new audit committee and auditor independence requirements for ...

May 5, 2003
Contact
Cindy Young
Partner, Louisville
502.562.7292
cyoung@wyattfirm.com
This article is intended
for educational purposes
only and is not intended
as legal advice. This article
is considered attorney
advertising in some
jurisdictions.
New audit committee and auditor
independence requirements for reporting
companies under Sarbanes Oxley
The following highlights some of the new requirements that will
apply to the audit function at domestic reporting companies under
the SEC’s recent rule-making. 1 These new requirements will
be effective May 6, 2003, subject to grandfathering and transition
rules noted at the end of this memorandum. These rules
are intended to increase auditor independence and strengthen
the relationship and communication between the auditor and the
reporting company’s audit committee. It is important to note that
the rules make clear that violations of the new auditor independence
requirements contained in the rules will constitute separate
violations of the Exchange Act.
L O U I S V I L L E . K Y
L E X I N G T O N . K Y
B O W L I N G G R E E N . K Y
Additional requirements will also apply
to audit committees of companies listed
on an exchange or Nasdaq. These additional
“listed company” requirements
are discussed in a separate memorandum
and will be subject to additional
rule-making; compliance with them will
not be required until 2004 (at the earliest).
2
• the audit committee must approve the
engagement of the independent accountant
before the company engages the
accountant to render audit or non-audit
services; or
• the engagement to render the service
must be entered into pursuant to pre-approval
policies and procedures established
by the audit committee.
N E W A L B A N Y . I N
N A S H V I L L E . T N
M E M P H I S . T N
J A C K S O N . M S
Audit committee administration of
the engagement
Under the SEC’s auditor independence
rules, before an independent accountant
is engaged to render the audit or nonaudit
services for the company (or any of
its subsidiaries), either
In order to take advantage of this second
approach, the policies and procedures
must be detailed as to the particular
service and the audit committee must
be informed of each service and the
policies and procedures cannot delegate
the audit committee’s responsibilities to
management.
F O R T C O L L I N S . C O
1 The new rules strengthening the SEC’s requirements regarding auditor independence are contained in Release No. 33-8183;
34-47265; 35-27642; IC-25915; IA-2103, FR-68, File No. S7-49-02] can be found at http://www.sec.gov/rules/final/33-8183.
htm, with corrections at http://www.sec.gov/rules/final/33-8183a.htm. The new rules regarding disclosures about audit committee
financial experts are contained in Release Nos. 33-8177; 34-47235; File No. S7-40-02 and can be found at http://www.sec.
gov/rules/final/33-8177.htm, with corrections at http://www.sec.gov/rules/final/33-8177a.htm.
2 The new rules concerning standards related to listed company audit committees [Release Nos. 33-8220; 34-47654; IC-26001;
File No. S7-02-03] can be found at http://www.sec.gov/rules/final/33-8220.htm.
W W W. W Y A T T F I R M . C O M
This paper does not address the special requirements or treatment of investment companies, asset-backed issuers or foreign
private issuers (or foreign accounting firms).

Failure to comply with this pre-approval requirement
will mean that the accountant is not independent (and
cannot serve as the company’s auditor), subject to one
exception: The pre-approval requirement is waived for
the provision of services other than audit, review or attest
services if:
• the aggregate amount of all such services provided
constitutes no more than 5% of the total amount of revenues
paid by the company to its accountant during the
fiscal year in which the services are provided;
• such services were not recognized by the company at
the time of the engagement to be non-audit services;
and
• such services are promptly brought to the attention of
the audit committee of the company and approved prior
to the completion of the audit by the audit committee or
by one or more members of the audit committee who
are members of the board of directors to whom authority
to grant such approvals has been delegated by the
audit committee.
Note: Policies and procedures adopted by the audit
committees for approval of services will have to be
disclosed in the company’s proxy statement and annual
report filed with the SEC.
Additional note: There are some non-audit services that
an independent accountant cannot provide, regardless
of audit committee approval. These are described in
further detail below.
Auditor’s communication with audit committees
The company’s auditor is required to report to the audit
committee, prior to the filing of the audit report with the
SEC:
• all critical accounting policies and practices to be
used;
• all alternative treatments within GAAP for policies and
practices related to material items that have been discussed
with management of the company, including:
• ramifications of the use of such
alternative disclosures and treatments; and
• the treatment preferred by the auditor; and
• other material written communications between the
registered public accounting firm and the management
of the company, such as any management letter or
schedule of unadjusted differences;
Note: These items should be added to the agenda for
the audit committee meeting that occurs prior to the filing
of the Form 10-K.
Additional note: The SEC instructs reporting company
audit committees and their auditors to refer to the
guidance it provided in its December 2001 Cautionary
Advice Regarding Disclosure About Critical Accounting
Policies to determine the types of matters that should be
communicated to the audit committee. This guidance is
available at http://www.sec.gov/rules/other/33-8040.
htm.
Annual report disclosures about the audit
committee’s financial expertise
The SEC rules do not impose any financial expertise requirement
on audit committee members. However, they
will require disclosures about audit committee financial
expertise in annual reports on Form 10-K for fiscal years
ending on or after July 15, 2003 (or, for small business
issuers, on Form 10-KSB for fiscal years ending on or
after December 15, 2003). A company will be required
to disclose in its annual report whether the board of
directors has determined that the company either:
• has at least one audit committee financial expert serving
on its audit committee; or
• does not have an audit committee financial expert
serving on its audit committee.
If the board has determined that an audit committee
financial expert serves on the audit committee, the annual
report must disclose the name of the audit committee
financial expert and whether that person is independent.
Only one audit committee financial expert must
be identified as such, but if the company chooses to
disclose the identity of more than one financial expert, it
must indicate whether such persons are independent.
If the board has determined that no audit committee
financial expert is serving on the audit committee, the
annual report must explain why the company does not
have an audit committee financial expert.
An “audit committee financial expert” means a person
who has the following attributes:
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• an understanding of generally accepted accounting
principles and financial statements;
• the ability to assess the general application of such
principles in connection with the accounting for estimates,
accruals and reserves;
• experience preparing, auditing, analyzing or evaluating
financial statements that present a breadth and
level of complexity of accounting issues that are generally
comparable to the breadth and complexity of issues
that can reasonably be expected to be raised by the
company’s financial statements, or experience actively
supervising one or more persons engaged in such
activities;
• an understanding of internal controls and procedures
for financial reporting; and
• an understanding of audit committee functions;
and who acquired such attributes through:
• education and experience as a principal financial
officer, principal accounting officer, controller, public accountant
or auditor or experience in one or more positions
that involve the performance of similar functions;
• experience actively supervising a principal financial
officer, principal accounting officer, controller, public
accountant, auditor or person performing similar functions;
• experience overseeing or assessing the performance
of companies or public accountants with respect to the
preparation, auditing or evaluation of financial statements;
or
• other relevant experience.
If a person qualifies as an audit committee financial expert
based on “other relevant experience,” a brief listing
of that person's relevant experience will be required.
The SEC rules provide a safe harbor to make clear
that the designation of a person as an audit committee
financial expert does not make that person an “expert”
and does not change any duties, obligations or liability
that are greater than the duties, obligations and liability
imposed on any member (including the designated person)
of the audit committee or the board of directors.
The disclosure about the existence of an audit committee
financial expert is not required to be included a
proxy or information statement (although, like other disclosures
in Part III of the annual report, a company may
elect to include the information in the proxy statement
and incorporate it by reference into the annual report).
Proxy statement and annual report disclosures
about the auditor relationship
Proxy statements are required to disclose the aggregate
fees billed for each of the last two fiscal years for professional
services rendered by the principal accountant
for the reporting company
• under the caption Audit Fees, for the audit of the
company’s annual financial statements and review of financial
statements included in the company’s quarterly
SEC reports or services that are normally provided by
the accountant in connection with statutory and regulatory
filings or engagements for those fiscal years.
• under the caption Audit-Related Fees, for assurance
and related services that are reasonably related to the
performance of the audit or review of the company’s
financial statements and are not reported as Audit Fees.
The company must describe the nature of the services
comprising the fees disclosed under this category.
• under the caption Tax Fees, for professional services
for tax compliance, tax advice, and tax planning. The
company must describe the nature of the services comprising
the fees disclosed under this category.
• under the caption All Other Fees, for products and
services provided, other than the services reported as
Audit or Audit-Related Fees. The company is required to
describe the nature of the services comprising the fees
disclosed under this category.
The proxy statement is also required to disclose
• the audit committee's pre-approval policies and
procedures for the provision of audit and non-audit
services by the company’s auditor,
• the percentage of services included in the Audit Fees,
Audit-Related Fees and All Other Fees categories that
were approved by the audit committee after-the-fact
pursuant to the waiver provision noted above, and
• if greater than 50%, the percentage of hours expended
on the principal accountant’s engagement to audit
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the company’s financial statements for the most recent
fiscal year that were attributed to work performed by
persons other than the principal accountant’s full-time,
permanent employees.
These same types of disclosures will also be required in
the annual report on Form 10-K (and Form 10-KSB).
Avoiding conflicts of interest -- audit partner
rotation
In order for an auditor to be considered independent,
the audit partners must comply with the following requirements:
• Generally, an audit partner cannot perform the services
of a lead partner or concurring partner for more
than 5 consecutive years. After performing the services
of a lead or concurring partner for 5 consecutive years,
the audit partner must take a 5 year break before performing
the services of a lead partner or a concurring
partner, or a combination of those services.
• Similarly, an audit partner cannot perform one or
more of the following services for more than seven
consecutive years. After performing such services for 7
consecutive years, the audit partner must take a 2 year
break before performing such services again or acting
as a lead or a concurring partner for the company, or a
combination of those services. Services covered:
• provision of more than ten hours of audit,
review, or attest services in connection with the
annual or interim consolidated financial
statements of the company; and
• service as the "lead partner" in connection
with any audit or review related to the
annual or interim financial statements of a
subsidiary of the company whose assets or
revenues constitute 20% or more of the assets
or revenues of the company’s respective
consolidated assets or revenues.
Definition. An “audit partner” is generally defined to
include the lead partner and concurring partner as
well as any other audit engagement team partner who
provides the services described in the foregoing paragraph,
but does not include a partner who consults with
members of the audit engagement team on technical or
industry-specific issues, transactions or events.
Exception. Any accounting firm with less than five audit
clients that are reporting companies and less than ten
partners is exempt from these years of service limits
provided the Public Company Accounting Oversight
Board conducts a review at least once every three years
of each of the audit firm’s reporting company engagements
that would result in a lack of auditor independence
but for this exception.
No incentive compensation to audit partners for
cross-selling
In order for an auditor to be independent, no audit
partner can, at any point during the audit and professional
engagement period, earn or receive compensation
based on the audit partner procuring engagements
with the reporting company to provide any products or
services other than audit, review or attest services. The
same exception for small accounting firms with a limited
number of reporting company clients that applies
to the audit partner rotation requirements also applies
to this prohibition.
Limits on employment relationships
The company cannot employ a former partner, principal,
shareholder, or professional employee of the
company’s auditor in an accounting role or financial
reporting oversight role if the individual was a member
of the company’s audit engagement team during the
year preceding the date that audit procedures commenced
for the fiscal period in which the company
hired the individual. 3 Audit procedures are deemed
commenced for a particular fiscal period on the day
after the company files its Form 10-K for its prior fiscal
year. This restriction is in addition to existing SEC
rules that prevent a company from employing a former
partner, principal, shareholder or professional employee
of the auditor in an accounting role or a financial
reporting oversight role if the individual influences the
auditor’s operations or financial policies or has certain
financial interests in the auditor.
Employing a former partner, principal, shareholder or
professional employee of an auditor in violation of these
restrictions will render the auditor not independent.
3 Certain exceptions exist for certain members of the audit engagement team, such as a member other than a “lead” or “concurring” partner who provided 10 or
fewer hours of audit, review or attest services during the applicable period.
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Prohibited non-audit services
A reporting company’s auditor cannot, at any point
during the audit and professional engagement period, 4
provide any of the following non-audit services to the
audit client:
• Bookkeeping or other services related to the accounting
records or financial statements of the audit client.
Any service, 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, including:
• maintaining or preparing the audit client's
accounting records;
• preparing the audit client's financial
statements that are filed with the SEC or that
form the basis of financial statements filed with
the SEC; or
• preparing or originating source data
underlying the audit client's financial
statements.
• Financial information systems design and implementation.
Any service, 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, including:
• directly or indirectly operating, or supervising
the operation of, the audit client's information
system or managing the audit client's local area
network; or
• designing or implementing a hardware or
software system that aggregates source data
underlying the financial statements or
generates information that is significant to the
audit client's financial statements or other
financial information systems taken as a whole.
• Appraisal or valuation services, fairness opinions, or
contribution-in-kind reports. Any appraisal service, valuation
service, or any service involving a fairness opinion
or contribution-in-kind report for an audit client, 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.
• Actuarial services. Any actuarially-oriented advisory
service involving the determination of amounts recorded
in the financial statements and related accounts for the
audit client other than assisting a client in understanding
the methods, models, assumptions, and inputs used
in computing an amount, 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.
• Internal audit outsourcing services. Any internal audit
service that has been outsourced by the audit client that
relates to the audit client's internal accounting controls,
financial systems, or financial statements, for an audit
client 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.
• Management functions. Acting, temporarily or permanently,
as a director, officer, or employee of an audit
client, or performing any decision-making, supervisory,
or ongoing monitoring function for the audit client.
• Human resources.
• searching for or seeking out prospective
candidates for managerial, executive, or
director positions;
• engaging in psychological testing, or other
formal testing or evaluation programs;
• undertaking reference checks of prospective
candidates for an executive or director position;
• acting as a negotiator on the audit client's
behalf, such as determining position, status
or title, compensation, fringe benefits, or other
conditions of employment; or
• recommending, or advising the audit client
to hire, a specific candidate for a specific job
(except that an accounting firm may, upon
request by the audit client, interview candidates
and advise the audit client on the candidate's
competence for financial accounting,
administrative, or control positions).
• Broker-dealer, investment adviser, or investment
banking services. Acting as a broker-dealer (registered
or unregistered), promoter, or underwriter, on behalf of
4 “Audit and professional engagement period” includes both the period covered by the financial statements being audited or reviewed and the period of engagement
to audit or review the client’s financial statements or to prepare a report filed with the Commission. The period of engagement begins when the auditor signs
an initial engagement letter or begins audit, review or attest procedures, and ends when the client or the auditor notifies the Commission that the client is no longer
the auditor’s audit client.
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an audit client, making investment decisions on behalf
of the audit client or otherwise having discretionary
authority over an audit client's investments, executing a
transaction to buy or sell an audit client's investment, or
having custody of assets of the audit client, such as taking
temporary possession of securities purchased by the
audit client.
• Legal services. Providing any service to an audit client
that, under circumstances in which the service is provided,
could be provided only by someone licensed,
admitted, or otherwise qualified to practice law in the
jurisdiction in which the service is provided.
• Expert services unrelated to the audit. Providing an expert
opinion or other expert service for an audit client, or
an audit 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.
In any litigation or regulatory or administrative proceeding
or investigation, an accountant's independence shall
not be deemed to be impaired if the accountant provides
factual accounts, including in testimony, of work
performed or explains the positions taken or conclusions
reached during the performance of any service provided
by the accountant for the audit client.
Note. The SEC reiterated its long-standing position that
an auditor can generally provide tax services to its clients
without impairing its independence, though the SEC
cautioned that certain types of services labeled as ‘tax
services’ would or could impair the auditor’s independence
(e.g., acting as an advocate for the client in a tax
court case).
Transition and grandfathering
Provided they did not impair the accountant's independence
under pre-existing requirements, the existence of
the following relationships on May 6, 2003 will not be
deemed to impair an auditor’s independence:
• Employment relationships that commenced at the
company to prior May 6, 2003.
• Compensation earned or received, as described
above for cross-selling, during the fiscal year of the accounting
firm that includes May 6, 2003.
• Until May 6, 2004, the provision of prohibited nonaudit
services provided those services are pursuant to
contracts in existence on May 6, 2003.
• Until May 6, 2003, the provision of services by the accountant
that have not been pre-approved by the audit
committee.
• Until the first day of the company’s fiscal year beginning
after May 6, 2003, for services by a “lead” partner
and other audit partner (other than the "concurring"
partner) for a longer period of time than permitted under
the new rules.
• Until the first day of the company’s fiscal year beginning
after May 6, 2004 for services by a “concurring”
partner providing services in excess of those permitted
under the new rules.
For the purposes of calculating periods of
maximum service:
• For the lead partner and concurring partner,
the period of service includes time served as the
lead or concurring partner prior to May 6,
2003; and
• For audit partners other than the lead partner
or concurring partner, the period of service
does not include time served on the audit
engagement team prior to the first day of the
company’s fiscal year beginning on or after
May 6, 2003.
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