company’s audit committee to pre-approve any non-audit services provided to the investment
company’s investment adviser and any entity controlling, controlled by, or under common
control with the investment adviser that provides services to the investment company. The
final rules limit the audit committee’s pre-approval responsibility to those services provided
directly to the investment company and those services provided to an entity in the investment
company complex where the nature of the services provided have a direct impact on the
operations or financial reporting of the investment company. In addition, the final rules clarify
that only those service providers that provide “ongoing” services to the investment company
must have their non-audit services pre-approved.
In order to ensure that the audit committee is informed of all services the accountant is
providing to the investment company complex, the final rules include a requirement that the
accountant disclose to the audit committee on a quarterly basis all services provided to the
investment company complex, including the fees associated with those services.
The Commission’s original rule proposal contained a five percent de minimis exception
to the pre-approval requirements for non-audit services. The de minimis exception would have
calculated the percentage threshold based on the total revenues paid to the investment
company’s accountant by the investment company, its adviser, and any entity controlling,
controlled by, or under common control with the investment adviser that provides services to
the investment company. The final rules calculate the five percent threshold based on the total
amount of fees for services provided to the investment company complex that were subject to
the pre-approval requirements for the investment company’s audit committee.
These rules apply to all audit, review, and attest services and non-audit services that are
entered into after the Effective Date. For arrangements for non-audit services entered into prior
to the Effective Date of these rules—regardless of whether or not they were approved by the
audit committee—the accounting firm will have 12 months from the Effective Date to complete
the engagement.
V. Compensation
Under the Commission’s original proposal, a partner, principal or shareholder who is a
member of the audit engagement team may not, during the audit and engagement period, earn
or receive compensation based on the performance or procuring of engagements with that audit
client to provide non-audit services. The Release notes that commenters expressed concern that
the proposed rule was not directly related to sales activities. For example, under the proposed
rule, a partner’s compensation could not include a proportionate share of the accounting firm’s
overall profits, since some of those profits may be derived from non-audit services provided by
other firm personnel. To address these concerns, the final rule adopted by the Commission
clarifies that compensation concerns exist where the audit partner’s compensation is based on
the act of selling non-audit services.
5
These rules will be effective in the fiscal period of the accounting firm that commences
after the Effective Date.
VI. Communications with Audit Committees
Consistent with the Commission’s original proposal, the final rules require the auditor
to report to the audit committee: (1) all critical accounting policies and practices; (2) all
alternative treatments within generally accepted accounting principles for policies and practices
related to material items that have been discussed with management;7 and (3) other material
written communications between the accounting firm and the investment company, such as any
management letter or schedule of unadjusted differences.
The proposed rules would have required these communications to take place prior to
the filing of an audit report with the Commission. For those investment company complexes
that have funds with staggered fiscal year-ends, the proposed rules would require these
communications to take place as frequently as monthly. As adopted, the final rules require the
accountant to communicate to the audit committee of an investment company annually, and if
the annual communication is not within 90 days prior to the filing, provide an update within
the 90-day period prior to the filing, of any changes to the previously reported information. The
adopted rules, in effect, would require the accountant to communicate the required information
no more frequently than four times during a calendar year.
VII. Disclosure of Fees and Services
Consistent with the Commission’s proposal, the final rules require issuers to provide
disclosure of fees paid to the independent accountant segregated into four categories: (1) audit
fees; (2) audit-related fees; (3) tax fees; and (4) all other fees. Issuers are required to describe the
types of services provided within each of the latter three categories. Issuers must also disclose
any audit committee pre-approval policies procedures, and the percentage of fees in each of the
three non-audit service categories representing services that were entered into pursuant to the
five percent de minimis exception. This information must be provided for the two most recent
fiscal years. The information must be disclosed in any proxy or information statement and in
the Form N-CSR filing covering the annual period.8
The Commission’s proposal would have required an investment company to disclose
the audit fees paid to its accountant and the aggregate fees paid for audit-related, tax services,
and other services to the investment company’s accountant by the investment company and its
investment adviser, and any entity controlling, controlled by, or under common control with
the adviser that provides services to the investment company. The final rule requires
investment companies to disclose separately those audit and non-audit fees from services
provided directly to the investment company and those non-audit fees from services provided
7 The discussion of alternative treatments must include: (1) ramifications of the use of such alternative disclosures
and treatments; and (2) the treatment preferred by the accounting firm.
8 The Form N-CSR filing may incorporate by reference the required information from the definitive proxy or
information statement.
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to all other entities in the investment company complex where the services were subject to pre-
approval by the investment company’s audit committee.
The final rule also will require the investment company to disclose if the audit
committee has considered whether the provision of non-audit services provided to the
investment company’s adviser and its related parties that were not subject to the investment
company audit committee’s pre-approval is compatible with maintaining the principal
accountant’s independence.
These disclosure requirements are effective for annual filings for the first fiscal year
ending after December 15, 2003.
Gregory M. Smith
Director – Operations/
Compliance & Fund Accounting