June 16, 2003
PROHIBITED NON-AUDIT SERVICES
Richard F. Langan, Jr.
In furtherance of the requirements of Section 201 of the Sarbanes-Oxley Act of 2002, the Securities and Exchange Commission adopted final rules prohibiting, during audit and professional engagement periods, both U.S. and non-U.S. accounting firms from providing to their audit clients that are SEC reporting companies ten specified types of non-audit services or any non-audit service that impairs an accountant’s independence from its audit clients. This summary describes the application of those rules to domestic U.S. issuers other than issuers of asset-backed securities.
The prohibition of specified non-audit services is predicated on three basic principles:
• An auditor cannot function in the role of management;
• An auditor cannot audit its own work; and
• An auditor cannot serve in an advocacy role for its client.
Subject to satisfying the pre-approval requirements, an accounting firm can provide tax services to its audit clients. Permitted tax services include providing tax compliance, tax planning and tax advice to audit clients. The SEC has emphasized, however, that the provision of certain tax services would or could impair an auditor’s independence. For example, the auditor would lack independence if it represented an audit client before a tax court. Similarly, the SEC, in its adopting release, exhorts the audit committee to carefully consider whether an accountant should be retained in a transaction the sole purpose of which may be tax avoidance, and the tax treatment may not be supported by relevant tax law and related regulations.
An accountant’s independence would be impaired by engaging in the following prohibited non-audit services on behalf of an non-audit client.
In this issue:
• Prohibited Non-Audit Services
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Bookkeeping or Other Services Relating to Accounting Records or Financial
Statements
An accountant would lack independence if it provides any bookkeeping services to an audit client “unless it is reasonable to conclude that the results of those services will not be subject to audit procedures during an audit of the audit client’s financial statements.” The prohibition utilizes the previous SEC definition of bookkeeping and other services, which focuses on the provision of services involving:
• Maintaining or preparing the audit client’s accounting records;
• Preparing financial statements that are filed with the SEC or the information that constitutes the basis of those financial statements; or
• Preparing or originating source data underlying the audit client’s financial statements.
The exception to the prohibition on bookkeeping or other services where it is reasonable to conclude that the results of those services will not be subject to audit procedures during the audit applies also to the next four categories of otherwise prohibited services. In its release adopting the new auditor independence rules, the SEC emphasized that there is a rebuttable presumption against the provision of these services and the limited exemption applies only in a narrow range of circumstances.
Financial Reporting Systems Design and Implementation
An accountant’s independence would be impaired if the accountant:
• Directly or indirectly operates or supervises the operation of the audit client’s information system or manages the audit client’s local area network or information system; or
• Designs or implements 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,
in each case, “unless it is reasonable to conclude that the results of those services will not be subject to audit procedures during an audit of the audit client’s financial statements.” Information is significant if it is reasonably likely to be material to the financial statements of the audit client taken as a whole. In addition to being somewhat imprecise, this standard can be particularly difficult to assess in practice because, as noted by the SEC, materiality standards may not be complete before financial statements are generated. An accounting firm, however, could evaluate and make recommendations to management concerning internal controls of a system as it is being designed, installed or operated.
Appraisal or Valuation Services, Fairness Opinions or Contribution-in-Kind
Reports
An accountant would not be independent if the accounting firm provides appraisal or valuation services, fairness opinions or contribution-in-kind reports to an audit client “unless it is reasonable to conclude that the results of those services will not be subject to audit procedures during an audit of the audit client’s financial statements.” However, the rules do not prohibit an auditor from providing services
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review the work done by the audit client or an independent third-party specialist so long as the audit client’s third-party specialist provides the technical expertise that is used by the client in determining the required amounts recorded in the client’s financial statements.
Actuarial Services
An auditor is proscribed from providing to an audit client any actuarially oriented advisory services involving the determination of amounts recorded in the company’s 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 actuarial figures “unless it is reasonable to conclude that the results of those services will not be subject to audit procedures during an audit of the audit client’s financial statements.” The accountant may use its own actuaries to assist the audit provided the client uses its own actuaries or third-party actuaries to provide management with its actuarial capabilities.
Internal Audit Outsourcing Services
An accountant is precluded from performing internal audit services that have been outsourced by an audit client that relate to the audit client’s internal accounting controls, financial systems or financial statements “unless it is reasonable to conclude that the results of those services will not be subject to audit procedures during an audit of the audit client’s financial statements.” The SEC stated that this prohibition does not include non-recurring evaluations of discrete items or other programs, such as agreed-upon procedures engagements related to the client’s internal controls, or operational internal audits that are not related to the internal accounting controls, financial systems or financial statements.
Management Functions
An accountant is prohibited from acting, temporarily or permanently, as a director, officer or employee of an audit client, or performing any decision-making, supervisory or ongoing monitoring functions for the audit client. However, an accountant’s independence would not be impaired by providing services in connection with the assessment of the effectiveness of internal accounting and risk management controls and providing recommendations for improvements. For example, the auditor could make recommendations on internal control components included in an inventory control system designed and implemented by a third-party service.
Human
Resources
An auditor’s independence is impaired when the accountant:
• Searches for or seeks out prospective managerial, executive or director positions;
• Acts as a negotiator for the client on such matters as position, status, compensation, fringe benefits or other conditions of employment;
• Undertakes reference checks;
• Engages in psychological testing or other formal testing or evaluation programs; or
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Broker-Dealer, Investment Adviser or Investment Banking Services
An auditor lacks independence when it performs brokerage or investment advising services for an audit client such as:
• Serving as a broker-dealer (regardless of whether registered or unregistered), promoter or underwriter;
• Making investment decisions on behalf of the audit client or 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.
Legal Services
An accountant lacks independence if the accountant provides any service to the audit client that, under the 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
An accountant is prohibited from providing expert opinions or other services for an audit client or its legal representative for the purpose of advocating the client’s interests in connection with legal, administrative or regulatory proceedings. Moreover, the accountant’s independence would be impaired by providing services to an audit client’s legal counsel to prepare the counsel for a litigation, proceeding or investigation. The prohibition does not include:
• Conducting procedures, with the approval of the audit committee, to search for fraud that is material to the audit client’s financial statements in furtherance of the auditor’s obligations under Section 10A of the Securities Exchange Act and generally accepted auditing standards so long as, if litigation or an investigation commences while the auditor is conducting those procedures, the auditor remains in control of his or her work and that work does not become subject to the direction or influence of legal counsel for the audit client.
• Assisting the audit committee or its counsel in fulfilling its responsibilities to investigate a potential accounting impropriety (excluding defending or helping to defend the audit committee or audit client other than as a fact witness); or
• Providing factual accounts or testifying about the audit work performed by it.
R
Advisory Tips
SEC reporting companies should consider the following when dealing with issues that may involve prohibited non-audit services:
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• The audit committee should review carefully proposed tax services for the reasons stated above. In this regard, while the auditors should be permitted to represent an audit client before the Internal Revenue Services on an audit matter, the auditor cannot represent the company in the tax court or before the court of claims.
• Similarly, in connection with its pre-approval process, the audit committee should review carefully services proposed to be provided in connection with mergers and acquisitions. While services for mergers and acquisitions frequently will be audit-related to some extent, the audit committee should ensure that they do not involve prohibited bookkeeping, appraisal, or valuation or expert services.
• The audit committee may want to impose maximum fees in connection with its pre-approval policies and procedures based either on the type of pre-approved service or on a time period, or both. The fee cap would add a level of detail encouraged by the SEC and enhance the level of audit committee involvement in the pre-approval process. Services involving fees in excess of the fee cap would be subject to specific consideration by the audit committee.
• Although Section 302 of the Sarbanes-Oxley Act requires that the chief executive officer and chief financial officer certify as to the adequacy of internal controls, it may be desirable to ensure consistency between the Section 302 certification and the audit committee report in the proxy statement to have the audit committee participate in the review of internal accounting controls. Under the auditor independence rules, the company’s principal accountants cannot be engaged to assist the audit committee with this task. The audit committee may wish to engage an accounting consultant to review internal controls. If the audit committee takes on this task, the committee should maintain a record of the review process.
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If you have any questions or require further information regarding these or any other matters, please call your regular Nixon Peabody contact or feel free to contact any of the partners and counsel in our Corporate Governance Law practice group listed on the final page of this Corporate Responsibility Alert.
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