FR Doc 02-30884
[Federal Register: December 13, 2002 (Volume 67, Number 240)]
[Proposed Rules]               
[Page 76779-76817]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr13de02-21]                         




[[Page 76779]]


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Part II










Securities and Exchange Commission










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17 CFR Parts 210, 240, 249, and 274






Strengthening the Commission's Requirements Regarding Auditor 
Independence; Proposed Rule




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SECURITIES AND EXCHANGE COMMISSION


17 CFR Parts 210, 240, 249 and 274


[Release No. 33-8154; 34-46934; 35-27610; IC-25838; IA-2088, FR-64, 
File No. S7-49-02]
RIN 3235-AI73


 
Strengthening the Commission's Requirements Regarding Auditor 
Independence


AGENCY: Securities and Exchange Commission.


ACTION: Proposed rule.


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SUMMARY: The Securities and Exchange Commission (``SEC'' or 
``Commission'') is proposing amendments to its existing requirements 
regarding auditor independence to enhance the independence of 
accountants that audit and review financial statements and prepare 
attestation reports filed with the Commission. The proposed rules 
recognize the critical role played by audit committees in the financial 
reporting process and the unique position of audit committees in 
assuring auditor independence. As directed by section 208(a) of the 
Sarbanes-Oxley Act of 2002, we are proposing rules to: Revise the 
Commission's regulations related to the non-audit services that, if 
provided to an audit client, would impair an accounting firm's 
independence; define the circumstances whereby an issuer's audit 
committee can and should pre-approve all audit and allowable non-audit 
services provided to the issuer by the auditor of an issuer's financial 
statements; prohibit partners on the audit engagement team from 
providing audit services to the issuer for more than five consecutive 
years; prohibit an accounting firm from auditing an issuer's financial 
statements if certain members of management of that issuer had been 
members of the accounting firm's audit engagement team within the one-
year period preceding the commencement of audit procedures; and require 
that the auditor of an issuer's financial statements report certain 
matters to the issuer's audit committee, including ``critical'' 
accounting policies used by the issuer.
    In addition to the provisions required by the Act, we also are 
proposing rules defining an accountant as not being independent from an 
audit client if any partner, principal or shareholder of the accounting 
firm who is a member of the engagement team received compensation based 
on any service provided or sold to that client other than audit, review 
and attest services. Further, we proposed to amend and require 
additional disclosures to investors of information related to the audit 
and non-audit services provided by, and fees paid by the issuer to, the 
auditor of the issuer's financial statements.


DATES: Comments should be received on or before January 13, 2003.


ADDRESSES: You should send three copies of your comments to Jonathan G. 
Katz, Secretary, U.S. Securities and Exchange Commission, 450 Fifth 
Street, NW., Washington, DC, 20549-0609. You also may submit your 
comments electronically to the following address: rule-
comments@sec.gov. To help us process and review your comments more 
efficiently, comments should be submitted by one method only. All 
comment letters should refer to File No. S7-49-02; this file number 
should be included in the subject line if you use electronic mail. 
Comment letters will be available for public inspection and copying at 
the Commission's Public Reference Room, 450 Fifth Street, NW., 
Washington, DC 20549-0102. We will post electronically-submitted 
comment letters on the Commission's Internet Web site (http://www.sec.gov
). We do not edit personal identifying information, such as 
names or electronic mail addresses, from electronic submissions. Submit 
only information you wish to make publicly available.


FOR FURTHER INFORMATION CONTACT: Samuel L. Burke, Associate Chief 
Accountant, or Robert E. Burns, Chief Counsel, at (202) 942-4400, 
Office of the Chief Accountant, or, with respect to questions about 
investment companies, Brian D. Bullard, Chief Accountant, at (202) 942-
0590, Division of Investment Management, U.S. Securities and Exchange 
Commission, 450 Fifth Street, NW., Washington, DC 20549.


SUPPLEMENTARY INFORMATION: We are proposing to add rule 2-07 to 
Regulation S-X \1\ and to amend rule 2-01 of Regulation S-X,\2\ to 
amend item 9 of Regulation S-K,\3\ to amend forms 10-K, 10-KSB, 20-F 
and 40-F \4\ and to amend proposed form N-CSR.\5\
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    \1\ 17 CFR 210.2-07.
    \2\ 17 CFR 210.2-01.
    \3\ 17 CFR 240.14a-101.
    \4\ 17 CFR 249.310; 17 CFR 249.310b; 17 CFR 249.220f; 17 CFR 
249.240f.
    \5\ 17 CFR 249.331; 17 CFR 274.128.
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I. Introduction and Background


    On July 30, 2002, the Sarbanes-Oxley Act of 2002 (``Sarbanes-Oxley 
Act'' or ``the Act'') was enacted.\6\ Title II of the Sarbanes-Oxley 
Act, entitled ``Auditor Independence,'' requires the Commission to 
adopt, by January 26, 2003, final rules, under which certain non-audit 
services will be prohibited, conflict of interest standards will be 
strengthened, auditor partner rotation and second partner review 
requirements will be strengthened, and the relationship between the 
independent auditor and the audit committee will be clarified and 
enhanced.
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    \6\ Pub. L. 107-204, 116 Stat. 745 (2002).
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    As directed by the Sarbanes-Oxley Act, the proposed rules focus on 
key aspects of auditor independence:\7\ the provision of certain non-
audit services and the unique ability of the audit committee to 
insulate the auditor from the pressures that may be exerted by 
management, the potential conflict of interest that can be created when 
a former member of the audit engagement team accepts a key management 
position with the audit client, and the need for effective 
communications between the auditor and audit committee. The proposed 
rules also address the possibility of any partner, principal or 
shareholder who is a member of the audit engagement team being unduly 
influenced by financial incentives to sell non-audit services to the 
audit client.
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    \7\ Consistent with the Commission's existing independence 
rules, these proposals would apply to foreign audit firms as well as 
firms domiciled in the United States. Additionally, these proposals 
coupled with the Commission's existing independence rules are 
proposed with the Principles of Auditor Independence and the Role of 
Corporate Governance in Monitoring an Auditor's Independence issued 
by the International Organization of Securities Commissions (IOSCO) 
in October 2002 in mind.
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    Title II of the Sarbanes-Oxley Act adds new subsections (g) through 
(l) to section 10A of the Securities Exchange Act of 1934 as follows:
    [sbull] Section 201 adds subsection (g), which specifies that a 
number of non-audit services are prohibited. Many of these services 
were previously prohibited by the Commission's independence standards 
adopted in November 2000 (with some exceptions and qualifications).\8\ 
These proposed rules amend the Commission's existing rules on auditor 
independence and clarify the meaning and scope of the prohibited 
services under the Sarbanes-Oxley Act.
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    \8\ The Commission adopted a comprehensive set of rules 
governing auditor independence on November 21, 2000. See Release No. 
33-7919 (Nov. 21, 2000); 65 FR 76008 (Dec. 5, 2000) (hereinafter 
``November 2000 release'').
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    [sbull] Section 201 also adds subsection (h) and requires that non-
audit services that are not prohibited under the Sarbanes-Oxley Act and 
the Commission's rules be subject to pre-approval by the registrant's 
audit committee. These proposed rules specify the requirements


[[Page 76781]]


for obtaining such pre-approval from the registrant's audit committee.
    [sbull] Section 202 adds subsection (i), which requires an audit 
committee to pre-approve allowable non-audit services and specifies 
certain exceptions to the requirement to obtain pre-approval. These 
proposed rules specify the requirements of the registrant's audit 
committee for pre-approving non-audit services by the auditor of the 
registrant's financial statements.
    [sbull] Section 203 adds subsection (j), which establishes 
mandatory rotation of the engagement partner, and the reviewing (or 
``concurring'') partner every five years. These proposed rules expand 
the number of engagement personnel covered by the rotation requirement 
and clarify the ``time out'' period.
    [sbull] Section 204 adds subsection (k), which requires that the 
auditor report on a timely basis certain information to the audit 
committee. In particular, the Sarbanes-Oxley Act requires that the 
auditor report to the audit committee on a timely basis (a) all 
critical accounting policies used by the registrant, (b) alternative 
accounting treatments that have been discussed with management along 
with the potential ramifications of using those alternatives, and (c) 
other written communications provided by the auditor to management, 
including a schedule of unadjusted audit differences.\9\ These proposed 
rules strengthen the relationship between the audit committee and the 
auditor.
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    \9\ Statement on Auditing Standards No. 89, ``Audit 
Adjustments,'' (Dec. 1999).
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    [sbull] Section 206 adds subsection (l) addressing certain conflict 
of interest provisions. The Sarbanes-Oxley Act prohibits an accounting 
firm from performing audit services for a registrant if certain key 
members of management have recently been employed in an audit capacity 
by the audit firm. These proposed rules clarify which members of 
management are covered by these conflict of interest rules.
    In addition to the mandate under title II of the Act, these 
proposed rules address situations where partners, principals, or 
shareholders of the firm who work on the audit of a company are 
compensated for selling non-audit services to the same audit client.
    As noted above, the proposed rules establish and clarify the 
important roles and responsibilities of registrant audit committees as 
well as the registrant's independent accountant.\10\
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    \10\ The Commission's proposals respond not only to the 
provisions of the Sarbanes-Oxley Act but also the rulemaking 
petitions filed by the AFL-CIO on December 11, 2001, and The 
Honorable H. Carl McCall on January 21, 2002. Both petitions are 
available on the Commission's Web site (http://www.sec.gov).
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    We have proposed a separate rule under Exchange Act section 10A 
(240.10A-2) to implement section 3(b)(1) of the Sarbanes-Oxley Act and 
clarify that our rules implementing title II of Sarbanes-Oxley not only 
define conduct that impairs independence but also constitute separate 
violations under the Exchange Act. We have otherwise drafted the 
proposed rules (except for the proxy disclosure changes) as part of 
Regulation S-X, and propose to place them among the current auditor 
independence provisions. These provisions are generally based on 
whether an accountant is ``independent'' in the conduct of the audit. 
We are considering changing the format from rules defining actions that 
impair the auditor's independence to rules prohibiting such actions and 
placing them with other Exchange Act rules. The Act supplemented 
section 10A of the Exchange Act and gave us express authority to adopt 
rules to implement these new statutory provisions. Among the reasons to 
move these rules under that provision is to: (1) Organize the related 
statutory and regulatory provisions more logically, and (2) make 
explicit that violations would be punishable as Exchange Act 
violations, as contemplated by sections 3(b)(1) and 208 of the 
Sarbanes-Oxley Act, with all the remedies available for Exchange Act 
violations, including penalties. Even if we were to move the rules out 
of Regulation S-X, we would intend for these provisions also to remain 
professional standards of independence. If we move them to be Exchange 
Act rules, we are considering a new provision in Regulation S-X that 
would state that a violation of these rules would also render the 
auditor not independent under Regulation S-X. Violations of these 
provisions could therefore also result in professional discipline in 
the event of a violation and cause the issuer's financial statement to 
fail to conform to Regulation S-X.
    We seek comment on this alternative approach. We recognize that 
auditors have traditionally looked to Regulation S-X as the place where 
rules relating to audits are placed, and we do not intend to make 
reference to and compliance with the rules more difficult. We seek 
comment on whether any conforming changes in other parts of the 
securities laws would be necessary if we adopted these rules and made 
them Exchange Act rules. We also seek comment on whether any of the 
current auditor independence rules or definitions under Regulation S-X, 
the substance of which we do not propose to change in light of the 
Sarbanes-Oxley Act, should also be made into Exchange Act rules, or 
conversely, whether any of the particular proposed or existing rules 
relating to audits should stay in Regulation S-X even if all or most of 
the remaining proposed rules are adopted as Exchange Act rules.


II. Discussion of Proposed Rules


A. Conflicts of Interest Resulting From Employment Relationships


    The Commission's existing rules deem a firm to not be independent 
with respect to an audit client if a former partner, principal, 
shareholder, or professional employee of an accounting firm \11\ 
accepts employment with a client if he or she has a continuing 
financial interest in the accounting firm or is in a position to 
influence the firm's operations or financial policies. These proposed 
rules renumber, but do not otherwise change, that existing 
requirement.\12\
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    \11\ The terms accounting firm and accountant are used 
interchangeably in this proposing release. The term ``accountant'' 
is defined in 210.2-01(f) below.
    \12\ 17 CFR 210.2-01(c)(2)(iii)(A).
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    Consistent with section 206 of the Sarbanes-Oxley Act, we propose 
adding a restriction on employment with audit clients by former 
employees of the accounting firm. The Act specifies that an accounting 
firm cannot perform an audit for a registrant:


 * * * [i]f a chief executive officer, controller, chief financial 
officer, chief accounting officer, or any person serving in an 
equivalent position for the issuer, was employed by that registered 
independent public accounting firm and participated in any capacity 
in the audit of that issuer during the 1-year period preceding the 
date of the initiation of the audit.\13\ (Emphasis added.)
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    \13\ See section 206 of the Sarbanes-Oxley Act.


    Consistent with that directive, we propose that the employment of 
audit engagement team \14\ members of an accounting firm in a financial 
reporting oversight role at an audit client within one year prior to 
the commencement of procedures for the current audit engagement would 
cause the accounting firm not to be independent with respect to that 
registrant. The rules that we are proposing would apply to employment 
relationships entered into between audit engagement team members and 
their audit clients.\15\
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    \14\ 17 CFR 210.2-01(f)(7).
    \15\ 17 CFR 210.2-01(f)(6).
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    As discussed later in this release, the term ``financial reporting 
oversight role'' refers to any individual who has direct responsibility 
for oversight over those


[[Page 76782]]


who prepare the registrant's financial statements and related 
information (e.g., management's discussion and analysis) that are 
included in filings with the Commission.
    The concept of a ``cooling-off'' period before an auditor can take 
a position at the audit client was previously considered by the 
Independence Standards Board.\16\ In considering a cooling-off period, 
the Independence Standards Board noted that a mandated cooling-off 
period for partners and professional staff might create a greater 
appearance of independence between the accounting firm and the 
registrant.\17\ Ultimately, however, the Independence Standards Board 
provided for an alternative to a strict cooling-off period. The 
Independence Standards Board concluded that:
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    \16\ The Independence Standards Board was a private sector body 
that, from 1997 to 2001, was charged with the responsibility to set 
auditor independence standards for auditors of the financial 
statements of SEC registrants. See Financial Reporting Release Nos. 
50 (February 18, 1998) and 50A (July 17, 2001).
    \17\ Independence Standards Board, ``Employment with Audit 
Clients,'' Discussion Memorandum 99-1 (March 12, 1999).


    An audit firm's independence is impaired with respect to an 
audit client that employs a former firm professional who could, by 
reason of his or her knowledge of and relationships with the audit 
firm, adversely influence the quality or effectiveness of the audit, 
unless the firm has taken steps that effectively eliminate such 
risk.\18\
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    \18\ Independence Standards Board, ``Employment with Audit 
Clients,'' Standard No. 3 (July 2000).


    Independence Standards Board's Standard No. 3 specifically notes 
that additional caution is warranted when it has been less than one 
year since the professional disassociated him or herself from the 
firm.\19\ The provisions of the Sarbanes-Oxley Act reflect the view 
that the passage of time is the only appropriate safeguard to reduce 
the perceived loss of independence for the audit firm caused by the 
acceptance of employment by a member of the engagement team with an 
audit client.
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    \19\ Id., ]2(b)(iii).
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    The Act specifies that the cooling off period must be one year. 
Under our proposed rules, the prohibition would commence one year prior 
to the earlier of either when the accountant began the current fiscal 
year's audit or when the accountant began review procedures necessary 
to conduct a timely review of the registrant's quarterly financial 
information associated with the current fiscal year. The measurement 
period is based upon the year the former employee commenced initial 
employment. For example, if audit engagement team member A last worked 
on the audit engagement on January 31, 2002 (audit report filed with 
the Commission on February 19, 2002), and joined audit client B on 
September 1, 2003, and the review procedures for B commenced on 
February 20, 2003, the accounting firm would not lose its independence 
with respect to the audit client since audit engagement team member A 
did not participate as an audit engagement team member subsequent to 
February 19, 2002. With respect to determining commencement dates, 
generally accepted auditing standards require that an audit engagement 
be properly planned. As such, procedures associated with the planning 
of the engagement constitute the commencement of an audit.\20\ 
Additionally, SAS No. 71 establishes the procedures necessary to 
conduct a timely review of interim information.\21\
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    \20\ Considerations necessary to plan an audit engagement are 
discussed in SAS Nos. 22, ``Planning and Supervision'' (AU Sec.  
311), 47, ``Audit Risk and Materiality in Conducting an Audit'' 
(AUSec.  312), 48, ``The Effects of Computer Processing on the Audit 
of Financial Statements'' (AU Sec. Sec.  311, 326), 54, ``Illegal 
Acts by Clients'' (AU Sec.  317), 55, ``Consideration of Internal 
Control in a Financial Statement Audit'' (AU Sec.  319), 56, 
``Analytical Procedures'' (AU Sec.  329), 65, ``The Auditor's 
Consideration of the Internal Audit Function in an Audit of 
Financial Statements'' (AU Sec.  322), 70, ``Service Organizations'' 
(AU Sec.  324), 73, ``Using the Work of a Specialist'' (AU Sec.  
336), 78, ``Consideration of Internal Control in a Financial 
Statement Audit'' (AU Sec.  319), 82, ``Consideration of Fraud in a 
Financial Statement Audit'' (AU Sec.  312), 83, ``Establishing an 
Understanding With the Client'' (AU Sec.  310), 84, ``Communications 
Between Predecessor and Successor Auditors'' (AU Sec.  315), 89, 
``Audit Adjustments'' (AU Sec.  310), and 94, ``The Effect of 
Information Technology on the Auditor's Consideration of Internal 
Control in a Financial Statement Audit'' (AU Sec.  319) as well as 
amendments to these documents.
    \21\ SAS No. 71, ``Interim Financial Information'' (AU Sec.  
722). In November 2002, the Auditing Standards Board issued SAS No. 
100, ``Interim Financial Information.'' SAS No. 100 supercedes SAS 
No. 71 and is effective for interim periods within fiscal years 
beginning after December 15, 2002.
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    The Commission is also considering whether it should provide an 
exemption from these requirements for companies meeting certain 
criteria, in order to address the practical difficulties that some 
companies to hire qualified personnel. The criteria might include the 
available pool of candidates for a position, the size of the company, 
and the audit committee's role in ensuring the independence of the 
auditor.
    [sbull] Is the one-year cooling-off period sufficiently long to 
achieve an appearance of independence by the accounting firm? If not, 
what period would be appropriate?
    [sbull] Is the term audit engagement team sufficiently clear? If 
not, what changes would improve the description to describe the group 
of accountants who would be covered?
    [sbull] Is the phrase commencement of the audit sufficiently clear? 
If not, what changes would improve the description? Is that the 
appropriate time to mark the commencement of the period? Is there a 
better mark?
    [sbull] Is the phrase commencement of review procedures 
sufficiently clear? If not, what changes would improve the description?
    [sbull] Is it appropriate that the cooling-off period provisions 
apply to employment relationships involving audit engagement team 
members and their audit clients? Should the requirements be limited to 
audit clients who are issuers as defined in section 205 of the Act?
    [sbull] Are the appropriate officers covered by the proposed rule? 
If not, which additional individuals should be subject to the cooling-
off period provision? For example, should national office personnel who 
would be excluded under the proposal be included?
    [sbull] Should the proposed rules apply equally to large firms/
companies as small firms/companies? Would the proposed rules impose a 
cost on smaller issuers that is disproportionate to the benefits that 
would be achieved? Why or why not? Should there be an exemption to this 
requirement for smaller businesses?
    [sbull] The ``cooling off'' period applies to all entities in the 
investment company complex. Is this too broad? Why or why not?
    [sbull] Should the Commission include exceptions subject to certain 
criteria? If so, what should these criteria be?


B. Services Outside the Scope of the Practice of Auditors


    Section 201(a) of the Sarbanes-Oxley Act adds new section 10A(g) to 
the Securities Exchange Act of 1934. This section states that it shall 
be unlawful for a registered public accounting firm that performs an 
audit of an issuer's financial statements (and any person associated 
with such a firm) to provide to that issuer, contemporaneously with the 
audit, any non-audit service, including nine services set forth in the 
Act. There is an exception, however, for ``any non-audit service, 
including tax services, that is not described'' as a prohibited service 
``only if'' the service has been pre-approved by the issuer's audit 
committee. The nine prohibited non-audit services included in the Act 
are:
    [sbull] Bookkeeping or other services related to the accounting 
records or financial statements of the audit client;


[[Page 76783]]


    [sbull] Financial information systems design and implementation;
    [sbull] Appraisal or valuation services, fairness opinions, or 
contribution-in-kind reports;
    [sbull] Actuarial services;
    [sbull] Internal audit outsourcing services;
    [sbull] Management functions or human resources;
    [sbull] Broker or dealer, investment adviser, or investment banking 
services;
    [sbull] Legal services and expert services unrelated to the audit; 
and
    [sbull] Any other service that the Board \22\ determines, by 
regulation, is impermissible.
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    \22\ As used in this section of the Act, the term Board refers 
to the Public Company Accounting Oversight Board.
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    Many of these services are already the subject of our rules. As 
explained more fully below, we interpret the legislative history as 
indicating (1) Congress did not intend the rules to contain broad 
categorical exceptions and (2) the scope of the prohibited services 
should be judged against three basic principles. Those three broad 
principles are that an auditor cannot (1) audit his or her own work, 
(2) perform management functions, or (3) act as an advocate for the 
client. To do so would impair the auditor's independence.
    Under section 201(b) of the Act, the Board,\23\ on a case-by-case 
basis, may exempt any issuer, accounting firm or transaction from the 
prohibition on the provision of services under section 10A(g) to the 
extent that the exemption is ``necessary or appropriate in the public 
interest and is consistent with the protection of investors, and 
subject to review by the Commission.''
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    \23\ Id.
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    The Senate Report on the bill that was the primary foundation for 
the Act,\24\ states, in part:
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    \24\ Report of the Senate Comm. on Banking, Housing, and Urban 
Affairs to Accompany S. 2673, Public Company Accounting Reform and 
Investor Protection Act of 2002, S. Report 107-205, 107th Cong., 2d 
Sess. (July 3, 2002).


    The intention of this provision is to draw a clear line around a 
limited list of non-audit services that accounting firms may not 
provide to public company audit clients because their doing so 
creates a fundamental conflict of interest for the accounting firms. 
The list is based on simple principles. An accounting firm, in order 
to be independent of its audit client, should not audit its own 
work, which would be involved in providing bookkeeping services, 
financial information systems design, appraisal or valuation 
services, actuarial services, and internal audit outsourcing 
services to an audit client. The accounting firm should not function 
as part of management or as an employee of the audit client, which 
would be required if the accounting firm provides human resources 
services such as recruiting, hiring, and designing compensation 
packages for the officers, directors, and managers of an audit 
client. The accounting firm should not act as an advocate of the 
audit client, which would be involved in providing legal and expert 
services to an audit client in legal, administrative, or regulatory 
proceedings, or serving as a broker-dealer, investment adviser, or 
investment banker to an audit client, which places the auditor in 
the role of promoting a client's stock or other interests.\25\
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    \25\ Id. at 18.


    In statements made on the floor of the Senate on July 25, 2002, the 
day the Senate passed the final bill, Senator Sarbanes discussed the 
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auditor independence provisions in the bill and stated, in part:


    What has happened in recent years is that the fees earned from 
the consulting work have dwarfed the fees earned from the auditors, 
which inevitably leads to concerns that punches be pulled on the 
audit to accommodate the significant and remunerative involvement on 
the consulting side. Certain enumerated consulting practices are 
therefore not allowed, with the exception that a case-by-case 
exemption can be obtained from the oversight board that this 
legislation establishes.* * *
    Senator Gramm has suggested that the conference report should be 
changed to give the SEC or the Oversight Board authority to grant 
broad categorical exemptions from the list of non-audit services 
that section 201 of the bill prohibits registered public accounting 
firms to provide to public company audit clients. Such a change, in 
my view, would weaken one of the fundamental objectives of the 
conference report: to draw a bright line around a limited list of 
non-audit services that accounting firms may not provide to public 
company audit clients because their doing so creates a fundamental 
conflict of interest for the accounting firms.
    This list is based on a set of simple principles:
    A public company auditor, in order to be independent, should not 
audit its own work (as it would if it provided internal audit 
outsourcing services, financial information systems design, 
appraisal or valuation services, actuarial services, or bookkeeping 
services to an audit client).
    A public company auditor should not function as part of 
management or as an employee of the audit client (as it would if it 
provided human resources services such as recruiting, hiring, and 
designing compensation packages for the officers, directors, and 
managers of an audit client).
    A public company auditor, to be independent, should not act as 
an advocate of its audit client (as it would if it provided legal 
and expert services to an audit client in judicial or regulatory 
proceedings).
    A public company auditor should not be a promoter of the 
company's stock or other financial interests (as it would be if it 
served as a broker-dealer, investment adviser, or investment banker 
for the company).
    The exemptive authority provided to the Board is intentionally 
narrow to apply to individual cases where the application of the 
statutory requirement would impose some extraordinary hardship or 
circumstance that would merit an exemption consistent with the 
protection of the public interest and the protection of investors. 
But the fundamental presumption of the provision is that these non-
audit services, by their very nature, present a conflict of interest 
for an accounting firm if provided to a public company audit 
client.* * *
    The conference report chose not to follow the approach of 
imposing a complete prohibition on the provision of non-audit 
services to audit clients. Instead it chose the approach of 
identifying the non-audit services which by their very nature pose a 
conflict of interest and should be prohibited.* * *
    In my view granting broad exemption authority to the Oversight 
Board or the SEC to permit these non-audit services would undermine 
the separation the conference report is intended to establish.\26\
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    \26\ 148 Cong. Rec. S7351 and S7364 (July 25, 2002).


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(Emphasis added.)


    The Commission last amended its auditor independence rules in 
November 2000. In so doing, the Commission identified many of the same 
services included in the Act that would impair an auditor's 
independence. In doing so, after public comment, the Commission 
included certain exceptions and qualifications to these services in 
those rules. As part of that rulemaking, the Commission utilized 
concepts similar to those expressed in the Senate Report in evaluating 
independence matters. Rule 2-01 of Regulation S-X \27\ contains a 
preliminary note that is comprised of concepts that are similar to 
those outlined in the legislative history to the Sarbanes-Oxley Act. 
The preliminary note is used to evaluate independence matters that 
arise but that are not specifically addressed in rule 2-01. The 
proposals that we are considering are based on the same factors that 
have been utilized by the staff in evaluating independence matters.
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    \27\ See Release No. 33-7870 (June 30, 2000), proposed rules 2-
01(b)(1)-(4), and preliminary note to rule 2-01 of Regulation S-X, 
17 CFR 210.2-01. As stated in the preliminary note, in making 
independence determinations ``the Commission looks in the first 
instance to whether a relationship or the provision of a service: 
(a) Creates a mutual or conflicting interest between the accountant 
and the audit client; (b) places the accountant in the position of 
auditing his or her own work; (c) results in the accountant acting 
as management or an employee of the audit client; or (d) places the 
accountant in the position of being an advocate for the audit 
client.''
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    The Commission had proposed more restrictive independence rules in 
June 2000.\28\ In the period between


[[Page 76784]]


publication of the proposed rules and the adoption of the final rules, 
the Commission conducted public hearings at which over 100 persons 
testified, a congressional hearing was held, and over 3,000 comment 
letters were received.
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    \28\ Release No. 33-7870 (June 30, 2000); 65 FR 43148 (July 12, 
2000).
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    It seems clear that Congress did not intend to codify unchanged the 
current auditor independence rules, as the Commission adopted them in 
November 2000. In Senator Sarbanes' statements, quoted above, he notes 
the debate with Senator Gramm about the use of ``categorical 
exemptions'' from the prohibitions in the Act and states that the Act 
was not intended to give the Commission ``broad exemption authority.'' 
We assume, therefore, that Congress intended the Commission to revise 
its existing rules, at a minimum, to eliminate categorical exceptions 
and exemptions.
    We note that the terms used by Congress could be construed very 
broadly. We nevertheless believe that Congress did not intend to ban 
any service that could conceivably fall within one of the prohibited 
categories of services. Both the language in the Act and the 
legislative history argue against such a broad construction. Each 
service as properly interpreted would be banned; however, proper 
interpretation must be made in light of the three basic principles. For 
example, the statute prohibits ``expert'' services. A broad 
interpretation of this prohibition could lead one to conclude that 
almost all services provided by a certified public accountant (CPA) 
could be considered to be ``expert'' services. For example, tax 
services would seem to be among the services that are provided by an 
``expert.'' However, it is clear that Congress did not wish to ban all 
expert services because the Act specifically provided for an auditor to 
be able to perform certain services, including tax services, if the 
audit committee approves them in advance.
    Both the Senate Report and Senator Sarbanes' statements on the 
Senate floor describe each service as fulfilling one of the enumerated 
``simple principles.'' In the Senate Report, these principles are that 
an accounting firm should not (1) audit its own work, (2) function as a 
part of management or as an employee of the audit client, or (3) act as 
an advocate of the audit client. In his July 25th floor statement, 
Senator Sarbanes added a fourth principle, the notion that an 
accounting firm should not be a promoter of the issuer's stock or other 
financial interests.\29\
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    \29\ These principles are similar to those that the Commission 
proposed in June 2000 as part of the auditor independence rules and 
subsequently adopted as a preliminary note to those rules. See 
Release No. 33-7870 (June 30, 2000), proposed rules 2-01(b)(1)-(4), 
and preliminary note to rule 2-01 of Regulation S-X, 17 CFR 210.2-
01. As stated in the preliminary note, in making independence 
determinations ``the Commission looks in the first instance to 
whether a relationship or the provision of a service: (a) Creates a 
mutual or conflicting interest between the accountant and the audit 
client; (b) places the accountant in the position of auditing his or 
her own work; (c) results in the accountant acting as management or 
an employee of the audit client; or (d) places the accountant in the 
position of being an advocate for the audit client.''
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    We therefore propose to amend the auditor independence rules to 
remove categorical exemptions and to define each term in the list of 
prohibitions in section 201(a) of the Act in relation to the ``simple 
principle'' that is at the foundation of that prohibition. In doing so, 
we intend to prohibit any service or scenario that reasonably could 
create one or more of the conflicts identified in the principles.
    The proposed rules, like our current independence requirements, 
govern non-audit services provided by an accountant to an audit client 
during the audit and professional engagement period.\30\ They do not 
govern non-audit services when provided to non-audit clients.
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    \30\ Audit client is a term defined generally in Sec.  2-
01(f)(6) of Regulation S-X, as the entity whose financial statements 
or other information is being audited and any affiliates of the 
audit client. Affiliates of the audit client, as defined in Sec.  2-
01(f)(4), are entities that have control relationships or other 
significant influence relationships with the audit client, which in 
the case of registered investment companies includes all entities in 
the investment company complex, as defined under Sec.  2-01(f)(14).
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    The proposed rule does not provide an all-inclusive list of the 
services that are incompatible with proposed rule 2-01(b). Whether the 
provision of a non-audit service not specified in the proposed rule 
impairs an accountant's independence will be measured against the four 
general principles set forth in the preliminary note to rule 2-01 and 
the ``simple principles'' in the legislative history noted above.
    [sbull] Are there other non-audit services that are incompatible 
with rule 2-01(b) or that raise independence concerns? If so, what are 
they, and why do they raise independence concerns?
    [sbull] Is the meaning of the general principles sufficiently 
clear?
1. Bookkeeping or Other Services Related to the Audit Client's 
Accounting Records or Financial Statements of the Audit Client
    Currently, an auditor's independence is impaired if the auditor 
provides bookkeeping services to an audit client except in limited 
situations, such as in an emergency or where the services are provided 
in a foreign jurisdiction and certain conditions are met.\31\ Proposed 
rule 2-01(c)(4)(i) continues the prohibition on bookkeeping, but we 
propose to eliminate the limited situations where bookkeeping services 
may be provided under the current rules. As noted earlier, the proposed 
rules are predicated on three basic principles. One of those principles 
is that an auditor cannot audit his or her own work and maintain his or 
her independence. When an auditor performs bookkeeping services for a 
client, he or she is placed in a situation of auditing his or her own 
work. Accordingly, we are proposing that all bookkeeping services would 
cause the auditor to lack independence.
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    \31\ 17 CFR 210.2-01(c)(4)(i).
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    The proposed rules utilize the existing definition of bookkeeping 
or other services, which focuses on the provision of services 
involving: (1) Maintaining or preparing the audit client's accounting 
records, (2) preparing financial statements that are filed with the 
Commission or the information which forms the basis of financial 
statements filed with the Commission, (3) preparing or originating 
source data underlying the audit client's financial statements.
    When an accounting firm provides bookkeeping services for an audit 
client, the firm may be put in the position of later auditing the 
accounting firm's work. If, during an audit, an auditor must audit the 
bookkeeping work performed by his or her accounting firm, it is 
questionable that the auditor could, or that a reasonable investor 
would believe that the auditor could, remain objective and impartial. 
If the auditor found an error in the bookkeeping, the auditor could 
well be under pressure not to raise the issue with the client if 
raising the issue could jeopardize the firm's contract with the client 
for bookkeeping services or result in heightened litigation risk for 
the firm. In addition, keeping the books is a management function, the 
performance of which leads to an inappropriate mutuality of interests 
between the auditor and the audit client.\32\
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    \32\ Letter of Samuel L. Burke, Associate Chief Accountant, SEC, 
to Florida Institute of Certified Public Accountants re: bookkeeping 
(March 4, 2002).
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    We understand that auditors are sometimes asked to prepare 
statutory financial statements for foreign companies, and these are not 
filed with us. Consistent with the Commission's existing rules, an 
accountant's independence would be impaired where


[[Page 76785]]


the accountant prepared the statutory financial statements if those 
statements form the basis of the financial statements that are filed 
with us. Under these circumstances, an auditor or accounting firm who 
has prepared the statutory financial statements of an audit client is 
put in the position of auditing its own work when auditing the 
resultant U.S. GAAP converted financial statements.
    [sbull] Should the definition of bookkeeping be further clarified? 
If so, how?
    [sbull] Does the definition cover all the bookkeeping services that 
would impair an accountant's independence?
    [sbull] Should an auditor be permitted to provide bookkeeping 
services to an audit client if it is not reasonably likely that the 
results of those services will be subject to audit procedures during 
the audit of the client's financial statements? Why or why not?
    [sbull] Is the standard of reasonably likely sufficiently clear? If 
not, should we use some other standard? If so, what standard should we 
use?
    [sbull] Is the phrase ``preparing statutory statements which form 
the basis of U.S. GAAP statements'' sufficiently clear? If not, how 
might the phrase be revised?
2. Financial Information Systems Design and Implementation
    Currently, paragraph (c)(4)(ii) identifies certain information 
technology services that, if provided to an audit client, impair the 
accountant's independence. The proposed rules identify the information 
technology services that would impair the auditor's independence. Under 
paragraph (c)(4)(ii)(A) of the proposed rule, an accountant is not 
independent 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. 
Further, paragraph (c)(4)(ii)(B) of the proposed rule provides that an 
accountant is not deemed independent if the accountant 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 taken as a 
whole. These services impair an accountant's independence under 
existing Commission rules.\33\ However, consistent with the 
Commission's existing rules, the proposed rules do not preclude an 
audit firm from working on hardware or software systems that are 
unrelated to the audit client's financial statements or accounting 
records as long as those services are pre-approved by the audit 
committee.
---------------------------------------------------------------------------


    \33\ 17 CFR 210.2-01(c)(4)(ii).
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    By ``significant'' to the financial statements taken as a whole, we 
refer to information that is reasonably likely to be material to the 
financial statements of the audit client. Since materiality 
determinations may not be complete before financial statements are 
generated, the audit client and accounting firm by necessity will need 
to evaluate the general nature of the information rather than only 
system output during the period of the audit engagement. An accountant, 
for example, would not be independent of an audit client for which it 
designed an integrated Enterprise Resource Planning (``ERP'') system.
    Operating, designing or implementing systems affecting the 
financial statements may place the auditor in a management role, or 
result in the accountant auditing his or her own work or attesting to 
the effectiveness of internal control systems designed or implemented 
by that accountant.\34\ For example, if an auditor designs and installs 
a computer system that generates the financial records, and that system 
generates incorrect data, the accountant is placed in a position of 
having to report on his or her firms' own work. Investors may perceive 
that the accountant would be unwilling to challenge the integrity and 
efficacy of the client's financial or accounting information collection 
systems that the accountant designed or installed.
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    \34\ See Section 404(b) of the Sarbanes-Oxley Act.
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    [sbull] Is an auditor's independence impaired when the auditor 
helps select or test computer software and hardware systems that 
generate financial data used in or underlying the financial statements? 
Why or why not?
    [sbull] Whether a system is used to generate information that is 
``significant'' to the audit client's financial statements may depend 
on the size of the engagement. Does the magnitude as a percentage of 
either audit fees or total fees of the fees for such services make a 
difference on whether performance of the service impairs independence?
3. Appraisal or Valuation Services, Fairness Opinions, or Contribution-
in-Kind Reports
    Under the Commission's current independence rules, an accountant is 
deemed to lack independence when providing appraisal or valuations 
services, fairness opinions, or contribution-in-kind reports for audit 
clients. However, the current rules contain certain exemptions that we 
propose to eliminate.\35\ These proposals would provide that the 
auditor is not independent if the auditor provides appraisal or 
valuation services, or contribution-in-kind reports,\36\ where there is 
a reasonable likelihood that the results of the service will be subject 
to audit procedures by the auditor because the auditor is in a position 
of auditing his or her own work. Additionally, an auditor is not 
independent under the proposal if he or she provides a fairness opinion 
because to do so requires the auditor to function as a part of 
management and may require the auditor to audit the results of his or 
her own work.
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    \35\ Current exemptions include: (1) Firm's valuation expert can 
review the work of a client's specialist; (2) firm's actuaries can 
value a client's pension or other post-retirement benefit obligation 
provided that the client assumes responsibility for significant 
assumptions; (3) valuations performed for planning and implementing 
tax-planning strategies; and (4) valuations for non-financial 
purposes which do not affect the financial statements.
    \36\ Contribution-in-kind reports in certain foreign countries 
require the auditor to express an opinion on the fairness of the 
transaction, the value of a security, or the adequacy of 
consideration to shareholders.
---------------------------------------------------------------------------


    Appraisal and valuation services include any process of valuing 
assets, both tangible and intangible, or liabilities. They include 
valuing, among other things, in-process research and development, 
financial instruments, assets and liabilities acquired in a merger, and 
real estate. Fairness opinions and contribution-in-kind reports are 
opinions and reports in which the firm provides its opinion on the 
adequacy of consideration in a transaction.
    Providing these services to audit clients raises several auditor 
independence concerns. When it is time to audit the financial 
statements, the accountant could likely end up reviewing his or her own 
work, including key assumptions or variables that underlie an entry in 
the financial statements. Also, where the appraisal methodology 
involves projection of future results of operations and cash flows, 
some believe that the accountant that prepares the projection could 
have a mutuality of interest with the client in attaining forecast 
results.\37\ The auditor may feel constrained by the valuation and 
appraisal issued by the firm, and as a result, the auditor may be 
unable to evaluate skeptically and without bias


[[Page 76786]]


the accuracy of that valuation or appraisal.
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    \37\ As discussed in the preliminary note to rule 2-01, the 
Commission considers the impact on the auditor's independence of 
situations where the auditor has a mutuality of interest with its 
auditor client. This concept was not included in the legislation.
---------------------------------------------------------------------------


    Our proposals do not prohibit an accounting firm from providing 
such services for non-financial reporting (e.g., transfer pricing 
studies, cost segregation studies) purposes.
    The proposed rule does not limit an accounting firm from utilizing 
its own valuation specialist to review the work done by the audit 
client itself or an independent, third-party specialist employed by the 
audit client, provided the audit client or the client's specialist (and 
not the specialist used by the accounting firm) provides the technical 
expertise that the client uses in determining the required amounts 
recorded in the client financial statements. In those instances, 
because a third party or the audit client is the source of the 
financial information subject to the review or audit, the accountant 
will not be reviewing or auditing his or her own work. Additionally, 
the quality of the audit may be improved where specialists are utilized 
in such situations.
    [sbull] Does providing valuation or appraisal services that are 
unrelated to the financial statements, such as for certain regulatory 
purposes, impair an accountant's independence?
    [sbull] Does providing valuation or appraisal services for tax 
purposes impair an accountant's independence?
    [sbull] Are there certain types of appraisal or valuation services, 
or certain instances in which they are provided, that do not raise 
auditor independence concerns? Are there circumstances in which an 
accounting firm may be required by law or regulation to provide such 
services, either in the United States or abroad?
    [sbull] Should we provide an exemption for such services provided 
to a foreign private issuer by its accountant where local law requires 
such services (e.g. contribution in-kind reports)?
    [sbull] The Commission staff, when providing interpretations of the 
application of the auditor independence rules to contribution in-kind 
reports, has worked with foreign jurisdictions to accommodate the 
statutory requirements in those jurisdictions.\38\ Should the 
Commission's rules provide that similar practices or arrangements be 
permitted where contribution in-kind reports are required by foreign 
statute?
---------------------------------------------------------------------------


    \38\ Letter of Lynn Turner, Chief Accountant, SEC, to 
Commissione Nazionale per la Societa Sonieta e la Borsa re: 
statutory procedures (August 24, 2000).
---------------------------------------------------------------------------


4. Actuarial Services
    The current rules generally bar auditors only from providing 
actuarial services related to insurance company policy reserves and 
related accounts. Consistent with our approach to implementing the Act, 
we are proposing to broaden this prohibition by providing that the 
accountant is not independent if the auditor provides any advisory 
service involving the amounts recorded in the financial statements and 
related accounts for the audit client where it is reasonably likely 
that the results of these services will be subject to audit procedures 
during an audit of the audit client's financial statements because 
providing these services may cause an accountant later to audit his or 
her own work. Additionally, accountants providing these services assume 
a key management task. Stated differently, to perform these services 
would violate two of the three basic principles espoused in the 
legislative history of the Act. In addition, actuarially oriented 
advisory services may affect amounts reflected in some company's 
financial statements, such as an insurance company's financial 
statements. The proposed rules provide that the accountant may utilize 
his or her own actuaries to assist in conducting the audit provided the 
audit client uses its own actuaries or third-party actuaries to provide 
management with the primary actuarial capabilities.
    [sbull] Are there certain circumstances under which an accountant 
can provide actuarial services to an audit client without impairing 
independence?
    [sbull] Have we appropriately described the actuarial services 
prohibited by the Act?
5. Internal Audit Outsourcing
    Our current rules allow a company to outsource part of its internal 
audit function to the independent audit firm subject to certain 
exemptions. For example, smaller businesses are exempted from the 
internal audit outsourcing prohibition because there have been concerns 
about the potentially disproportionate impact on such companies. The 
line between performing management functions and performing an audit is 
not always clear. Some companies ``outsource'' internal audit functions 
by contracting with an outside source to perform, among other things, 
all or part of their audits of internal controls. As emphasized by the 
Committee of Sponsoring Organizations (``COSO''), internal auditors 
play an important role in evaluating and monitoring a company's 
internal control system.\39\ As a result, some argue that internal 
auditors are, in effect, part of a company's system of internal 
accounting control.\40\
---------------------------------------------------------------------------


    \39\ See Committee of Sponsoring Organizations of the Treadway 
Commission (COSO), Internal Control--Integrated Framework, at 7 
(1992) (the ``COSO Report'').
    \40\ See SAS No. 65, ``The Auditor's Consideration of the 
Internal Audit Function in an Audit of Financial Statements,'' 
AUSec.  322.
---------------------------------------------------------------------------


    Since the external auditor generally will rely, at least to some 
extent, on the internal control system when conducting the audit of the 
financial statements,\41\ the auditor may be relying on his or her 
firm's own work, which was performed as part of the internal controls 
and internal audit function. In essence, by outsourcing the internal 
audit function, the auditor assumes a management responsibility and 
becomes part of the company's control system.
---------------------------------------------------------------------------


    \41\ AICPA SAS No. 55, AU Sec.  319 (effective for audits on or 
after January 1, 1990).
---------------------------------------------------------------------------


    Proposed rule 2-01(c)(4)(v) provides that an auditor is not 
independent when the auditor performs internal audit services related 
to the internal accounting controls, financial systems, or financial 
statements, for an audit client. This does not include nonrecurring 
evaluations of discrete items or programs that are not in substance the 
outsourcing of the internal audit function. It also does not include 
operational internal audits unrelated to the internal accounting 
controls, financial systems, or financial statements.
    We are concerned about the effect of the proposed rule on small 
businesses that have no internal audit department or staff. Smaller 
firms may not have sufficient need for full-time internal auditors but 
nonetheless, may need some services that internal auditors typically 
provide, which they obtain from their external auditors. We understand 
that, unless these companies can turn to their external auditors, the 
work may not be done at all or only at a significant cost to the 
company because the company would have to engage a separate accounting 
firm to provide these services.\42\ Existing Commission independence 
rules contain an exception for small businesses identified as those 
with assets totaling less than $200 million.\43\ However, our proposed 
rules contain no such exception because, regardless of the entity's 
size, the Act appears to view the auditor as being in a position of 
auditing his or her own work.
---------------------------------------------------------------------------


    \42\ See Release No. 33-7919.
    \43\ 17 CFR 2-01(c)(4)(v) currently includes a $200 million 
threshold.
---------------------------------------------------------------------------


    [sbull] Is the definition of the ``internal audit function'' 
sufficiently clear?
    [sbull] We solicit comment on whether an exception should be 
provided for small


[[Page 76787]]


businesses. If so, what criteria should we consider in providing such 
an exception?
    [sbull] Does it impair an auditor's independence if the auditor 
does not provide to the client outsourcing services related to the 
internal audit function of the audit client, but rather performs 
individual audit projects for the client?
    [sbull] Are there safeguards that can be established by the auditor 
that would allow the audit client to outsource the internal audit 
function to the auditor without impairing its independence?
    [sbull] Would it impair the auditor's independence if the auditor 
performs only operational audits that are unrelated to the internal 
controls, financial systems, or financial statements?
    [sbull] Is additional guidance necessary to distinguish the 
services that would be prohibited under this proposed rule from those 
services that would be permitted as operational audits?
6. Management Functions
    We are not proposing any significant change to our current rule on 
management functions. Proposed rule 2-01(c)(4)(vi) provides that an 
accountant's independence is impaired with respect to an audit client 
for which the accountant acts, temporarily or permanently, as a 
director, officer, or employee of an audit client, or performs any 
decision-making, supervisory, or ongoing monitoring functions for the 
audit client. This provision is consistent with the provisions of 
existing rule 2-01(c)(4)(vi).\44\
---------------------------------------------------------------------------


    \44\ 17 CFR 210.2-01(c)(4)(vi).
---------------------------------------------------------------------------


    We believe, however, that provided the auditor does not act as an 
employee or perform management functions, services in connection with 
the assessment of internal accounting and risk management controls as 
well as providing recommendations for improvements do not impair an 
auditor's independence. Accountants must gain an understanding of their 
audit clients' systems of internal accounting controls when conducting 
an audit in accordance with generally accepted auditing standards.\45\ 
With this insight, auditors often become involved in diagnosing, 
assessing, and recommending to audit committees and management, ways in 
which their audit client's internal controls can be improved or 
strengthened.\46\ These services can be extremely valuable to 
companies, and they may also facilitate the performance of a high 
quality audit. For these reasons, we are proposing to continue to allow 
auditors to assess the effectiveness of internal controls and to 
recommend improvements in the design and implementation of internal 
controls and risk management controls.
---------------------------------------------------------------------------


    \45\ AU 319, ``Consideration of Internal Control in a Financial 
Statement Audit.'' In addition, section 404(b) of the Act requires a 
company's audit to attest to the internal control report provided 
annually by management.
    \46\ AU 325, ``Communication of Internal Control Related Matters 
Noted in an Audit,'' requires the auditor to communicate reportable 
conditions and material weaknesses in internal control to the 
company's audit committee or equivalent.
---------------------------------------------------------------------------


    At the same time, we recognize that when an auditor designs and 
implements its audit client's internal accounting and risk management 
control systems, some believe that the auditor will lack objectivity if 
called upon to audit financial statements that are derived, at least in 
part, from data from those systems or when reporting on those controls 
or on management's assessment of those controls. As such, we believe 
that design and implementation of internal accounting and risk 
management controls are fundamentally different from obtaining an 
understanding of the controls and testing the operation of the controls 
which is an integral part of any audit of the financial statements of a 
company. Likewise, design and implementation of these controls is 
different from recommending improvements in the internal accounting and 
risk management controls of an audit client.
    Because of this fundamental difference, we believe that designing 
and implementing internal accounting and risk management controls 
impairs the auditor's independence because it places the auditor in the 
role of management. Conversely, obtaining an understanding of, 
assessing effectiveness of, and recommending improvements to the 
internal accounting and risk management controls is fundamental to the 
audit process and does not impair the auditor's independence.
    [sbull] Do services related to designing or implementing internal 
accounting controls and risk management controls result in the auditor 
auditing his or her own work? Would such services impair an auditor's 
independence when the auditor is required to issue an opinion on the 
effectiveness of the control systems that he or she designed or 
implemented?
    [sbull] Do services related to assessing or recommending 
improvements to internal accounting controls and risk management 
controls result in the auditor auditing his or her own work? Would such 
services impair an auditor's independence when the auditor is required 
to issue an attestation report on the effectiveness of the control 
systems that he or she has assessed or evaluated for effectiveness?
    [sbull] We request comment on whether there are circumstances under 
which an accounting firm can perform or assume management functions or 
responsibilities for an audit client without impairing independence?
7. Human Resources
    Our current rules deem an auditor to lack independence when 
performing certain human resources functions, and we do not propose any 
significant change to those rules. Consistent with our current rules, 
proposed rule 2-01(c)(4)(vii) provides that an auditor's independence 
is impaired with respect to an audit client when the auditor searches 
for or seeks out prospective candidates for managerial, executive or 
director positions; acts as negotiator on the audit client's behalf, 
such as determining position, status, compensation, fringe benefits, or 
other conditions of employment; or undertakes reference checks of 
prospective candidates. Under the proposed rule, an auditor's 
independence also is impaired when the auditor advises an audit client 
about the design of its management or organizational structure, when it 
engages in psychological testing, or other formal testing or evaluation 
programs, or recommends or advises the audit client to hire a specific 
candidate for a specific job.
    Assisting management in human resource selection or development 
places the auditor in the position of having an interest in the success 
of the employees that the auditor has selected, tested, or evaluated. 
Accordingly, observers may perceive that an auditor would be reluctant 
to suggest the possibility that those employees failed to perform their 
jobs appropriately, or at least reasonable investors might perceive the 
auditor to be reluctant, because doing so would require the auditor to 
acknowledge shortcomings in its human resource service. The auditor 
also would have other incentives not to report such employees' 
ineffectiveness, including that the auditor would identify and be 
identified with the recruited employees.
    [sbull] Are there additional types of human resource and employee 
benefit services that impair an auditor's independence?
    [sbull] Would an auditor's independence be impaired if the auditor 
provided personnel hiring assistance for only non-executive or non-
financial personnel?


[[Page 76788]]


    [sbull] Does it impair an auditor's independence if the auditor 
provides consultation with respect to the compensation arrangements of 
the company's executives?
8. Broker-Dealer, Investment Adviser Or Investment Banking Services
    Our current rules deem an auditor to lack independence when 
performing brokerage or investment advising services for an audit 
client.\47\ We are proposing to add serving as an unregistered broker-
dealer \48\ to our rules that prohibit serving as a promoter or 
underwriter, making investment decisions on behalf of the audit client 
or otherwise having discretionary authority over an audit client's 
investments, or executing a transaction to buy or sell an audit 
client's investment, or having custody of assets of the audit client. 
The proposed rule is substantially the same as the Commission's 
existing rule related to the provision of these types of services to 
audit clients.\49\ We are including unregistered broker-dealers within 
the proposed rules because the nature of the threat to independence is 
unchanged whether the entity is or is not a registered broker-dealer.
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    \47\ These proposed rules are not meant to change the 
Commission's current position that an audit firm's broker-dealer 
division can cover an industry which includes an audit client when 
performing analyst functions. However, analysis of a specific audit 
client's stock places the auditor in the position of acting as an 
advocate for the client and would cause the auditor to lack 
independence.
    \48\ Accountants and the companies that retain them should 
recognize that the key determination required here is a functional 
one (i.e., is the accounting firm or its employee acting as a 
broker-dealer?). The failure to register as a broker-dealer does not 
necessarily mean that the accounting firm is not a broker-dealer. In 
relevant part, the statutory definition of ``broker'' captures 
persons ``engaged in the business of effecting transactions in 
securities for the account of others.'' Securities Exchange Act of 
1934 Sec.  3(a)(4). Unregistered persons who provide services 
related to mergers and acquisitions or other securities-related 
transactions should limit their activities so they remain outside of 
that statutory definition. A person may ``effect transactions,'' 
among other ways, by assisting an issuer to structure prospective 
securities transactions, by helping an issuer to identify potential 
purchasers of securities, or by soliciting securities transactions. 
A person may be ``engaged in the business,'' among other ways, by 
receiving transaction-related compensation or by holding itself out 
as a broker-dealer. Involvement of accounting personnel as 
unregistered broker-dealers not only can impair auditor 
independence, but also would violate section 15(a) of the Exchange 
Act.
    \49\ 17 CFR 210.2-01(c)(4)(viii) and Release No. 33-7919, at 
Section D.
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    Selling--directly or indirectly--an audit client's securities is 
incompatible with the auditor's responsibility of assuring the public 
that the company's financial condition is fairly and accurately 
presented. When an accountant, in any capacity, recommends to anyone 
(including non-audit clients) that they buy or sell the securities of 
an audit client or an affiliate of the audit client, the accountant has 
an interest in whether those recommendations were correct. That 
interest could affect the audit of the client whose securities, or 
whose affiliate's securities, were recommended. These concepts are 
echoed in the ``simple principles'' included in the legislative history 
to the Sarbanes-Oxley Act.\50\ For example, if an auditor uncovers an 
accounting error in a client's financialstatements, and the auditor, in 
an investment adviser capacity, had recommended that client's 
securities to investment clients, the auditor performing the audit may 
be reluctant to recommend changes to the client's financial statements 
if the changes could negatively affect the value of the securities 
recommended by the auditor to its investment adviser clients.
---------------------------------------------------------------------------


    \50\ Floor Statement of Senator Sarbanes, 148 Cong. Rec. S7364 
(July 25, 2002) ``. * * * A public company auditor should not be a 
promoter of the company's stock or other financial interest (as it 
would be if it served as broker-dealer, investment adviser, or 
investment banker for the company).''
---------------------------------------------------------------------------


    Broker-dealers \51\ often give advice and recommendations on 
investments and investment strategies. The value of that advice is 
measured principally by the performance of a customer's securities 
portfolio. When the customer is an audit client, the accountant has an 
interest in the value of the audit client's securities portfolio, even 
as the accountant values the portfolio as part of an audit. Thus, the 
auditor would be placed in a position of auditing his or her own work. 
Furthermore, the auditor is placed in a position of acting as an 
advocate on behalf of the client.
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    \51\ In the past, some have expressed concern that terms such as 
``securities professional'' and ``analyst'' are not defined in the 
securities laws and use of the terms could cause confusion. Because 
of that concern, we have not used those terms in these proposed 
rules. We note, however, that broker-dealers provide an array of 
services that may include certain analyst activities.
---------------------------------------------------------------------------


    [sbull] We solicit comment on the scope of the proposal. Are there 
other securities professional services that the rule should expressly 
identify as impairing independence?
    [sbull] Would an auditor's independence be impaired if the auditor 
acted as a securities analyst covering the sector or industry of an 
audit client?
    [sbull] Should we adopt rules that would clarify when the auditor 
is acting as an unregistered broker-dealer? If so, what should those 
rules be?
9. Legal Services
    Our current rule states that an auditor is deemed to lack 
independence when he or she provides legal services to an audit client. 
The proposed rule provides that an accountant is not independent of an 
audit client if the accountant provides any service to the 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. The 
proposed rules would apply to foreign and U.S. accounting firms 
equally, minimizing the instances where legal services are provided by 
the auditor to the audit client.
    A lawyer's core professional obligation is to advance clients' 
interests. Rules of professional conduct require the lawyer to 
``represent a client zealously and diligently within the bounds of the 
law.''\52\ The lawyer must ``take whatever lawful and ethical measures 
are required to vindicate a client's cause or endeavor. * * * In the 
exercise of professional judgment, a lawyer should always act in a 
manner consistent with the best interests of the client.''\53\ Unlike 
an auditor, a lawyer takes basic direction from the client. We have 
long maintained that an individual cannot be both a zealous legal 
advocate for management or the client company, and maintain the 
objectivity and impartiality that are necessary for an audit.\54\ The 
Supreme Court has agreed with our view. In Arthur Young, the Supreme 
Court emphasized, ``If investors were to view the auditor as an 
advocate for the corporate client, the value of the audit function 
itself might well be lost.''\55\
---------------------------------------------------------------------------


    \52\ See, e.g., D.C. Rules of Professional Conduct, rule 1.3(a).
    \53\ Id. at rule 1.5.
    \54\ In the Matter of Charles Falk, AAER No. 1134 (May 19, 1999) 
(formally disciplining an attorney/accountant who gave legal advice 
to an audit client of another partner in his accounting firm).
    \55\ United States v. Arthur Young, 465 U.S 805 (1984) at 819-20 
n.15.
---------------------------------------------------------------------------


    We recognize that there may be implications for some foreign 
registrants from this proposal. For example, we understand that in some 
jurisdictions it is mandatory that someone licensed to practice law 
perform tax work, and that an accounting firm providing such services, 
therefore, would be deemed to be providing legal services. Accordingly, 
we are interested in understanding the implications of this proposal on 
foreign private issuers.
    [sbull] Are there any particular legal services that should be 
exempted from the rule?
    [sbull] Would making the rule's application depend upon the 
jurisdiction in which the service is provided leave the rule subject to 
any


[[Page 76789]]


significant uncertainty, or pose the prospect of any significant 
complexity or unfairness?
    [sbull] Should there be any exception for legal services provided 
in foreign jurisdictions? For example, in some countries only a law 
firm may provide tax services. Should a foreign accounting firm be 
permitted to provide, through an affiliated law firm, tax or other 
services that a U.S. accounting firm could provide to a U.S. audit 
client without impairing the firm's independence? Why or why not?
    [sbull] Should there be an exception for legal services provided to 
issuers in foreign jurisdictions? Should any such exception be tailored 
to avoid undermining the purpose of the restriction? For example, could 
fees for legal services be limited to a small percentage (e.g., 5% or 
10%) of the amount of fees for audit services? Could partners providing 
audit services be prohibited from being involved in the provision of 
legal services or from receiving compensation based on such services?
    [sbull] Should any such exception have a ``sunset'' provision that 
would both allow foreign private issuers a transition period and allow 
the Commission to review the situation regarding legal services?
10. Expert Services
    Our current rules do not provide that an auditor is deemed to lack 
independence when providing expert services to an audit client. The 
Act, however, includes expert services in the list of prohibited 
services. As discussed earlier, the legislative history, particularly 
related to expert services, is focused on the auditor's role when 
serving in an advocacy capacity. Our proposed rules interpret the 
legislative prohibition in light of the three basic principles of 
independence discussed previously.
    During the Senate Floor debate, Senator Sarbanes stated, ``A public 
company auditor, to be independent, should not act as an advocate of 
its audit client (as it would if it provided legal and expert services 
to an audit client in judicial or regulatory proceedings).'' \56\ The 
proposed rule, therefore, states that an accountant's independence is 
impaired as to an audit client if the accountant provides expert 
opinions for an audit client in connection with legal, administrative, 
or regulatory proceedings or acts as an advocate for an audit client in 
such proceedings.
---------------------------------------------------------------------------


    \56\ See Floor Statement of Senator Sarbanes, 148 Cong. Rec. 
S7364 (July 25, 2002).
---------------------------------------------------------------------------


    Clients retain experts to lend authority to their contentions in 
various proceedings by virtue of the expert's specialized knowledge and 
experience. The provision of expert services by the accountant may 
create the appearance that the accountant is acting as the client's 
advocate in pursuit of the client's interests. The appearance of 
advocacy (and the corresponding appearance of mutual interest) created 
by providing expert services is sufficient to deem the accountant's 
independence impaired.
    Our prohibition on the provision of expert services would include 
providing consultation and other services to an audit client's legal 
counsel in connection with litigation, administrative or regulatory 
proceedings. As discussed above in the context of the provision of 
legal services, legal counsel have an ethical duty to ``represent a 
client zealously and diligently within the bounds of the law'' and to 
``take whatever lawful and ethical measures are required to vindicate a 
client's cause or endeavor.'' \57\ An auditor who takes on such duties, 
either directly or by being engaged by the audit client's legal 
counsel, takes on a role as an advocate for the client.
---------------------------------------------------------------------------


    \57\ See, e.g., D.C. Rules of Professional Conduct, rule 1.3(a) 
and 1.5.
---------------------------------------------------------------------------


    The prohibition on providing ``expert'' services included in this 
rule proposal covers services that result in the accounting firm's 
specialized knowledge, experience and expertise being used to support 
the contentions of the audit client in various adversarial proceedings. 
Therefore, under our proposed rule, an auditor's independence would be 
impaired if the auditor were engaged by the audit client's legal 
counsel to provide expert witness or other services, including 
accounting advice, opinions, or forensic accounting services, in 
connection with the client's participation in a legal, administrative, 
or regulatory proceeding. For example, an auditor could not provide 
forensic accounting services to the audit client's legal representative 
in connection with an investigation by the Commission's Division of 
Enforcement. Nor could an accounting firm appear as an expert witness 
in a utility rate setting proceeding in support of an audit client's 
request for an increase in fees.
    Our proposals, however, would not prohibit an auditor from 
assisting the audit committee in fulfilling its responsibilities in 
connection with the financial reporting process.\58\ Although under our 
proposals, an auditor's independence would be impaired if it were 
engaged by the audit client's counsel to provide advice or forensic 
accounting services in connection with a legal, administrative or 
regulatory proceeding,\59\ the auditor's independence would not be 
impaired if it were assisting the audit committee in fulfilling its 
responsibility to conduct its own investigation of a potential 
accounting impropriety, so long as the auditor did not take on the role 
of an advocate in such an investigation.\60\ For example, an audit 
committee may engage the auditor to render forensic services, and 
should the audit committee choose to engage counsel, the work product 
of the auditor may be provided to the audit committee's counsel without 
impairing the auditor's independence. We believe it is important that 
auditors be allowed to assist the audit committee in their capacity as 
investors' representatives.
---------------------------------------------------------------------------


    \58\ For example, section 301 of the Act stipulates that each 
audit committee shall have the authority to engage independent 
counsel and other advisers, as it determines necessary to carry out 
its duties.
    \59\ In October 2001, we set forth some of the criteria that we 
considered important to assessing whether to credit self-policing, 
self-reporting, remediation and cooperation in SEC enforcement 
investigations. One of the criteria we identified related to whether 
the company had undertaken a thorough review of the conduct at 
issue:
     10. Did the company commit to learn the truth, fully and 
expeditiously? Did it do a thorough review of the nature, extent, 
origins and consequences of the conduct and related behavior? Did 
management, the Board or committees consisting solely of outside 
directors oversee the review? Did company employees or outside 
persons perform the review? If outside persons, had they done other 
work for the company? Where the review was conducted by outside 
counsel, had management previously engaged such counsel? Were scope 
limitations placed on the review? If so, what were they?
    Report of Investigation Pursuant to Section 21(a) of the 
Securities Exchange Act of 1934 and Commission Statement on the 
Relationship of Cooperation to Agency Enforcement Decisions, 
Accounting and Auditing Enforcement Release (``AAER'') No. 1470 
(Oct. 23, 2001).
    Depending on the conduct at issue, it may be necessary for a 
company to engage an accountant to conduct a forensic accounting 
review or audit. While our proposal does not set forth independence 
requirements for forensic consultants, consistent with the 
principles we set forth in October 2001, we will consider the 
objectivity of the forensic accountant as to the issues being 
investigated in assessing whether to credit the forensic work.
    \60\ An auditor's independence would, however, be impaired if 
its assistance to the audit committee included defending, or helping 
to defend, the audit committee or the company generally in a 
shareholder class action or derivative lawsuit, other than as a fact 
witness.
---------------------------------------------------------------------------


    In this regard, our proposals also would not prohibit an auditor 
from testifying as a fact witness to its audit work for a particular 
audit client. In those instances, the auditor is merely


[[Page 76790]]


providing a factual account of what he or she observed and the 
judgments he or she made. An accounting firm that, after receiving 
appropriate authorization from an audit client's audit committee, had 
prepared an audit client's tax returns, also could appear as a fact 
witness in tax court to explain how the returns were prepared.
    [sbull] Are there circumstances in which providing audit clients 
with expert services in legal, administrative, or regulatory filings or 
proceedings should not be deemed to impair independence?
    [sbull] Should an auditor be permitted to serve as a non-testifying 
expert for an audit client in connection with a proceeding?
    [sbull] Is the definition of prohibited expert services 
appropriate? Why or why not?
    [sbull] Is the distinction between advocacy and providing 
appropriate assistance to an audit committee sufficiently clear?
11. Tax Services
    Section 201 of the Sarbanes-Oxley Act identifies specific 
categories of non-audit services that are prohibited for accounting 
firms to provide for their audit clients. Additionally, the Act 
specifies that the audit committee must pre-approve all non-prohibited 
non-audit services. In particular, the Act states that:


    A registered public accounting firm may engage in any non-audit 
service, including tax services, that is not described in any of 
paragraphs (1) through (9) of subsection (g) for an audit client, 
only if the activity is approved in advance by the audit committee 
of the issuer.\61\ (Emphasis added.)
---------------------------------------------------------------------------


    \61\ Sarbanes-Oxley Act of 2002, section 201.


    Nothing in these proposed rules is intended to prohibit an 
accounting firm from providing tax services to its audit clients when 
those services have been pre-approved by the client's audit committee. 
As discussed in our previously proposed rules \62\ on independence, tax 
services are unique, not only because there are detailed tax laws that 
must be consistently applied, but also because the Internal Revenue 
Service has discretion to audit any tax return.\63\ In addition, the 
Congressional intent behind the above quoted reference to ``tax 
services'' would appear to be that auditor independence is not impaired 
by an accountant providing traditional tax preparation services to an 
audit client or an affiliate of an audit client.
---------------------------------------------------------------------------


    \62\ Release Nos. 33-7870, ``Revision of the Commission's 
Auditor Independence Requirements,'' (June 30, 2000) (65 FR 43148).
    \63\ Id.
---------------------------------------------------------------------------


    While we do not define ``tax services,'' we understand that tax 
services can include a range of activities including the preparation of 
tax returns, tax compliance, tax planning, tax recovery, and other tax-
related services. In addition, many engagements will require that an 
auditor review the tax accrual that is included in the financial 
statements. Reviewing tax accruals is part of audit services and is 
not, in and of itself, deemed to be a tax compliance service.
    Classifying a service as a ``tax service'' however, does not mean 
that the service may not be within one of the categories of prohibited 
services or may not result in an impairment of independence under rule 
2-01(b). The accounting firm and the registrant's audit committee 
should consider, for example, whether the proposed non-audit service is 
an allowable tax service or constitutes a prohibited legal service or 
expert service. As part of this process, the accounting firm and the 
audit committee should be mindful of the three basic principles which 
cause an auditor to lack independence with respect to an audit client: 
(1) The auditor cannot audit his or her own work, (2) the auditor 
cannot function as a part of management, and (3) the auditor cannot 
serve in an advocacy role for the client.\64\ For example, where an 
accountant provides representation before a tax court the accountant 
serves as an advocate for his or her client and the accountant's 
independence would be impaired. Another example would be the 
formulation of tax strategies (e.g. tax shelters) designed to minimize 
a company's tax obligations.\65\ The provision of these types of 
services may require the accountant to audit his or her own work, to 
become an advocate for the client's position on novel tax issues, or to 
assume a management function.
---------------------------------------------------------------------------


    \64\ These principles are similar to the four governing 
principles included in the preliminary note to the Commission's 
current independence rules. The four governing principles are 
whether the accountant: (1) Has a mutual or conflicting interest 
with the audit client, (2) audits his or her firm's own work, (3) 
functions as management or an employee of the audit client, or (4) 
acts as an advocate for the audit client.
    \65\ U.S. v KPMG LLP (July 9, 2002) and U.S. v BDO Seidman (July 
9, 2002).
---------------------------------------------------------------------------


    We also are considering whether special considerations apply when 
the auditor provides a tax opinion for the use of a third party in 
connection with a business transaction between the audit client and the 
third party. The tax opinion may be vital in the audit client's efforts 
to induce the third party to enter into the transaction, particularly 
when the transaction is tax-driven. Under those circumstances, the 
auditor may be acting as an advocate for the audit client by actively 
promoting the client's interests.
    [sbull] We request comment on whether providing tax opinions, 
including tax opinions for tax shelters, to an audit client or an 
affiliate of an audit client under the circumstances described above 
would impair, or would appear to reasonable investors to impair, an 
auditor's independence.
    [sbull] Are there tax services that should be prohibited by the 
Commission's independence rules?
    [sbull] Is it meaningful to categorize tax services into permitted 
and disallowed activities? If so, what categories and related 
definitions would make the demarcation meaningful?


C. Partner Rotation


    Section 301 of the Sarbanes-Oxley Act specifies that the audit 
committee has the responsibility for appointment, compensation, and 
oversight of the work of the company's audit firm. In that capacity, 
the audit committee has the responsibility for evaluating and 
determining that the audit engagement team has the competence necessary 
to conduct the audit engagement in accordance with GAAS.
    The Sarbanes-Oxley Act also requires rotation of certain audit 
partners on a five-year basis in order to continue to provide audit 
services for a registrant. Section 203 of the Sarbanes-Oxley Act of 
2002 specifies that:


    It shall be unlawful for a registered public accounting firm to 
provide audit services to an issuer if the lead (or coordinating) 
audit partner (having primary responsibility for the audit), or the 
audit partner responsible for reviewing the audit, has performed 
audit services for that issuer in each of the 5 previous fiscal 
years of that issuer.


    The concept of audit partner \66\ rotation is not new. Indeed, 
accounting firms that audit registrants are currently subject to audit 
partner rotation requirements. The current requirements of the AICPA's 
SEC Practice Section (``SECPS'') call for the engagement partner to 
rotate off the engagement after seven years to remain off the 
engagement for two years.\67\
---------------------------------------------------------------------------


    \66\ For purposes of this portion of the release, the term 
partner refers to an individual who is a proprietor, partner, 
principal, or shareholder of the accounting firm.
    \67\ American Institute of Certified Public Accountants (AICPA), 
SEC Practice Section, Requirements of Members, at item e. The 
membership requirements are available online at http://www.aicpa.org/members/div/secps/require.htm.
 Audit firms which are 
members of the SEC Practice Section must comply with its rules 
(e.g., partner rotation) and undergo periodic peer review to ensure 
that the firms' audit practice is consistent with both the rules of 
the AICPA and those of the Commission.


---------------------------------------------------------------------------


[[Page 76791]]


    The Sarbanes-Oxley Act clearly specifies that the lead audit 
partner and reviewing partner should serve on the engagement in that 
capacity for no more than five consecutive years. The Commission is 
proposing rules to clarify the five-year rotation requirement specified 
in the Sarbanes-Oxley Act.
    As noted above, existing SECPS membership requirements stipulate 
that a rotated partner may not serve on the audit engagement for two 
consecutive years following rotation.\68\ In addition to covering more 
partners,\69\ the proposed rules expand this requirement and require 
that, following rotation, a partner may not provide such services for a 
period of five consecutive years. We believe that partners should not 
return to the engagement for five-years in order to ensure investors 
that there will be a periodic fresh look at the accounting and auditing 
issues confronting the company. If a shorter ``time-out'' provision is 
used, investors might believe that partners merely would be placed in 
secondary role for a year or two, only to resume the same roles that 
they previously occupied and to return to the prior engagement team's 
approach to the accounting and auditing issues. If a partner is removed 
from an engagement for five-years, it would appear more likely that the 
partner will be placed on a different engagement and not held in 
abeyance only to return to the previous engagement. While we anticipate 
that accounting firms, when possible, would stagger the rotation of 
partners to provide a continuity of knowledge about the company, we 
believe the five-year period in the proposed rule would assure a 
complete turnover of personnel every five years.
---------------------------------------------------------------------------


    \68\ Id.
    \69\ The current SECPS membership requirements stipulate that 
the audit engagement partner be rotated every seven years except 
that firms with less five SEC audit clients and less than ten 
partners are exempted. The existing SECPS membership requirements 
also do not require that the concurring partner be rotated.
---------------------------------------------------------------------------


    With respect to determining which partners, principals and 
shareholders should be included, the proposed rules would go beyond the 
minimum specified by the Act. As noted above, the Act requires that the 
lead or coordinating audit partner and the audit partner responsible 
for reviewing the audit rotate every five years. Clearly, the lead 
partner as well as the concurring review partner perform critical 
functions that affect the conduct and effectiveness of the engagement. 
However, in many larger engagements, the engagement team will include 
more than just the lead partner and the concurring review partner. 
Obviously, the larger the registrant and the more diversified the 
registrant's activities, the more likely that the engagement team will 
include multiple partners, principals or shareholders.
    While under this proposal, firms would be required to rotate 
multiple partners in these situations, nothing in this proposal is 
intended to imply that all partners would need to be rotated at the 
same time. Indeed, we would expect that firms would stagger the 
rotation of partners to ensure that the engagement team continues to 
have appropriate expertise to allow the audit engagement to be 
conducted in accordance with GAAS.
    Partners, principals or shareholders who are members of the audit 
engagement team \70\ make significant decisions that can affect the 
conduct and effectiveness of the audit. As a result, the proposed rules 
would require rotation not just of the lead and reviewing partner,\71\ 
but of partners who perform audit services for the issuer.\72\ This 
rotation requirement would include the lead partner, the concurring 
review partner, the client service partner, and other ``line'' partners 
directly involved in the performance of the audit. The proposed rules 
ensure that professionals do not ``grow-up'' or spend their entire 
career on one engagement.
---------------------------------------------------------------------------


    \70\ 17 CFR 210.2-01(f)(7).
    \71\ For purposes of this requirement, references to partner 
include principals, shareholders and other positions with equivalent 
responsibility.
    \72\ Under these proposals, we believe that those partners who 
are involved on a continuous basis in the audit of material balances 
in the financial statements would be subject to the rotation 
requirements of this proposal. For example, an actuarial specialist 
who assists in auditing the loss reserves for an insurance company 
would be subject to the rotation requirement.
---------------------------------------------------------------------------


    Since most registrants are taxable entities, an assessment of the 
registrant's tax provision accounted for in accordance with GAAP \73\ 
is a necessary part of the audit engagement. As a consequence, there 
may be ``tax'' partners who perform significant services related to the 
audit engagement. To the extent that such services are a necessary part 
of the accounting firm's ability to complete the audit, partners 
providing those services would be subject to these rotation 
requirements. However, the accounting firm may also perform tax 
services for the registrant. These services can include tax compliance 
services as well as certain tax planning services.\74\ Such services 
are not, in and of themselves, deemed to be part of the audit or other 
attest engagement.\75\ Thus, a partner who only provides tax services 
for the registrant would not be subject to the rotation requirements. 
However, since the financial statements typically include the amount 
currently payable or refundable, the accounting firm must carefully 
evaluate whether ``tax'' partners are performing exclusively tax 
services or whether their services play a role in the audit engagement.
---------------------------------------------------------------------------


    \73\ Statement of Financial Accounting Standards No. 109, 
``Accounting for Income Taxes'' (Feb 1992).
    \74\ These services would, of course, be subject to the audit 
committee pre-approval requirements specified in section 202 of the 
Sarbanes-Oxley Act and the accompanying rules proposed in this 
release.
    \75\ See the discussion in part B.11 of this release, supra.
---------------------------------------------------------------------------


    In many cases, registrants have complex business transactions and 
other situations which may require that the engagement team consult 
with the accounting firm's national office or others on technical 
issues. Partners assigned to ``national office'' duties (which can 
include both technical accounting and centralized quality control 
functions) who may be consulted on specific accounting issues related 
to a client are not considered members of the audit engagement team 
even though they may consult on client matters regularly.\76\ While 
these partners play an important role in the audit process, they serve, 
primarily, as a technical resource for members of the audit team. 
Because these partners are not involved in the audit per se and do not 
routinely interact or develop relationships with the audit client, we 
do not believe that it is necessary to rotate the involvement of these 
personnel.
---------------------------------------------------------------------------


    \76\ 17 CFR 210.2-01(f)(7).
---------------------------------------------------------------------------


    In addition to the audit, registrants are required to have their 
quarterly financial information subjected to a timely review by the 
accounting firm. Such review is typically conducted according to the 
provisions required by generally accepted auditing standards.\77\ 
Furthermore, section 404 of the Sarbanes-Oxley Act, as well as the 
Commission's proposed rules,\78\ would require the accounting firm to 
attest to management's report on the registrant's internal controls. 
Both a timely review engagement and an attestation engagement require 
the accounting firm to be independent with respect to the registrant. 
Accordingly, the Commission's proposed rules for partner rotation 
extend to partners who serve on the engagement team that conducts the 
timely review of the registrant's interim financial


[[Page 76792]]


information as well as the engagement team that conducts the attest 
engagement on management's report on the registrant's internal 
controls.
---------------------------------------------------------------------------


    \77\ See Codification of Statements on Auditing Standards 
AUSec.  722.
    \78\ Release No. 33-8138 (Oct. 22, 2002) (67 FR 66208).
---------------------------------------------------------------------------


    Under the proposed rules, a partner performing audit, review or 
attest services to an investment company could only do so if they had 
not performed such services for any entity within the investment 
company complex, as defined in rule 2-01(f)(14) of Regulation S-X 
during the previous five consecutive years. For example, the proposed 
rule would prohibit a partner from rotating between two separate 
investment company issuers within an investment company complex. The 
proposed rule also would prohibit a partner from rotating between an 
investment company issuer and any other entity within the investment 
company complex.
    While we are proposing that all partners on the engagement team who 
perform a continuing audit function be subject to the partner rotation 
requirements, we are interested in understanding the implications of 
this proposed requirement on audit firms. For example, it has been 
suggested by some that the need for the audit firm to rotate its audit 
partners might be obviated by having a second audit firm periodically 
perform a forensic audit to evaluate the work of the existing auditor, 
the condition of the company's internal controls, the company's 
accounting and reporting practices, and other matters. Forensic audits 
are typically conducted by specialized accountants and are designed to 
go beyond the scope of a financial statement audit. Indeed, forensic 
audits are typically conducted when there is already reason to suspect 
wrongdoing or fraud. Some believe that having a separate set of 
examiners conduct periodic forensic audits would encourage financial 
statement auditors to take greater responsibility for the detection of 
fraud and illegal acts when auditing financial statements due to the 
fact that another set of auditors would be critically evaluating their 
role. Additionally, forensic audits conceivably could give the audit 
committees a tool to better evaluate the quality of the financial 
statement auditors.
    A possible consequence of the auditor rotation requirement is that 
some firms may be unable staff the audit engagement team with 
sufficient partners who are qualified to understand some of the 
difficult issues that the audit client faces. This may be particularly 
true in industries where there are specialized transactions, regulatory 
processes, or accounting principles. Nonetheless, the auditor is 
required to conduct the audit in accordance with generally accepted 
auditing standards. In particular, the third general standard requires 
that the auditor exercise due professional care in the conduct of the 
audit (see AU 150.02). In order to exercise due professional care, it 
would be necessary to ensure that the engagement was properly staffed 
with individuals competent to understand the unique issues relevant to 
that audit. Additionally, the quality control standards require that 
the firm have processes in place to ensure that appropriate personnel 
are assigned to each audit engagement (see QC 20.13).
    [sbull] Should the Commission adopt rules requiring that issuers 
engage forensic auditors periodically to evaluate the work of the 
financial statement auditors? If so, how often should the forensic 
auditors be engaged? What should be the scope of the forensic auditors' 
work? Would doing so obviate the need to require partner rotation for 
the audit firm? Alternatively, could the company obtain the necessary 
expertise by engaging other outside consultants? If so, what type of 
consultants should it engage?
    [sbull] Would the establishment of rules requiring companies to 
engage forensic auditors periodically provide an opportunity to other 
firms to enter the market to provide these services?
    [sbull] Should the Commission establish requirements for firms 
conducting forensic audits? If so, what should those requirements be?
    [sbull] Should issuers be given a choice between engaging forensic 
auditors periodically and having the audit partners on their engagement 
team be subject to the rotation requirements? Why or why not?
    [sbull] What are the costs and benefits of engaging forensic 
auditors to evaluate the work of the financial statement audit firm?
    [sbull] This proposed rule would apply to the audits of the 
financial statements of ``issuers.'' Should the Commission consider 
applying this rule to a broader population such as audits of the 
financial statements of ``audit clients'' as defined in 2-01(f)(6) of 
Regulation S-X? Why or why not?
    [sbull] For organizations other than investment companies, the 
rotation requirements would apply to significant subsidiaries of 
issuers. Should a different approach be considered? Is so, what 
approach would be appropriate?
    [sbull] Should the rotation requirements apply to all partners on 
the audit engagement team? If not, which partners should be subject to 
the requirements?
    [sbull] Is the proposed guidance sufficiently clear as to which 
audit engagement team partners would be covered by the rule? Is the 
proposed approach appropriate? If not, how can it be improved?
    [sbull] Is the exclusion of certain ``national office partner'' 
personnel from the rotation requirements appropriate?
    [sbull] Is the guidance on national office partners who are 
exempted from the rotation requirements sufficiently clear?
    [sbull] Is the distinction between a member of the engagement team 
and a national office partner who consults regularly (or even 
continually) on client matters sufficiently clear?
    [sbull] Should certain partners performing non-audit services for 
the client in connection with the audit engagement be excluded from the 
rotation requirements?
    [sbull] Should additional personnel (such as senior managers) be 
included within the mandatory rotation requirements?
    [sbull] Is it appropriate to provide transitional relief where the 
proposed rules are more restrictive that the provisions of the 
Sarbanes-Oxley Act?
    [sbull] Are there situations in foreign jurisdictions that extended 
partner rotation could be modified with additional safeguards or 
limitations that would recognize the jurisdictional requirements as 
well as logistical limitations that may exist?
    [sbull] Should the rotation requirements be different for small 
firms? What changes would be appropriate and why? If so, how should 
small firms be defined?
    [sbull] Would the proposed rules impose a cost on smaller firms 
that is disproportionate to the benefits that would be achieved?
    [sbull] Is the five-year ``time out'' period necessary or 
appropriate? Would some shorter time period be sufficient, such as two, 
three or four years? Should there be different ``time out'' periods 
based on a partner's role in the audit process?
    [sbull] If a partner rotates off an engagement after fewer than 
five years, should the ``time out'' period also be reduced? Why or why 
not? If so, how much should the reduction in the time out period be?
    [sbull] Are the partner rotation requirements, as proposed, for 
investment company issuer's or other entities in the investment company 
complex too broad? Should we only prohibit a partner from rotating 
between investment company issuers within the same investment company 
complex? Why or why not?
    [sbull] The proposed rules would not require all partners on the 
audit engagement team to rotate at the same time. Should it? Why or why 
not?


[[Page 76793]]


D. Audit Committee Administration of the Engagement


    The proposed rules recognize the critical role played by audit 
committees in the financial reporting process and the unique position 
of audit committees in assuring auditor independence. An effective 
audit committee may enhance the auditor's independence by, among other 
things, providing a forum apart from management where the auditors may 
discuss their concerns. It may facilitate communications among the 
board of directors, management, internal auditors and independent 
accountants. An audit committee also may enhance auditor independence 
from management by appointing, compensating and overseeing the work of 
the independent auditors.
    The audit committee should approve the engagement of the 
independent accountant to audit the issuer and its subsidiary's 
financial statements and have ongoing communications with the 
accountant. The proposals would require that the audit committee pre-
approve all permissible non-audit services and all audit, review or 
attest engagements required under the securities laws. The proposals 
require that either:
    [sbull] Before the accountant is engaged by the audit client to 
provide services other than audit, review or attest services, the audit 
client's audit committee expressly approve the particular engagement; 
or
    [sbull] Any such engagement be entered into pursuant to detailed 
pre-approval policies and procedures established by the audit committee 
and the audit committee is informed on a timely basis of each service.
    As provided in the Sarbanes-Oxley Act, the proposed rules recognize 
audit services to be broader than those services required to perform an 
audit pursuant to generally accepted auditing standards. For example, 
the Act identifies services related to the issuance of comfort letters 
and services related to statutory audits required for insurance 
companies for purposes of state law as audit services.\79\ We recognize 
that domestically and internationally there are various requirements 
for statutory audits. These proposals contemplate this fact; 
accordingly, such engagements are viewed as audit services in the 
context of these proposals. These rules require that the audit 
committee pre-approve all such services. These proposals do anticipate 
that the audit committee may approve broadly the provision of audit, 
review and attest services by the auditor to the issuer and its 
subsidiaries.
---------------------------------------------------------------------------


    \79\ Section 202 of the Sarbanes-Oxley Act; 15 U.S.C 78j-
1(i)(1)(A).
---------------------------------------------------------------------------


    The audit committee also would have the sole authority to pre-
approve the engagement of the company's independent accountant to 
expressly perform particular non-audit services. The audit committee 
also could establish policies and procedures provided they are detailed 
as to the particular service and designed to safeguard the continued 
independence of the auditor. Additionally, the Sarbanes-Oxley Act 
allows for one audit committee member to pre-approve the service.
    Unlike other issuers, the investment adviser to the investment 
company issuer will generally engage the issuer's accountant to perform 
non-auditing services that might impact the accountant's independence. 
The proposed rule would require pre-approval not only of the non-
auditing services provided to the investment company issuer, but also 
require pre-approval by the investment company issuer's audit committee 
of the non-auditing services provided to the investment adviser of an 
investment company issuer and any entity controlling, controlled by, or 
under common control with the investment adviser that provides services 
to the investment company. The proposed rule would not, however, 
require the audit committee of an investment company to approve the 
auditing or non-auditing services provided: (i) To another investment 
company registrant within an investment company complex as defined in 
rule 2-01(f)(14); (ii) to a sub-adviser that primarily provides 
portfolio management services and is under the direction of another 
investment adviser; and (iii) to other entities within the investment 
company complex that do not provide services to the fund.
    Under the proposed rule, the investment company's audit committee 
would be able to establish policies and procedures for pre-approving 
non-auditing services provided not only to the investment company 
issuer, but also its investment adviser and related entities that 
provide services to the fund. The proposed rule would permit, for 
purposes of determining whether a non-auditing service meets the de 
minimis exception, the investment company's audit committee to 
aggregate the total amount of revenues paid to the investment company's 
accountant by the investment company, its investment adviser and any 
entity controlling, controlled by, or under common control with the 
investment adviser that provides services to the investment company.
    Also, as discussed later in this release, these provisions are 
supplemented as a result of the proposed proxy disclosure requirements. 
We believe that disclosure of the procedures the audit committee uses 
to pre-approve audit services will provide investors valuable 
information that may be used to evaluate the relationships that exist 
between the auditor and the audit client.
    [sbull] Should the Commission create other exceptions (beyond the 
de minimis exception) that would allow an audit committee to adopt a 
policy that contracts that are recurring (e.g., due diligence 
engagements in connection with a series of insignificant acquisitions) 
and less than a stated dollar amount (such as $25,000) or less than a 
stated percentage of annual revenues (such as 1% or 5%) could be 
entered into by management and would be reviewed by the audit committee 
at its next periodic meeting?
    [sbull] Is allowing the audit committee to engage an auditor to 
perform non-audit services by policies and procedures, rather than a 
separate vote for each service, appropriate? If so, how do we ensure 
that audit committees have rigorous, detailed procedures and do not, in 
essence, delegate that authority to management?
    [sbull] Should more or fewer aspects be left to the discretion of 
the audit committee?
    [sbull] Are there specific matters that should be communicated to 
or considered by the audit committee prior to its engaging the auditor?
    [sbull] What, if any, audit committee policies and procedures 
should be mandated to enhance auditor independence, interaction between 
auditors and the audit committee, and communications between and among 
audit committee members, internal audit staff, senior management and 
the outside auditor?
    [sbull] Our proposed rules do not contain exemptions for foreign 
filers. Are there legal or regulatory impediments which may make it 
difficult for certain foreign filers to comply? If so, what safeguards 
can these foreign filers employ to ensure that they comply with the 
proposed rules?
    [sbull] Our proposed rules requiring the audit committee to pre-
approve non-audit services to be provided by the company's auditor do 
not contain an exemption for foreign filers. Are there legal or 
regulatory impediments which may make it difficult for certain foreign 
filers to comply? If so, what safeguards can these foreign filers 
employ to ensure that there is an authorization process to


[[Page 76794]]


pre-approve such services that is separate from management?
    [sbull] In addition to legal or regulatory impediments, are there 
practical impediments which would make it difficult for certain foreign 
filers to comply with the pre-approval requirements? If so, what are 
these impediments? What safeguards can such an entity establish to 
better implement the proposed rules (which is to separate the decision 
to engage the auditor for non-audit services from management)?
    [sbull] Should the Commission provide additional specific guidance 
to assist audit committees when deliberating auditor independence 
issues? What topics would be helpful?
    [sbull] Our proposed rules would require the audit committee of an 
investment company to pre-approve the non-auditing services provided by 
the accountant of the investment company 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. Should the audit committee of an investment 
company registrant be required to approve any non-auditing services 
provided to the investment adviser and any entity controlled, 
controlled by, or under common control with the investment adviser that 
provides services to the fund? Should the scope of the pre-approval 
requirement be expanded or narrowed? Why or why not?
    [sbull] Under the proposed rules, the pre-approval of non-auditing 
services would permit, for purposes of determining whether a non-
auditing service meets the de minimis exception, the investment 
company's audit committee to aggregate total revenues paid to the 
investment company's accountant by the investment company, its 
investment adviser and any entity controlled, controlled by, or under 
common control with the investment adviser that provides services to 
the fund. Should the de minimis exception be determined separately 
based on the total revenues paid to the investment company's accountant 
by each entity?
    [sbull] This proposed rule would apply to ``issuers.'' Should the 
Commission consider applying this rule to a broader population such as 
``audit clients'' as defined in 2-01(f)(6) of Regulation S-X? Why or 
why not?
    [sbull] In addition to the requirement that a majority of the 
directors who are not interested persons of the registered investment 
company appoint the independent accountant of a registered investment 
company under the Investment Company Act of 1940, the proposed rules 
would also require the audit committee of an investment company to 
separately approve the accountant. For registered investment companies, 
who should approve the selection of the accountant, i.e. independent 
directors, the audit committee, or both? If both, should the audit 
committee nominate the independent accountant with the independent 
directors making the selection?


E. Compensation


    We propose to amend the auditor independence rules to address the 
practice of auditors being compensated by their firms for selling non-
audit services to their audit clients. The new rule would provide that 
an accountant is not independent if, at any point during the audit and 
professional engagement period,\80\ any partner, principal or 
shareholder of the accounting firm who is a member of the audit 
engagement team earns or receives compensation based on the performance 
of, or procuring of, engagements with that audit client, to provide any 
services, other than audit, review, or attest services.
---------------------------------------------------------------------------


    \80\ ``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. 
See rule 2-01(f)(5) of Regulation S-X, 17 CFR 210.2-01(f)(5).
---------------------------------------------------------------------------


    Some accounting firms offer their professionals cash bonuses and 
other financial incentives to sell products or services, other than 
audit, review, or attest services to audit clients. We view such 
incentive programs as inconsistent with the independence and 
objectivity of external auditors that is necessary for them to 
maintain, both in fact and in appearance. The Commission believes that 
any partner, principal or shareholder who is a member of the audit 
engagement team could be influenced adversely as a result of the 
economic benefits that may be derived by promoting the firm's non-audit 
services to audit clients. We are concerned that an auditor might be 
viewed as compromising accounting judgments in order not to jeopardize 
the potential for increased income from sales of non-audit services.
    ``Compensation,'' as used in the proposed rule, would include any 
form of income or monetary benefit distributed to the partner, 
principal or shareholder. Compensation would be based on the 
performance or sale of non-audit services if the partner, principal, or 
shareholder were financially rewarded in any way for the performance or 
sale of such services. For example, this provision would result in 
accounting firms removing the sale of non-audit services to a partner's 
audit clients from the criteria used to allocate partnership ``units'' 
to that partner. It also would apply to any other vehicle used in 
determining compensation for any partner, principal or shareholder who 
is a member of the engagement team. This provision also reinforces the 
position that accountants at the partner level should be viewed as 
skilled professionals and not as conduits for the sale of non-audit 
services. This proposal recognizes and focuses on the need for 
independence of the most senior members of the engagement team as well 
as the accounting firm.
    [sbull] We seek comments on all aspects of incentive compensation 
for audit partners, principals and shareholders and on the following:
    [sbull] What economic impact will our proposal have on the current 
system of partnership compensation in accounting firms?
    [sbull] Are there other approaches that should be considered with 
respect to compensation packages that pose a concern about auditor 
independence? If so, what are they?
    [sbull] Would the proposed rule change be difficult to put into 
practice? If so, why? How could it be changed to be more effectively 
applied?
    [sbull] Should managers, supervisors or staff accountants who are 
members of the audit engagement team also be covered by this proposal?
    [sbull] Does this proposal cover the appropriate time period or 
should a measure other than the audit and professional engagement 
period be considered?
    [sbull] Does the proposed rule cover the entire component of an 
audit partner's compensation that gives rise to independence concerns?
    [sbull] Will this compensation limitation disproportionately affect 
some firms because of their size or compensation structure? If so, how 
may we accomplish our goal while taking these differences into account?
    [sbull] Our proposal references compensation based on the 
performance or sale of non-audit services. Is there a better test that 
permits partners to participate in the overall success of the firm 
while addressing the influence that such services might have on a 
particular auditor-client relationship?


[[Page 76795]]


F. Definitions


1. Accountant
    The term ``accountant'' currently is defined under the rules of the 
Commission as a ``certified public accountant or public accountant 
performing services in connection with an engagement for which 
independence is required.''\81\ The proposed rules add to the 
definition the phrase a ``registered public accounting firm.'' Under 
the provisions of the Sarbanes-Oxley Act, public accounting firms must 
register with the Public Company Accounting Oversight Board (the 
``Board'') in order to prepare or issue, or to participate in the 
preparation or issuance of any audit report with respect to any 
issuer.\82\ Thus, the term ``registered public accounting firm'' refers 
to a firm that has registered in accordance with the requirements of 
the Sarbanes-Oxley Act. Accordingly, the proposals would include 
registered public accounting firms within the definition of 
accountants.
---------------------------------------------------------------------------


    \81\ 17 CFR 2-01(f)(1).
    \82\ See section 102(a) of the Sarbanes-Oxley Act.
---------------------------------------------------------------------------


2. Accounting Role
    Under the existing rules of the Commission, accounting role and 
financial reporting oversight role were included as a single 
definition. However, because the proposed rules that require a cooling-
off period relate only to those performing a financial reporting 
oversight role, the Commission proposes to define separately 
``accounting role'' and ``financial reporting oversight role.'' As 
proposed, the term ``accounting role'' refers to a role where a person 
can or does exercise more than minimal influence over the contents of 
the accounting records or over any person who prepares the accounting 
records. All persons in a ``financial reporting oversight role'' 
(defined below) are also in an ``accounting role.'' However, persons in 
an accounting role include individuals in clerical positions 
responsible for accounting records (e.g., payroll, accounts payable, 
accounts receivable, purchasing, sales) as well as those who report to 
individuals in financial reporting oversight roles (e.g., assistant 
controller, assistant treasurer, manager of internal audit, manager of 
financial reporting).
    [sbull] Is this proposed definition sufficiently clear? If not, 
what changes would make the definition clearer and more operational?
3. Financial Reporting Oversight Role
    The term ``financial reporting oversight role'' refers to a role in 
which an individual has direct responsibility or oversight of those who 
prepare the registrant's financial statements and related information 
(e.g., management discussion and analysis), which will be included in a 
registrant's document filed with the Commission. As noted above, 
``accounting role and financial reporting oversight role'' previously 
was one definition. In order to subject the appropriate individuals to 
certain portions of the proposed rules, we are proposing to bifurcate 
the definitions.
    [sbull] Is this proposed definition sufficiently clear? If not, 
what changes would make the definition clearer and more operational?
4. Audit Committee
    Section 205 of the Sarbanes-Oxley Act defines an audit committee 
as:


    A committee (or equivalent body) established by and amongst the 
board of directors of an issuer for the purpose of overseeing the 
accounting and financial reporting processes of the issuer and 
audits of the financial statements of the issuer.


The Act further stipulates that if no such committee exists, then the 
audit committee is the entire board of directors. The Commission 
proposes to adopt the same meaning for audit committee as used in the 
Act.
    The audit committee serves as an important body, serving the 
interests of investors, to help ensure that the registrant and its 
auditors fulfill their responsibilities under the securities laws. 
Because the definition of an audit committee includes the entire board 
of directors if no such committee of the board exists, these rules do 
not require registrants to establish audit committees.
    Some companies do not have boards of directors and therefore do not 
have audit committees. For example, some limited liability companies 
and limited partnerships that do not have a corporate general partner 
may not have an oversight body that is the equivalent of an audit 
committee. We do not propose to exempt these entities from the proposed 
requirements. Rather, such issuers should look through each general 
partner of the limited partnerships acting as general partner until a 
corporate general partner or an individual general partner is reached. 
With respect to a corporate general partner, the registrant should look 
to the audit committee of the corporate general partner or to the full 
board of directors as fulfilling the role of the audit committee. With 
respect to an individual general partner, the registrant should look to 
the individual as fulfilling the role of the audit committee.
    We do, however, propose to exempt asset-backed issuers \83\ and 
unit investment trusts \84\ from this proposed requirement. Because of 
the nature of these entities, such issuers are subject to substantially 
different reporting requirements. Most significantly, asset-backed 
issuers are not required to file financial statements like other 
companies. Similarly, unit investment trusts are not required to 
provide shareholder reports containing audited financial statements. 
Also, such entities typically are passively managed pools of assets. 
Therefore, we do not propose to apply the requirements related to audit 
committees in this release to such entities.
---------------------------------------------------------------------------


    \83\ As defined in 17 CFR 240.13a-14(g) and 240.15d-14(g).
    \84\ As defined by section 4(2) of the Investment Company Act 
(15 U.S.C. 80a-4(2)).
---------------------------------------------------------------------------


    [sbull] Some registrants may not have designated boards of 
directors or audit committees (e.g. benefit plans required to file form 
11-K). Does the definition of audit committee sufficiently describe who 
should serve in this capacity where such situations exist? If not, what 
additional guidance would be appropriate?
    [sbull] Our proposed rules exempt unit investment trusts and asset-
backed issuers from the rule requiring the audit committee to approve 
auditing and non-auditing services. Should unit investment trusts and 
asset-backed issuers be subject to these requirements? If so, given 
that unit investment trusts and asset-backed issuers are not actively 
managed, who should be responsible for approving the auditing and non-
auditing services? Are there other, similar entities that should be 
exempt from the pre-approval requirements?
    [sbull] Are the existing definitions in Regulation S-X and rule 2-
01 of Regulation S-X of audit client, issuer, and subsidiary 
sufficiently clear?


G. Communication With Audit Committees


    Section 204 of the Sarbanes-Oxley Act directs the Commission to 
issue rules requiring timely reporting of specific information by 
auditors to audit committees. We are proposing to amend Regulation S-X 
to require each public accounting firm registered with the Public 
Company Accounting Oversight Board that audits an issuer's financial 
statements to report, prior to the filing of such report with the 
Commission, to the issuer or registered investment


[[Page 76796]]


company's audit committee: (1) All critical accounting policies and 
practices used by the issuer or registered investment company, (2) all 
alternative accounting treatments of financial information within 
generally accepted accounting principles (``GAAP'') that have been 
discussed with management, including the ramifications of the use of 
such alternative treatments and disclosures and the treatment preferred 
by the accounting firm, and (3) other material written communications 
between the accounting firm and management of the issuer or registered 
investment company.
    We believe that this section of the Sarbanes-Oxley Act and these 
proposed rules largely codify current requirements under Generally 
Accepted Auditing Standards (``GAAS'') for auditors of public companies 
to discuss matters with management and audit committees. We further 
believe that specifying the timing of these communications will 
facilitate more open dialogue between auditors and audit committees.
    Certain specific oral or written communications with audit 
committees are currently required by GAAS, including:
    (1) Methods used to account for significant unusual transactions,
    (2) Effects of significant accounting policies in controversial or 
emerging areas for which there is a lack of authoritative guidance or 
consensus,
    (3) Process used by management in formulating particularly 
sensitive accounting estimates and the basis for the auditor's 
conclusions regarding the reasonableness of those estimates,
    (4) Material audit adjustments proposed and immaterial adjustments 
not recorded by management,
    (5) Auditor's judgments about the quality of the company's 
accounting principles, and
    (6) Disagreements with management over the application of 
accounting principles, the basis for management's accounting estimates, 
and the disclosures in the financial statements.\85\
---------------------------------------------------------------------------


    \85\ See Codification of Statement on Auditing Standards AU 
Sec.  380, ``Communication with Audit Committees.''
---------------------------------------------------------------------------


    Auditors are required under GAAS to provide these communications in 
a timely manner but not necessarily before the issuance of the audit 
report.\86\ Auditors also may communicate with audit committees on 
matters in addition to those specifically required by AU Sec.  380, 
including auditing issues, engagement letters, management 
representation letters, internal controls, auditor independence, and 
others.
---------------------------------------------------------------------------


    \86\ Id.
---------------------------------------------------------------------------


    [sbull] In light of the requirements for the CEO and CFO to certify 
information in the company's periodic filings,\87\ should the auditor 
be required to communicate information on critical accounting policies 
and practices and alternative accounting treatments to management as 
well as to the audit committee?
---------------------------------------------------------------------------


    \87\ See Release No. 33-8124, ``Certification of Disclosure in 
Companies' Quarterly and Annual Reports,'' (Aug. 29, 2002).
---------------------------------------------------------------------------


1. Critical Accounting Policies and Practices
    We are proposing rules requiring communication by auditors to audit 
committees of all critical accounting policies and practices. This 
communication can be oral or written. In December 2001, we issued 
cautionary advice regarding each issuer disclosing in the Management's 
Discussion and Analysis \88\ Section of its annual report those 
accounting policies that management believes are most critical to the 
preparation of the issuer's financial statements.\89\ The cautionary 
advice indicated that ``critical'' accounting policies are those that 
are both most important to the portrayal of the company's financial 
condition and results and require management's most difficult, 
subjective or complex judgments, often as a result of the need to make 
estimates about the effect of matters that are inherently 
uncertain.\90\ As part of that cautionary advice, we stated:
---------------------------------------------------------------------------


    \88\ Item 303 of Regulation S-K, (17 CFR 229.303), which 
requires disclosure about, among other things, trends, events or 
uncertainties known to management that would have a material impact 
on reported financial information.
    \89\ Release No. 33-8040 (Dec. 12, 2001) (66 FR 65013).
    \90\ Id.


    Prior to finalizing and filing annual reports, audit committees 
should review the selection, application and disclosure of critical 
accounting policies. Consistent with auditing standards, audit 
committees should be apprised of the evaluative criteria used by 
management in their selection of the accounting principles and 
methods. Proactive discussions between the audit committee and the 
company's senior management and auditor about critical accounting 
policies are appropriate.\91\
---------------------------------------------------------------------------


    \91\ Id. (footnotes omitted).


    In May 2002, the Commission proposed rules to require disclosures 
that would enhance investors' understanding of the application of 
companies' critical accounting policies.\92\ The May 2002 proposed 
rules cover (1) accounting estimates a company makes in applying its 
accounting policies and (2) the initial adoption by a company of an 
accounting policy that has a material impact on its financial 
presentation. Under the first part of those proposed rules, a 
``critical accounting estimate'' is defined as an accounting estimate 
recognized in the financial statements (1) that requires the registrant 
to make assumptions about matters that are highly uncertain at the time 
the accounting estimate is made and (2) for which different estimates 
that the company reasonably could have used in the current period, or 
changes in the accounting estimate that are reasonably likely to occur 
from period to period, would have a material impact on the presentation 
of the registrant's financial condition, changes in financial condition 
or results of operations. The May 2002 proposed rules outline certain 
disclosures that a company would be required to make about its critical 
accounting estimates. In addition, under the second part of the May 
2002 proposed rules, a company would be required to make certain 
disclosures about its initial adoption of accounting policies, 
including the choices the company had among accounting principles.
---------------------------------------------------------------------------


    \92\ Release No. 33-8090 (May 10, 2002) (67 FR 35620).
---------------------------------------------------------------------------


    Auditors may want to read and refer to the December 2001 Cautionary 
Guidance as well as the May 2002 proposed rules as a guide to 
determining the types of matters that should be communicated to the 
audit committee under this proposed rule. We do not propose to require 
that those discussions follow a specific form or manner, but we expect, 
at a minimum, that the discussion of critical accounting estimates and 
the selection of initial accounting policies will include the reasons 
why certain estimates or policies are or are not considered critical 
and how current and anticipated future events impact those 
determinations. In addition, we anticipate that the communications 
regarding critical accounting policies will include an assessment of 
management's disclosures along with any significant proposed 
modifications by the auditors that were not included.
    [sbull] Should the auditor be required to provide additional 
information to the audit committee regarding the company's critical 
accounting policies?
    [sbull] When should the communication take place?
    [sbull] Should the auditor be required to provide the communication 
in writing?
    [sbull] Is it appropriate that investment companies would be 
subject to the rules regarding critical accounting policies?


[[Page 76797]]


2. Alternative Accounting Treatments
    We recognize that the complexity of financial transactions results 
in accounting answers that are often the subject of significant debate 
between management and the auditors. We believe that these discussions 
of accounting alternatives that occur between management and the 
auditors should be shared with the audit committee in their oversight 
role. The report by the Senate Committee on Banking, Housing, and Urban 
Affairs on the bill that later became the foundation for the Sarbanes-
Oxley Act, in addressing section 204, stated, in part:


    The Committee believes that it is important for the audit 
committee to be aware of key assumptions underlying a company's 
financial statements and of disagreements that the auditor has with 
management. The audit committee should be informed in a timely 
manner of such disagreements, so that it can independently review 
them and intervene if it chooses to do so in order to assure the 
integrity of the audit.\93\
---------------------------------------------------------------------------


    \93\ Report of the Senate Committee on Banking, Housing, and 
Urban Affairs, ``Public Company Accounting Reform and Investor 
Protection Act of 2002,'' Senate Report 107-205, 107th Cong., 2d 
Sess., at 21 (July 3, 2002).


    Therefore, we are proposing rules requiring communication, either 
orally or in writing, by auditors to audit committees of alternative 
accounting treatments of financial information within GAAP that have 
been discussed with management, including the ramifications of the use 
of such alternative treatments and disclosures and the treatment 
preferred by the accounting firm. This proposed rule is intended to 
cover recognition, measurement, and disclosure considerations related 
to the accounting for specific transactions as well as general 
accounting policies.
    We believe that communications regarding specific transactions 
should identify, at a minimum, the underlying facts, financial 
statement accounts impacted, and applicability of existing corporate 
accounting policies to the transaction. In addition, if the accounting 
treatment proposed does not comply with existing corporate accounting 
policies, or if an existing corporate accounting policy is not 
applicable, then an explanation of why the existing policy was not 
appropriate or applicable and the basis for the selection of the 
alternative policy should be discussed. Regardless of whether the 
accounting policy selected preexists or is new, the entire range of 
alternatives available under GAAP that were discussed by management and 
the auditors would be communicated along with the reasons for not 
selecting those alternatives. If the accounting treatment selected is 
not the preferred method in the auditor's opinion, we would expect that 
the reasons why the auditor's preferred method was not selected by 
management also would be discussed.
    Communications regarding general accounting policies would focus on 
the initial selection of and changes in significant accounting 
policies, as required by AU Sec.  380, and would include the impact of 
management's judgments and accounting estimates, as well as the 
auditor's judgments about the quality of the entity's accounting 
principles. The discussion of general accounting policies would include 
the range of alternatives available under GAAP that were discussed by 
management and the auditors along with the reasons for selecting the 
chosen policy. If an existing accounting policy is being modified, then 
the reasons for the change would also be communicated. If the 
accounting policy selected is not the auditor's preferred policy, then 
we would expect the discussions to include the reasons why the auditor 
considered one policy to be preferred but that policy was not selected 
by management.
    The separate discussion of critical accounting policies and 
estimates is not considered a substitute for communications regarding 
general accounting policies, since the discussion about critical 
accounting policies and estimates might not encompass any new or 
changed general accounting policies and estimates. Likewise, this 
discussion of general accounting policies and estimates is not intended 
to dilute the communications related to critical accounting policies 
and estimates, since the issues affecting critical accounting policies 
and estimates, such as sensitivities of assumptions and others, may be 
tailored specifically to events in the current year, and the selection 
of general accounting policies and estimates should consider a broad 
range of transactions over time.
    [sbull] Is the discussion of which accounting policies require 
communication with the audit committee sufficiently clear?
    [sbull] Should additional matters be required to be communicated to 
the audit committee? If so, which matters?
    [sbull] Is it appropriate that investment companies would be 
subject to the proposed rules regarding alternative accounting 
treatments?
3. Other Material Written Communications
    We understand written communications between auditors and 
management range from formal documents, such as engagement letters, to 
informal correspondence, such as administrative items. We also 
acknowledge that not all forms of written communications provided to 
management also are provided to the audit committee. The decision 
whether to provide written communications to the audit committee is 
subjective and is influenced by auditing standards. Our proposed rule 
is intended to clarify the substance of information that would be 
provided by auditors to audit committees to facilitate auditor and 
management oversight by those committees. We anticipate that the 
proposed rule would result in auditors and audit committees having more 
robust discussions of accounting and auditing matters.
    The Sarbanes-Oxley Act specifically cites the management letter and 
schedules of unadjusted differences as examples of material written 
communications to be provided to audit committees. Examples of 
additional written communications that we expect would be considered 
material to an issuer include:
    [sbull] Management representation letter; \94\
---------------------------------------------------------------------------


    \94\ See SAS 85 AUSec.  333, ``Management Representations.''
---------------------------------------------------------------------------


    [sbull] Reports on observations and recommendations on internal 
controls; \95\
---------------------------------------------------------------------------


    \95\ See SAS 60 AU Sec.  Communication of Internal Control 
Related Matters Noted in an Audit.''
---------------------------------------------------------------------------


    [sbull] Schedule of material adjustments and reclassifications 
proposed, and a listing of adjustments and reclassifications not 
recorded, if any; \96\
---------------------------------------------------------------------------


    \96\ See SAS 89, AUSec.  333, ``Audit Adjustments,'
---------------------------------------------------------------------------


    [sbull] Engagement letter; \97\ and
---------------------------------------------------------------------------


    \97\ See SAS 83 AUSec.  310, ``Establishing an Understanding 
With the Client.''
---------------------------------------------------------------------------


    [sbull] Independence letter.\98\
---------------------------------------------------------------------------


    \98\ See SQCS 2 QCSec.  20, ``System of Quality Control for a 
CPA Firm's Accounting and Auditing Practice.''
---------------------------------------------------------------------------


    These examples are not exhaustive, and auditors are encouraged to 
critically consider what additional written communications should be 
provided to audit committees.
4. Timing of Communications
    The Act requires that the aforementioned communications should be 
timely reported to the audit committee. For purposes of the 
requirements of this provision, the proposed rule specifies that the 
proposed communications between the


[[Page 76798]]


auditor and the audit committee occur prior to the filing of the audit 
report with the Commission pursuant to applicable securities laws. As a 
result, these discussions will occur, at a minimum, during the annual 
audit, but we expect that they could occur as frequently as quarterly 
or more often on a real-time basis.
    The timing of these communications is intended to occur before any 
audit report is filed with the Commission pursuant to the securities 
laws. We believe that this proposed rule will ensure that these 
communications occur prior to filing of annual reports and proxy 
statements, as well as prior to filing registration statements and 
other periodic or current reports when audit reports are included.
    [sbull] Should the timing of these communications be required to 
occur before any audit report is filed with the Commission or at some 
other time?
    [sbull] Should these communications regarding critical accounting 
policies be required to be in writing? If so, why?
    [sbull] Should we include specific instructions within the proposed 
rule regarding the nature of communications of critical accounting 
policies? If so, what instructions should be provided and why?
    [sbull] Do these required communications fulfill existing GAAS 
requirements? If not, why?
    [sbull] Should these communications regarding alternative 
accounting treatments be required to be in writing? If so, why?
    [sbull] Do these required communications fulfill the statutory 
requirements? If not, why?
    [sbull] Should the minimum requirements for discussion of 
alternative accounting treatments be expanded or reduced? If so, how?
    [sbull] Should the list of recommended other communications be 
expanded or reduced? If so, what specific items should be added and 
why?
    [sbull] Should the list of recommended other communications be 
required to be communicated to the audit committee? Why or why not?
    [sbull] Are the appropriate entities included under the term 
``issuer'' appropriate? If not, what entities should be included or 
excluded?
    [sbull] Is it appropriate that investment companies are required to 
make these communications to their audit committees? Why or why not?
    [sbull] This proposed rule would apply to ``issuers.'' Should the 
Commission consider applying this rule to a broader population such as 
``audit clients'' as defined in 2-01(f)(6) of Regulation S-X? Why or 
why not?


H. Expanded Disclosure


1. Principal Accountants' Fees
    To allow investors to be better able to evaluate the independence 
of the auditor of a company's financial statements in which they 
invest, the proxy disclosure rules currently require that a registrant 
disclose the professional fees it paid to its principal independent 
accountant in the most recent fiscal year. We propose to change both 
the types of fees that must be detailed and the years of service that 
are covered by the disclosure.\99\ The proposed rules would increase 
the disclosed categories of professional fees paid for audit and non-
audit services from three to four. The categories of reportable fees 
would be: (1) Audit Fees, (2) Audit-Related Fees, (3) Tax Fees, and (4) 
All Other Fees.\100\ The new disclosure would show fees for each of the 
two most recent fiscal years, rather than just the most recent fiscal 
year. In addition, registrants will be required to describe in 
subcategories the nature of the services provided that are categorized 
as audit-related fees and all other fees. We are also proposing 
disclosure requirements related to audit committee pre-approval 
policies and procedures for audit and non-audit services provided by an 
independent public accountant as well as the percentage of fees that 
were pre-approved.
---------------------------------------------------------------------------


    \99\ See proposed item 9(e), schedule 14A.
    \100\ Currently, registrants need disclose only ``Audit Fees,'' 
``Financial Systems Design and Implementation Fees'' and ``All Other 
Fees.'' (17 CFR 240.14a-101, item 9(e)). We are proposing to delete 
the category of ``Financial Systems Design and Implementation Fees'' 
because such services generally are prohibited. See section II.B.2 
of this release.
---------------------------------------------------------------------------


    We are proposing these changes partly in response to public comment 
on this disclosure since we adopted the requirement in 2000. For 
example, the definition of ``Audit Fees'' restricts the fees reportable 
in that category to the services necessary only to complete the basic 
audit, sign the audit opinion and perform the required quarterly 
reviews. This category was intended to include fees for only those 
services specifically required under GAAS.\101\ Some have suggested 
that the categories are not as clear as they can be and some 
commentators have questioned the usefulness of the current fee 
disclosures.
---------------------------------------------------------------------------


    \101\ See Application of Revised Rules on Auditor Independence: 
Frequently Asked Questions. Office of the Chief Accountant, January 
16, 2001, Question and answer no. 1.
---------------------------------------------------------------------------


    We recognize that there are certain accounting, audit, assurance 
and related services that accountants, in effect, must perform for 
their audit clients. Presently, registrants are required to combine 
fees for those services with fees paid for consulting and present the 
aggregate in the ``All Other Fees'' category. We recognize that this 
framework may make it difficult for shareholders to distinguish between 
fees for services traditionally performed by the accounting firm's 
auditors and fees for services performed by the accounting firm's 
consulting division. Some reporting companies have sought to add 
clarity by including further subcategories under ``All Other Fees'' to 
provide greater detail.
    While the proposed rules continue to require issuers to disclose 
fees paid to the principal accountant for audit services, we are 
expanding the types of fees that should be included in this category. 
In addition to including fees for services necessary to perform an 
audit or review in accordance with GAAS,\102\ this category also may 
include services that generally only the independent accountant can 
reasonably provide, such as comfort letters, statutory audits, attest 
services, consents and assistance with and review of documents filed 
with the Commission.
---------------------------------------------------------------------------


    \102\ See also section 2(a)(2) the Sarbanes-Oxley Act which 
defines the term ``audit''.
---------------------------------------------------------------------------


    We believe that the addition of a new category, ``Audit-Related 
Fees,'' will enable registrants to present the audit fee relationship 
with the principal accountant in a more transparent fashion. In 
general, Audit-Related Fees are assurance and related services that are 
traditionally performed by the independent accountant. More 
specifically, these services would include, among others: employee 
benefit plan audits, due diligence related to mergers and acquisitions, 
accounting assistance and audits in connection with proposed or 
consummated acquisitions, internal control reviews, consultation 
concerning financial accounting and reporting standards.
    We also believe it is appropriate to add transparency regarding a 
second category of fees: ``Tax Fees.'' Tax services traditionally have 
been viewed as closely related to audit services and as not being in 
conflict with an auditor's independence. However, such services would 
be subject to pre-approval by the audit committee. The review of a 
registrant's tax accruals and reserves is a task that requires 
extensive knowledge about the audit client--knowledge that has already 
been assimilated by the audit and tax professionals. In many public 
companies, the fee for tax services is substantial in relation to other 
services. Investors may benefit from being able to consider those fees


[[Page 76799]]


separately from the ``All Other Fees'' category. The ``Tax Fees'' 
category would capture all services performed by professional staff in 
the independent accountant's tax division. Typically, it would include 
fees for tax compliance, consultation and planning. Tax compliance 
generally involves preparation of original and amended tax returns, 
claims for refund and tax payment-planning services. Tax consultation 
and tax planning encompass a diverse range of services, including 
assistance and representation in connection with tax audits and 
appeals, tax advice related to mergers and acquisitions, employee 
benefit plans and requests for rulings or technical advice from taxing 
authorities.
    The category of ``All Other Fees'' would remain unchanged from the 
existing rule, except that to the extent that financial information 
systems implementation and design exist they would be disclosed as a 
component of ``All Other Fees.''
    Thus, this proposal would add two new categories to the 
disclosures: (1) Audit-related fees and (2) tax fees. This proposal 
also would eliminate one of the current categories: financial 
information technology consulting fees. This category would be 
eliminated under this proposal because under the section of the 
proposal addressing nonaudit services, auditors would no longer be 
permitted to provide most of these consulting services to audit 
clients. Thus, the Commission believes that this disclosure of fees 
paid in this category would no longer be necessary.
    For comparison purposes, two dollar amounts would be shown under 
each one of the four categories--one for each of the two most recent 
fiscal years. Each amount reported would represent the aggregate of all 
fees billed by the principal independent accountant that is appropriate 
to that category in one of those two years. As we note in the proposed 
Item, registrants also are required to describe each subcategory of 
services comprising the fees included in the ``audit related'' and 
``all other fees'' categories.
    The disclosures of the percentage of audit services that are not 
provided by permanent, full-time employees of the independent public 
accounting firm remain unchanged from previous rules.
2. Audit Committee Actions
    We propose to require that registrants filing proxy statements 
disclose any policies and procedures developed by the audit committee 
of the board of directors concerning pre-approval of the independent 
accountant to perform both audit and non-audit services. Section 202 of 
the Sarbanes-Oxley Act states the pre-approval requirements for all 
auditing and non-audit services, with exceptions provided for de 
minimis amounts under certain circumstances, as described in the Act 
and the proposed rules. This section also describes the delegation 
authority of the audit committee related to pre-approvals. We believe 
that investors should be informed of audit committee pre-approval 
procedures and policies in place to give investors a better 
understanding of how audit committees are managing relationships with 
independent accountants, including evaluating engagements with the 
accountant that could impair the accountant's independence.
    The proposed disclosure would set out in detail the audit 
committee's policies and procedures for engaging the independent 
accountant to perform services other than audit, review and attest 
services. We expect registrants to provide clear, concise and 
understandable descriptions of the policies and procedures. 
Alternatively, registrants could include a copy of those policies and 
procedures with the proxy statement delivered to investors and filed 
with the Commission. Either method should allow shareholders to obtain 
a complete and accurate understanding of the audit committee's policies 
and procedures. We expect the policies and procedures would address 
auditor independence oversight functions in a prudent and responsible 
manner. Additionally, these procedures would describe, if applicable, 
the specific processes in place that permit and monitor activities 
meeting the de minimis exception.
    We also believe investors would benefit from knowing what 
percentage of the fees reported in each of the ``Audit-Related Fees,'' 
``Tax Fees,'' and ``All Other Fees'' categories were pre-approved by 
the audit committee pursuant to the policies and procedures instituted 
by the audit committee. That disclosure would provide insight into the 
extent to which the audit committee takes an active, direct role in 
considering each category of non-audit fee engagements.
    The Sarbanes-Oxley Act requires the Commission to promulgate rules 
requiring companies to disclose the required information together with 
periodic reports required pursuant to sections 13(a) and 15(d) of the 
Exchange Act. In accordance with this mandate, we propose to require 
the new disclosures in a company's annual report. However, because we 
believe that this information is relevant to a decision to vote for a 
particular director or to elect, approve or ratify the choice of an 
independent public accountant, we propose to require this disclosure in 
a company's proxy statement on schedule 14A or information statement on 
schedule 14C. Because the information is proposed to be included in 
part III of annual reports on forms 10-K and 10-KSB, domestic companies 
would be able to incorporate the required disclosures from the proxy or 
information statement into the annual report.
    Our intent is that this information be made available to investors 
of all registrants. However, not all registrants are required to file 
proxy statements. Thus, consistent with the provisions in the Act, 
registrants that do not issue proxy statements would be required to 
include appropriate disclosures in their annual filing included in form 
10-K, form 10-KSB, 20-F, form 40-F and proposed form N-CSR as 
appropriate. For the reasons noted previously in this release, we 
propose to exempt asset-backed issuers and unit investment trusts from 
such disclosure requirements.
    In addition, we propose to require parallel disclosure for 
registered management investment companies (``funds'') in annual 
reports on proposed form N-CSR.\103\ Like operating companies, 
registered management investment companies would also be required to 
include this information in proxy or information statements that relate 
to the election of directors, or the election, approval, or 
ratification of an independent public accountant.\104\ However, in 
recent years, the proxy statement has become an ineffective vehicle for 
making information available to fund shareholders on a regular basis 
because many funds are no longer required to hold annual meetings.\105\


[[Page 76800]]


Accordingly, we believe that the disclosure regarding audit committee 
pre-approval policies and procedures for audit and non-audit services 
and professional fees billed by auditors should also be required in 
annual reports on proposed form N-CSR, which would be filed with the 
Commission and available to investors.
---------------------------------------------------------------------------


    \103\ Proposed form N-CSR would be used by registered management 
investment companies to file certified shareholder reports with the 
Commission under the Sarbanes-Oxley Act of 2002. See Investment 
Company Act Release No. 25723 (Aug. 30, 2002) (67 FR 57298 (Sept. 9, 
2002)); Sarbanes-Oxley Act of 2002, Pub. L. 107-204, 116 Stat. 745 
(2002).
    \104\ 17 CFR 240.14a-101, item 9(e).
    \105\ For historical and other reasons, most funds are organized 
under the laws of Massachusetts or Maryland. The organizational and 
operational requirements of Massachusetts business trusts are not 
specified by statute, and a fund's essential structure is contained 
in the trust agreement, which generally includes a provision 
eliminating the need for annual shareholder meetings to elect 
directors. See generally Jones, Moret, and Storey, The Massachusetts 
Business Trust and Registered Investment Companies, 13 DEL. J. CORP. 
L. 421 (1988). Under Maryland corporate law, fund charters or by-
laws are not required to provide that annual meetings be held in any 
year in which election of directors is not required by the 
Investment Company Act. MD. CODE ANN., CORPS. & ASS'NS Code 2-
501(b)(1)(2002). In addition, Delaware, Minnesota, and California 
also have business trust or special corporate law structures that 
have the effect of not requiring shareholder meetings other than 
those required by the Investment Company Act. DEL. CODE ANN. tit. 
12, Sec.  3806 (2001); Minn Stat. 302A.431 (2001); CAL. CORP. CODE 
600(b) (West 2001).
    Closed-end funds registered on national securities exchanges, 
however, are required to hold an annual meeting to elect directors 
under the rules of the exchanges. See, e.g., American Stock Exchange 
Company Guide Listing Standards, Policies and Requirements Sec.  
704; New York Stock Exchange Listed Company Manual 302.00. Closed-
end fund shareholders therefore generally would receive annual proxy 
statements.
---------------------------------------------------------------------------


    [sbull] Is the proxy statement the appropriate location for this 
disclosure? If not, why?
    [sbull] Should we permit incorporation by reference into the 
company's annual report?
    [sbull] Would expansion of the proxy disclosure of professional 
fees paid to the independent auditor from three categories to four 
provide more useful information to investors?
    [sbull] Are the new categories of disclosure appropriate? Are they 
well defined, or should they be more accurately defined? Should there 
be additional (or fewer) categories?
    [sbull] Is disclosure of two years of fees appropriate? Should the 
proposed additional fee disclosures be expanded to three years or 
remain at one year?
    [sbull] What, if any, additional information about professional 
fees would be useful to investors?
    [sbull] For a registrant not subject to the proxy disclosure rules, 
such as foreign private issuers, should we require that the same 
disclosures be placed in annual reports?
    [sbull] Is there any additional disclosure concerning the 
activities of audit committees that would be beneficial to investors?
    [sbull] Should companies be required to provide the information in 
their quarterly reports? Should it be required that the information be 
included in other filings such as form 10-Q or 10-QSB?
    [sbull] Should registered investment companies be required to 
provide the information in their semi-annual report to shareholders on 
proposed form N-CSR?
    [sbull] Registered investment companies are required to provide 
disclosure of audit fees billed for the registrant only, but are 
required to disclose other types of fees in the aggregate for the 
registrant, its investment adviser, and certain other parties.\106\ Is 
this appropriate, or should we also require disclosure of audit fees on 
an aggregate basis? In the alternative, should we require disclosure of 
audit-related fees or any other fees for the registrant only and not on 
an aggregate basis?
---------------------------------------------------------------------------


    \106\ Item 9(e)(1), (2), and (3) of schedule 14A (17 CFR 
240.14a-101, item 9(e)(1), (2), and (3)) (requiring disclosure under 
the caption ``Audit Fees'' of fees billed for audit of registrant's 
financial statements and disclosure under the captions ``Financial 
Information Systems Design and Implementation Fees,'' and ``All 
Other Fees'' of fees billed for services rendered to the registrant, 
its investment adviser, and any entity controlling, controlled by, 
or under common control with the adviser that provides services to 
the registrant); proposed item 9(e)(1), (2), (3) and (4) of schedule 
14A; proposed instruction 2 to item 9(e) of schedule 14A (proposing 
to require disclosure under the caption ``Audit Fees'' of fees 
billed for audit of registrant's financial statements, and 
disclosure under the captions ``Audit-Related Fees,'' ``Tax Fees,'' 
and ``All Other Fees'' of fees billed for services rendered to the 
registrant, the registrant's investment adviser, and any entity 
controlling, controlled by, or under common control with the adviser 
that provides services to the registrant).
---------------------------------------------------------------------------


    [sbull] If we adopt such a requirement, should we require or permit 
registrants to recalculate and report fees already disclosed for more 
than two years so that all fee information is consistently reported and 
available?


I. Transition Period


    While much of the current proposal implements title II of the Act, 
we are also proposing changes which go beyond the provisions of the 
Act. In those areas, we are proposing that the provisions would be 
effective upon adoption of final rules. However, for those situations, 
we are considering the appropriate timing for the implementation of 
final rules and how best to allow for an orderly transition as a result 
of the new requirements imposed by the proposals. We are considering 
whether the application of some of these provisions should be delayed 
to a later date. For example, we are considering transition provisions 
related to the rules concerning audit partner rotation, audit committee 
communications, disclosures of fees paid to auditors, and partner 
compensation.
    [sbull] Would a period of time beyond the adoption date of the 
final rules be necessary or appropriate for compliance with the final 
rules by smaller companies or companies with whose securities currently 
are not listed or quoted? If so, which rules should we consider a 
delayed effective date?
    [sbull] How should an effective date be determined with respect to 
each amendment?
    [sbull] Are there special considerations that we should take into 
account in providing a transition period for foreign private issuers?


III. General Request for Comments


    [sbull] We invite any interested person wishing to submit written 
comments on the proposals or any matters that may impact the proposals, 
to do so. We specifically request comments from investors, issuers, and 
accounting firms.
    [sbull] We solicit comment on each component of the proposals.
    [sbull] Would the proposals related to audit committees and partner 
compensation help alleviate the pressure that clients may place on 
engagement partners or accounting firms to acquiesce to the clients' 
views on accounting issues? What are some of the other scenarios where 
such pressures might exist?


IV. Paperwork Reduction Act


    Certain provisions of the proposed amendments to Regulation S-X, 
schedule 14A and forms 10-K, 10-KSB, 20-F, 40-F and proposed form N-CSR 
contain ``collection of information'' requirements within the meaning 
of the Paperwork Reduction Act of 1995 (``PRA'') (44 U.S.C. 3501 et 
seq.), and the Commission has submitted them to the Office of 
Management and Budget (``OMB'') for review in accordance with 44 U.S.C. 
3507(d) and 5 CFR 1320.11. An agency may not conduct or sponsor, and a 
person is not required to respond to, a collection of information 
unless it displays a currently valid control number. Compliance with 
the proposed requirements would be mandatory. There would be no 
mandatory retention period for the information disclosed under the 
rules being proposed in this release. Responses to the disclosure 
requirements would not be kept confidential.
    The titles for the collections of information are: ``Regulation S-
X''; ``Proxy Statements--Regulation 14A and Schedule 14A''; ``Form 10-
K''; ``Form 10-KSB''; ``Form 20-F''; ``Form 40-F''; and ``Form N-CSR 
under the Investment Company Act of 1940 and Securities Exchange Act of 
1934, Certified Shareholder Report.''
    Regulation S-X (OMB Control No. 3235-0009) is the central 
repository for rules related to the form and content of financial 
statements filed with the Commission. Regulation S-X, however, does not 
direct registrants to file financial statements or to collect financial 
data. Regulation S-X indicates


[[Page 76801]]


what should be in the financial statements and how financial statements 
should be presented when they are required to be filed by other rules 
or forms under the securities laws. Because Regulation S-X does not 
require any information to be filed with the Commission, only one 
burden hour is assigned to cover a reading of the regulation. Burden 
hours and costs associated with the preparation of financial statements 
in accordance with Regulation S-X are allocated to the rules or forms 
that require the financial statements to be filed.


A. Communication With Audit Committees


    As required by section 204 of the Sarbanes-Oxley Act, we are 
proposing to amend Regulation S-X to require each public accounting 
firm registered with the Public Company Accounting Oversight Board that 
audits an issuer's financial statements to report to the issuer's audit 
committee (1) all critical accounting policies and practices used by 
the issuer, (2) alternative accounting treatments within GAAP that have 
been discussed with management, including the ramifications of the use 
of the alternative treatments and the treatment preferred by the 
accounting firm, and (3) other material written communications between 
the accounting firm and management of the issuer such as any management 
letter or schedule of ``unadjusted differences.'' The required reports 
need not be in writing but the report would be required to be presented 
to the audit committee before the auditor's report on the financial 
statements is filed with the Commission.\107\
---------------------------------------------------------------------------


    \107\ Release No. 33-8040 (Dec. 12, 2001) (66 FR 65013). In May 
of this year, we proposed rules to require disclosures that would 
enhance investors' understanding of the application of companies' 
critical accounting policies. The proposed disclosures would focus 
on accounting estimates a company makes in applying its accounting 
policies and the initial adoption by a company of an accounting 
policy that has a material impact on its financial presentation. 
Release No. 33-8098 (May 10, 2002) (67 FR 35620).
---------------------------------------------------------------------------


    We believe that auditing standards currently require discussions 
between the auditors and the audit committee of significant unusual, 
controversial, or emerging accounting policies, of the process used by 
management to select certain estimates, and of disagreements over 
certain accounting matters.\108\ We further believe that audit 
committees generally are aware of management's letter making 
representations to the auditors, which the auditor uses in conducting 
the audit of the issuer's financial statements. Audit committees also 
should be aware of ``unadjusted differences,'' if any, as a result of 
the enactment of section 401 of the Sarbanes-Oxley Act, which added 
section 13(i) to the Securities Exchange Act of 1934 (``Exchange 
Act'').\109\ Under new section 13(i) of the Exchange Act, therefore, 
there should be no material ``unadjusted differences.''
---------------------------------------------------------------------------


    \108\ See SAS 61, AUSec.  380, ``Communication with Audit 
Committees or Others with Equivalent Authority and Responsibility.''
    \109\ Each financial report that contains financial statements, 
and that is required to be prepared in accordance with (or 
reconciled to) generally accepted accounting principles under this 
title and filed with the Commission shall reflect all material 
correcting adjustments that have been identified by a registered 
public accounting firm in accordance with generally accepted 
accounting principles and the rules and regulations of the 
Commission.
---------------------------------------------------------------------------


    Because of these GAAS and legal provisions, we believe that 
adoption of the proposed rules regarding auditor reports to audit 
committees would not increase significantly the burden hours on 
accounting firms or registrants.


B. Disclosures of Audit and Non-Audit Services


1. Proxy and Information Statements
    Schedule 14A \110\ (OMB Control No. 3235-0059) prescribes the 
information that a company must include in its proxy statement to 
ensure that shareholders are provided material information relating to 
voting decisions. The Commission currently estimates that 7,661 
registrants annually file schedule 14A. Schedule 14C \111\ (OMB Control 
No. 3235-0057) prescribes the information that a company that is 
registered under section 12 of the Exchange Act must include in its 
information statement in advance of a security holders' meeting when it 
is not soliciting proxies from its security holders. The Commission 
currently estimates that 464 registrants annually file schedule 14C.
---------------------------------------------------------------------------


    \110\ 17 CFR 240.14a-101.
    \111\ 17 CFR 240.14c-101.
---------------------------------------------------------------------------


    Item 9 of schedule 14A requires the disclosure of certain 
information regarding the registrant's relationship with the 
independent auditor of the company's financial statements when there is 
a solicitation relating to (1) a meeting at which directors to the 
company's board of directors are to be elected (or the solicitation of 
consents or authorizations in lieu of such a meeting) or (2) the 
election of the auditor, or the approval or ratification of the 
company's selection of the auditor. We are proposing to amend paragraph 
(e) of item 9 to provide more detailed information regarding the 
categories of fees paid by the registrant to the auditor and to inform 
investors about the critical role that audit committees play in 
assuring the auditor's independence. We believe that the proposed 
disclosure would allow investors to better assess an auditor's 
independence and the certain activities of an audit committee.
    Item 9(e) currently requires disclosure of fees billed by the 
auditor in the last fiscal year, with the fees broken down into three 
categories: Audit fees, financial information systems design and 
implementation fees, and all other fees. The proposals would add 
disclosure of two categories (tax fees and audit-related fees), while 
eliminating one category (financial information systems design and 
implementation), and require disclosure of one more past year of each 
of these fees. Because these fees are already being disclosed, 
repeating the prior year's disclosures for comparison purposes should 
not increase significantly a registrant's compliance burden. In 
addition, breaking tax fees and audit-related fees out of the ``all 
other'' category of fees currently being disclosed should not result in 
any significant incremental burden.
    Under the proposals, registrants also would be required to disclose 
any policies and procedures adopted by an audit committee to be 
followed for auditor engagements for services other than audit, review 
and attest services in the event that the audit committee does not 
expressly pre-approve the particular engagements. In addition, the 
proposals would require registrants to disclose what percentage of fees 
in each of the categories noted above (audit, audit-related, tax, and 
other) relate to engagements that were pre-approved by the audit 
committee.
    We estimate that the incremental disclosure of fees, the audit 
committee's policies and procedures for approval of audit engagements, 
and the percentage of fees pre-approved by the audit committee, would 
impose, on average, two additional burden hours on each of the 7,661 
filers of schedule 14A, or an aggregate 15,322 additional burden hours. 
We estimate that most of this time would relate to consideration and 
review of the disclosures of the audit committee's policies and 
procedures. We further estimate that approximately 75% of the extra 
burden hours, or approximately 11,492 hours, would be expended by 
internal staff and the remaining 25%, or 3,830 hours, would be for 
outside legal costs associated with reviewing the proposed disclosures. 
Assuming that outside legal costs would be an average of $300 per hour, 
the aggregate annual legal costs would be $1,149,000. Similarly, we 
estimate that these proposed disclosures would


[[Page 76802]]


impose, on average, two additional burden hours on each of the 464 
filers of schedule 14C, or an aggregate 928 additional burden hours. 
Using the same allocation of hours and cost estimate of legal fees as 
for schedule 14A, we estimate that 696 hours would be expended by 
internal staff and the remaining 232 hours would be for outside legal 
assistance, producing an outside legal cost of $69,600.
2. Annual Reports on Form 10-K
    The proposed disclosure generally should be presented in a 
company's proxy statement in accordance with item 9(e) of schedule 14A, 
and incorporated by reference into the form 10-K (OMB Control No. 3235-
0063). Some companies that file forms 10-K, however, are not subject to 
the proxy disclosure requirements. These companies would, therefore, 
now be required to present the required disclosures in the form 10-K. 
We do not believe, however, that the disclosures would be burdensome to 
these companies because the information to be disclosed (fees billed to 
the company by the auditor in the last fiscal year, with the fees 
broken down into certain categories) should be readily available to the 
company.
    We estimate that the incremental disclosure of fees, the audit 
committee's olicies and procedures for approval of audit engagements, 
and the percentage of fees pre-approved by the audit committee, would 
impose, on average, two additional burden hours per year on each of the 
8,484 filers of form 10-K. Six thousand six hundred and seventy-six 
(6,676) of those filers, however, would provide the information under 
schedule 14A and 209 of those filers would provide the information 
under schedule 14C.\112\ The burden hours for the disclosure by these 
filers therefore has been assigned to schedule 14A and schedule 14C, 
respectively. The burden imposed on the remaining 1,599 filers is being 
assigned to form 10-K. This results in 3,198 (2 hours x 1,599 filers) 
additional burden hours. We estimate that most of this time would 
relate to consideration and review of the disclosures of the audit 
committee's policies and procedures. We further estimate that 
approximately 75% of the extra burden hours, or approximately 2,399 
hours, would be expended by internal staff and the remaining 25%, or 
799 hours, would be for outside legal costs associated with reviewing 
the proposed disclosures. Assuming that outside legal costs would be an 
average of $300 per hour, the aggregate annual legal costs would be 
$239,700.
---------------------------------------------------------------------------


    \112\ These numbers are obtained by reviewing the number of 
filers that filed a form 10-K and schedule 14A or schedule 14C, 
respectively, between October 1, 2001, and September 30, 2002.
---------------------------------------------------------------------------


3. Annual Reports on Form 10-KSB
    Form 10-KSB (OMB Control No. 3235-0420) is the annual report filed 
with the Commission by ``small businesses issuers.'' A ``small business 
issuer'' is an entity that (1) has revenues of less than $25,000,000, 
(2) is a U.S. or Canadian issuer, (3) is not an investment company, and 
(4) if a majority owned subsidiary, the parent corporation is also a 
small business issuer. An entity is not a ``small business issuer,'' 
however, if the aggregate market value of its outstanding voting and 
non-voting common stock held by non-affiliates is $25,000,000 or 
more.\113\ We do not believe, however, that these disclosures would be 
burdensome to these companies because the information to be disclosed 
(fees billed to the company by the auditor in the last fiscal year, 
with the fees broken down into certain categories) should be readily 
available to the company.
---------------------------------------------------------------------------


    \113\ 17 CFR 240.12b-2.
---------------------------------------------------------------------------


    We estimate that the incremental disclosure of fees, the audit 
committee's policies and procedures for approval of audit engagements, 
and the percentage of fees pre-approved by the audit committee, would 
impose, on average, two additional burden hours per year on each of the 
3,820 filers of form 10-KSB. Nine hundred and eighty-five (985) of 
those filers, however, would provide the information under schedule 14A 
and 255 of those filers would provide the information under schedule 
14C. The burden hours for the disclosure by these filers has been 
assigned to schedule 14A and schedule 14C, respectively. The burden 
imposed on the remaining 2,580 filers is being assigned to form 10-KSB. 
This results in 5,160 (2 hours x 2,580 filers) additional burden hours. 
We estimate that most of this time would relate to consideration and 
review of the disclosures of the audit committee's policies and 
procedures. We further estimate that approximately 75% of the extra 
burden hours, or approximately 3,870 hours, would be expended by 
internal staff and the remaining 25%, or 1,290 hours, would be for 
outside legal costs associated with reviewing the proposed disclosures. 
Assuming that outside legal costs would be an average of $300 per hour, 
the aggregate annual legal costs would be $387,000.
    4. Annual Reports by Foreign Private Issuers on Form 20-F
    Form 20-F (OMB Control No. 3235-0288) is used for the registration 
of securities of foreign private issuers pursuant to sections 12(b) or 
12(g) of the Exchange Act and annual and transition reports filed with 
the Commission pursuant to sections 13(a) or 15(d) of the Exchange 
Act.\114\
---------------------------------------------------------------------------


    \114\ 17 CFR 249.220f.
---------------------------------------------------------------------------


    Foreign private issuers generally are not subject to the proxy 
disclosure requirements and, therefore, would be required to present 
the required disclosures on form 20-F. We do not believe, however, that 
these disclosures would be burdensome to these companies because the 
information to be disclosed (fees billed to the company by the auditor 
in the last fiscal year, with the fees broken down into certain 
categories) should be readily available to the company.
    We estimate that the incremental disclosure of fees, the audit 
committee's policies and procedures for approval of audit engagements, 
and the percentage of fees pre-approved by the audit committee, would 
impose, on average, two additional burden hours per year on each of the 
1,194 filers of form 20-F, or 2,388 additional burden hours. We 
estimate that most of this time would relate to consideration and 
review of the disclosures of the audit committee's policies and 
procedures. We further estimate that approximately 25% of the extra 
burden hours, or approximately 597 hours, would be expended by internal 
staff and the remaining 75%, or 1,791 hours, would be for outside legal 
costs associated with reviewing the proposed disclosures because this 
form is prepared by foreign private issuers who rely more heavily on 
outside counsel for assistance. Assuming that outside legal costs would 
be an average of $300 per hour, the aggregate annual legal costs would 
be $537,300.
5. Reports by Certain Canadian Issuers on Form 40-F
    Form 40-F is used by certain Canadian issuers to register 
securities with the Commission pursuant to section 12(b) or section 
12(g) and for reports pursuant to section 15(d) of the Exchange Act. A 
Canadian issuer may use the form if it is subject to the reporting 
requirements solely by reason of having filed a registration statement 
on form F-7, F-8, F-9, F-10, or F-80 under the Securities Act of 1933. 
A Canadian issuer also may use the form if it has a reporting 
obligation under the Exchange Act and (1) the issuer is incorporated 
under the laws of Canada or any Canadian province or territory, (2) the 
issuer is a foreign private issuer


[[Page 76803]]


or a crown corporation, (3) the issuer has been subject to periodic 
reporting requirements of any securities commission or equivalent 
regulatory authority in Canada for a period of at least 12 calendar 
months immediately preceding the filing of the form and currently is in 
compliance with such obligations, and (4) the aggregate market value of 
the public float of the issuer's outstanding equity shares is $75 
million or more (no market value threshold needs to be satisfied, 
however, in connection with non-convertible securities eligible for 
registration on form F-9).\115\
---------------------------------------------------------------------------


    \115\ 17 CFR 249.240f.
---------------------------------------------------------------------------


    Canadian companies that file form 40-F generally are not subject to 
the proxy disclosure requirements and, therefore, would be required to 
present the required disclosures on form 40-F. We do not believe, 
however, that these disclosures would be burdensome to these companies 
because the information to be disclosed (fees billed to the company by 
the auditor in the last fiscal year, with the fees broken down into 
certain categories) should be readily available to the company.
    We estimate that the incremental disclosure of fees, the audit 
committee's policies and procedures for approval of audit engagements, 
and the percentage of fees pre-approved by the audit committee, would 
impose, on average, two additional burden hours per year on each of the 
134 filers of form 40-F, or 268 additional burden hours. We estimate 
that most of this time would relate to consideration and review of the 
disclosures of the audit committee's policies and procedures. 
Consistent with our treatment of foreign private issuers filing form 
20-F, we further estimate that approximately 25% of the extra burden 
hours, or approximately 67 hours, would be expended by internal staff 
and the remaining 75%, or 201 hours, would be for outside legal costs 
associated with reviewing the proposed disclosures. Assuming that 
outside legal costs would be an average of $300 per hour, the aggregate 
annual legal costs would be $60,300.
6. Proposed Form N-CSR
    We issued a release proposing form N-CSR on August 30, 2002, 
pursuant to section 30 of the Investment Company Act (15 U.S.C. 80a-29) 
and sections 13 and 15(d) of the Exchange Act (15 U.S.C. 78m and 
78o(d)). The proposed disclosure would be required in a registered 
management investment company's annual report on proposed form N-CSR. 
We estimate that the additional disclosure of fees, the audit 
committee's policies and procedures for approval of audit engagements, 
and the percentage of fees pre-approved by the audit committee, would 
impose, on average, 1.5 additional burden hours per year on each of the 
anticipated 3,700 filers of proposed form N-CSR. This results in 5,550 
(1.5 hours x 3,700 filers) additional burden hours. We estimate that 
most of this time would relate to consideration and review of the 
disclosures of the audit committee's policies and procedures. We 
estimate that the cost of these burden hours would $81 per hour, 
resulting in aggregate internal costs of $449,550.\116\ Further, we 
estimate that this additional disclosure would require 0.5 hours in 
legal review by outside counsel at an average rate of $300 per hour, 
resulting in aggregate annual outside legal costs of $555,000.
---------------------------------------------------------------------------


    \116\ See Securities Industry Association, Report on Management 
& Professional Earnings in the Securities Industry 2002 (2002).
---------------------------------------------------------------------------


    Pursuant to 44 U.S.C. 3506(c)(2)(B), we solicit comments to: (1) 
Evaluate whether the proposed collections of information are necessary 
for the proper performance of the functions of the agency, including 
whether the information will have practical utility; (2) evaluate the 
accuracy of the Commission's estimates of the burden of the proposed 
collections of information; (3) determine whether there are ways to 
enhance the quality, utility, and clarity of the information to be 
collected; and (4) evaluate whether there are ways to minimize the 
burden of the collections of information on those who are to respond, 
including through the use of automated collection techniques or other 
forms of information technology.
    Persons submitting comments on the collection of information 
requirements should direct the comments to the Office of Management and 
Budget, Attention: Desk Officer for the Securities and Exchange 
Commission, Office of Information and Regulatory Affairs, Washington, 
DC 20503, and should send a copy to Jonathan G. Katz, Secretary, 
Securities and Exchange Commission, 450 Fifth Street, NW., Washington, 
DC 20549-0609, with reference to File No. S7-49-02. Requests for 
materials submitted to OMB by the Commission with regard to these 
collections of information should be in writing, refer to File No.S7-
49-02, and be submitted to the Securities and Exchange Commission, 
Records Management, Office of Filings and Information Services. OMB is 
required to make a decision concerning the collection of information 
between 30 and 60 days after publication of this release. Consequently, 
a comment to OMB is assured of having its full effect if OMB receives 
it within 30 days of publication.


V. Cost--Benefit Analysis


    We are sensitive to the costs and benefits imposed by our rules, 
and we have identified certain costs and benefits of these proposals. 
Additionally, certain of these costs are imposed by Congressional 
mandate through the enactment of the Sarbanes-Oxley Act. We request 
comments on all aspects of this cost-benefit analysis, including the 
identification of any additional costs or benefits. We encourage 
commenters to identify and supply relevant data concerning the costs or 
benefits of the proposed amendments.


A. Background


    The Sarbanes-Oxley Act was enacted on July 30, 2002. Title II to 
that Act adds sections 10A(g) through 10A(l) to the Securities Exchange 
Act of 1934 (``Exchange Act'') and requires that the Commission, within 
180 days of enactment, adopt rules to carry out each of those 
sections.\117\
---------------------------------------------------------------------------


    \117\ Section 208(a) of the Sarbanes-Oxley Act of 2002.
---------------------------------------------------------------------------


    The proposed rules, in general, would:
    [sbull] Revise the Commission's regulations related to the non-
audit services that, if provided to an audit client, would impair an 
accounting firm's independence \118\;
---------------------------------------------------------------------------


    \118\ See section 201 of the Sarbanes-Oxley Act.
---------------------------------------------------------------------------


    [sbull] Require that an issuer's audit committee pre-approve all 
audit and non-audit services provided to the issuer by the auditor of 
an issuer's financial statements \119\;
---------------------------------------------------------------------------


    \119\ See section 202 of the Sarbanes-Oxley Act.
---------------------------------------------------------------------------


    [sbull] Prohibit any partner on the audit engagement team from 
providing audit services to the issuer for more than five consecutive 
years \120\;
---------------------------------------------------------------------------


    \120\ See section 203 of the Sarbanes-Oxley Act.
---------------------------------------------------------------------------


    [sbull] Prohibit an accounting firm from auditing an issuer's 
financial statements if certain members of management of that issuer 
had been members of the accounting firm's audit engagement team within 
the one-year period preceding the commencement of audit procedures 
\121\;
---------------------------------------------------------------------------


    \121\ See section 206 of the Sarbanes-Oxley Act.
---------------------------------------------------------------------------


    [sbull] Require that the auditor of an issuer's financial 
statements report certain matters to the issuer's audit committee, 
including ``critical'' accounting policies used by the issuer \122\; 
and
---------------------------------------------------------------------------


    \122\ See section 204 of the Sarbanes-Oxley Act.


---------------------------------------------------------------------------


[[Page 76804]]


    [sbull] Require disclosures to investors of information related to 
the audit and non-audit services provided by, and fees paid by the 
issuer to, the auditor of the issuer's financial statements.\123\
---------------------------------------------------------------------------


    \123\ See generally, section 202 of the Sarbanes-Oxley Act; 
section 10A(i)(2) of the Exchange Act, 15 U.S.C. 78j-1(i)(2).
---------------------------------------------------------------------------


    In addition, under the proposed rules, an accountant would not be 
independent from an audit client if any partner, principal or 
shareholder of the accounting firm who is a member of the engagement 
team received compensation based directly on any service provided or 
sold to that client other than audit, review and attest services. We 
believe that accounting firms should discontinue compensating these 
individuals for ``cross-selling'' services. While many of these 
proposed rules would respond directly to the provisions of title II of 
the Sarbanes-Oxley Act, certain of these proposals would go beyond the 
specific provisions of the Act to more fully address what we believe to 
be the Congressional intent. These provisions include:
    [sbull] Our proposal requiring any partner on the audit engagement 
team be subject to the rotation requirements;
    [sbull] Requiring a one-year cooling-off period for all audit 
client's employment of engagement team personnel; and
    [sbull] Our proposal to limit an audit partner from receiving 
compensation for recommending non-audit services to an audit client.


B. Potential Benefits of the Proposed Rules


    Potential benefits resulting from the proposed amendments include 
increased investor confidence in the independence of auditors, in the 
audit process, and in the reliability of reported financial 
information. As discussed below, clearer auditor independence 
regulations should provide investors with comfort that auditors are 
placing the interests of investors over financial or personal 
incentives. Proposed rules mandating that auditors communicate certain 
matters to audit committees should benefit investors by enhancing the 
opportunities for meaningful audit committee oversight of the financial 
reporting process. Investors also would benefit from the enhanced 
disclosure of the non-audit services provided by, and fees paid to, the 
accounting firm that audits and reviews the company's financial 
statements, and from better disclosure of the audit committee's role in 
approving the provision of non-audit services by the accounting firm 
that audits the company's financial statements. We believe that these 
factors could improve the efficiency of the markets and result in a 
lower cost of capital.
1. Auditor Independence
    The amendments would facilitate the independence of the auditor 
from management in the following ways.
    [sbull] Providing clearer definition of the lines of non-audit 
services that would impair an auditor's independence;
    [sbull] Requiring that each engagement of the auditor to perform 
audit or non-audit services for the company be pre-approved by the 
audit committee, which serves as the representative of investors;
    [sbull] Requiring the ``rotation'' of partners on the audit 
engagement to assure a periodic fresh look at the accounting and 
auditing issues presented in the engagement;
    [sbull] Providing that the auditor's independence would be impaired 
if revenues to the accounting firm from the sale of non-audit services 
or products to a company were directly paid to any partner, principal, 
or shareholder of the firm who works on the audit of that company's 
financial statements. This provision should decrease the appearance of 
any pressure on the audit engagement partner to appease management 
during the audit process in order to facilitate sales of non-audit 
services and increase the appearance and reality of auditor 
independence; and
    [sbull] Requiring a ``cooling off'' period between working on the 
audit engagement team and joining the client as a member of management 
in order to assure that personal relationships and the new member of 
management's knowledge of the audit plan do not negatively impact the 
audit process.
    Strengthening auditor independence should provide investors with 
more comfort that the auditors would play their ``gatekeeper'' role in 
companies'' financial reporting and provide further assurance that the 
true financial condition of companies is reflected in their financial 
reporting thereby allowing public companies less costly access to the 
capital markets.
2. Auditor Reports to Audit Committees
    The proposed rules would require that each public accounting firm 
registered with the Public Company Accounting Oversight Board that 
audits an issuer's financial statements report to the issuer's audit 
committee (1) All critical accounting policies and practices used by 
the issuer, (2) alternative accounting treatments within GAAP that have 
been discussed with management, including the ramifications of the use 
of the alternative treatments and the treatment preferred by the 
accounting firm, and (3) other material written communications between 
the accounting firm and management of the issuer such as any management 
letter or schedule of ``unadjusted differences.''
    The report by the Senate Committee on Banking, Housing, and Urban 
Affairs on the bill that later became the foundation for the Sarbanes-
Oxley Act, in addressing the need for such reports from the auditor to 
the audit committee, stated, in part:


    The Committee believes that it is important for the audit 
committee to be aware of key assumptions underlying a company's 
financial statements and of disagreements that the auditor has with 
management. The audit committee should be informed in a timely 
manner of such disagreements, so that it can independently review 
them and intervene if it chooses to do so in order to assure the 
integrity of the audit.\124\


    \124\ Report of the Senate Committee on Banking, Housing, and 
Urban Affairs, ``Public Company Accounting Reform and Investor 
Protection Act of 2002,'' Senate Report 107-205, 107th Cong., 2d 
Sess., at 21 (July 3, 2002).
---------------------------------------------------------------------------


    Almost eight months before passage of the Sarbanes-Oxley Act, in 
December 2001, we issued cautionary advice regarding each issuer 
disclosing in the Management Discussion and Analysis \125\ section of 
its annual report those accounting policies that management believes 
are most critical to the preparation of the issuer's financial 
statements.\126\ The cautionary advice indicated that ``critical'' 
accounting policies are those that are both most important to the 
portrayal of the company's financial condition and results and require 
management's most difficult, subjective or complex judgments, often as 
a result of the need to make estimates about the effect of matters that 
are inherently uncertain.\127\ As part of that cautionary advice, we 
stated:
---------------------------------------------------------------------------


    \125\ Item 303 of Regulation S-K (17 CFR 229.303), which 
requires disclosure about, among other things, trends, events or 
uncertainties known to management that would have a material impact 
on reported financial information.
    \126\ Release No. 33-8040 (Dec. 12, 2001) (66 FR 65013).
    \127\ Id.


    Prior to finalizing and filing annual reports, audit committees 
should review the selection, application and disclosure of critical 
accounting policies. Consistent with auditing standards, audit 
committees should be apprised of the evaluative criteria used by 
management in their selection of the accounting principles and 
methods. Proactive discussions between the audit committee and the 
company's senior


[[Page 76805]]


management and auditor about critical accounting policies are 
appropriate.\128\
---------------------------------------------------------------------------


    \128\ Id. (footnotes omitted).


    We continue to believe that such communications are appropriate and 
facilitate the audit committee's oversight of the financial reporting 
process. Investors should benefit by the audit committee being in a 
position to challenge what it may view as novel or aggressive use of 
GAAP to enhance reports of the company's financial results or financial 
condition.
    The rules proposed in May 2002 provide additional information about 
the application of critical accounting policies, including ``critical 
accounting estimates'' and the initial adoption of material accounting 
policies. Auditors may want to refer to these proposed rules,\129\ as 
well as the December 2001 cautionary advice, in determining the types 
of matters to be communicated to the audit committee.
---------------------------------------------------------------------------


    \129\ Release Nos. 33-8098 (May 10, 2002) (67 FR 35620).
---------------------------------------------------------------------------


3. Enhanced Disclosures About the Services Provided by Auditors to 
Registrants
    Investors would receive more detailed information about:
    [sbull] Any policies and procedures adopted by an audit committee 
that are designed to assure that the provision of non-audit services 
and products by the auditor do not impair the auditor's independence,
    [sbull] The fees paid by the registrant to the auditor in each of 
the last two years for audit, audit-related, tax, and all other 
services, and
    [sbull] The percentage of fees in each of those categories that 
were pre-approved by the audit committee.
    The proposed disclosures will afford investors greater visibility 
into those aspects of the auditor-client relationship. Providing 
better, more complete information in cases where non-audit services 
occur allows investors to determine for themselves whether there are 
concerns related to the auditor's independence. It also may allow 
investors to ask more direct and useful questions of management and 
directors regarding their decisions to engage the auditors for such 
services.
4. Compensation
    The proposed rules specify that audit partners that are compensated 
for cross-selling non-audit services are not independent. This would 
further enhance the independence of the audit function since the audit 
partner's focus would be on the conduct of the audit rather than on 
efforts to sell other services to management. The danger inherent in 
compensation to audit partners for cross-selling non-audit services is 
that it might create a temptation for auditors to compromise the 
quality of the audit in order to maintain their relationship with 
clients to whom they hope to cross-sell such services.\130\
---------------------------------------------------------------------------


    \130\ Moreover, such compensation might increase the effect of 
any conflict of interest inherent in the provision of non-audit 
services. It would do this by inadvertently providing a mechanism by 
which an issuer may influence an audit partner short of the threat 
to change auditors. That is, if issuers are not pleased with the 
results of an audit, such a compensation structure gives them the 
option to ``punish'' the audit partner by discontinuing the purchase 
of (or by not purchasing) the non-audit services and thereby causing 
the audit partner's compensation to be directly reduced. Since this 
punitive action is apt to be less costly to the issuer than would be 
a change in auditors, it represents a more credible threat to the 
audit partner than does the threat to change auditors. As a 
consequence, issuers may be more willing to employ this avenue of 
improper influence than to actually change auditors, and, indeed, 
audit partners may be more responsive to such pressure, given its 
enhanced credibility.
---------------------------------------------------------------------------


C. Potential Costs of the Proposals


1. Auditor Independence
    Changes in our auditor independence regulations may impose costs on 
accounting firms and on any issuers that engage, or would like to 
consider engaging, the auditor of an issuer's financial statements to 
perform non-audit services.
    (a) Non-audit services. According to the information available to 
the staff in 2000, approximately 12,600 registrants did not purchase 
any consulting services from the auditor of their financial statements, 
and 4,100 registrants reported purchasing such services.\131\ Based on 
the scrutiny that these services have received over the past year, the 
Commission staff believes that the number of companies purchasing non-
audit services from their auditor might have decreased significantly.
---------------------------------------------------------------------------


    \131\ Id.; 65 FR at 43185.
---------------------------------------------------------------------------


    The current auditor independence rules state that the performance 
of certain non-audit services will impair an auditor's independence. 
The proposed rules, in some cases, would redefine the limits of those 
services and would add one more item, ``expert services,'' to the list 
of prohibited services. These changes could impact the competitive 
markets for these services. Issuers would be precluded from engaging 
auditors to perform certain services in the categories of internal 
audit services, financial systems design and implementation services, 
appraisal and valuation services, actuarial services, and others, that 
may be performed under the current rules. These companies may incur 
costs from having to use a separate vendor for such services resulting 
in the possible loss of any synergistic benefits of having a single 
provider for both audit and non-audit services. In particular, the loss 
of company-specific information that might flow from the non-audit team 
to the audit engagement team, or vice versa, could in some instances 
lower the quality of either service. Issuers also may incur costs 
locating a new vendor and developing a business relationship with that 
vendor. In addition, issuers may incur costs from not being able to 
retain their preferred provider of non-audit services, if that 
preferred provider happens to also be their auditor. The difference in 
value between a preferred provider and a second choice may be 
substantial, particularly if the preferred provider has relatively 
unique service offerings or service offerings that are particularly 
well suited to the needs of the issuer.
    Accounting firms may lose one or more sources of revenue if the 
proposed rules are adopted because they would no longer be able to sell 
certain non-audit services to their audit clients. We believe, however, 
that in view of the statements by the largest four accounting firms, 
and others, that they would no longer provide internal audit 
outsourcing services and financial system design and implementation 
services to audit clients,\132\ costs associated with the proposed 
rules may be limited. Also, to the extent non-audit services are merely 
redistributed among the firms, there would be no net loss of revenue to 
public accounting firms as a whole.
---------------------------------------------------------------------------


    \132\ Report of the Senate Committee on Banking, Housing, and 
Urban Affairs, ``Public Company Accounting Reform and Investor 
Protection Act of 2002,'' Senate Report 107-205, 107th Cong., 2d 
Sess., at 18 (July 3, 2002).
---------------------------------------------------------------------------


    (b) Audit Committee Pre-approval of Services. Under the proposed 
rules, all auditing and non-audit services to be provided by the 
auditor of an issuer's financial statements must be pre-approved by the 
issuer's audit committee.\133\ There may be incremental


[[Page 76806]]


costs associated with audit committees performing this function. Such 
costs might include more frequent committee meetings, an increased 
workload on audit committee members, and having legal counsel review 
the audit committee's draft policies and procedures for engaging the 
auditors for non-audit services. The increased burden on audit 
committee members might result in the need to increase their 
compensation, resulting in additional costs to issuers. Some of these 
costs may be mitigated by the provisions in the Act and in the proposed 
rules that would allow the audit committee to delegate to one or more 
audit committee members the authority to grant pre-approvals of these 
services.\134\
---------------------------------------------------------------------------


    \133\ Section 301 of the Sarbanes-Oxley Act of 2002 requires the 
Commission to direct the national securities exchanges and national 
securities associations to prohibit the listing of any security of 
an issuer that does not meet certain criteria, including having an 
audit committee that performs certain functions. See section 10A(m) 
of the Exchange Act, 15 U.S.C. 78j-1(m). The Sarbanes-Oxley Act 
defines ``audit committee'' to be ``(A) a committee (or equivalent 
body) established by and amongst the board of directors of an issuer 
for the purpose of overseeing the accounting and financial reporting 
processes of the issuer and audits of the financial statements of 
the issuer; and (B) if no such committee exists with respect to an 
issuer, the entire board of directors of the issuer.'' Section 
205(a) of the Sarbanes-Oxley Act, which, among other things, adds 
section 3(a)(58) to the Exchange Act.
    \134\ Section 202 of the Sarbanes-Oxley Act; section 10A(i)(3) 
of the Exchange Act, 15 U.S.C. 78j-1(i)(3).
---------------------------------------------------------------------------


    Inadvertent violations of the Act and the proposed rules that would 
add to the costs of the rules also may be mitigated by the de minimus 
exception to the pre-approval requirement.\135\ Under this exception, 
the pre-approval requirement is waived if: (1) The aggregate amount of 
the non-audit services is not more than five percent of the total 
amount of revenues paid by the issuer to the auditor during the fiscal 
year in which the non-audit services were provided, (2) at the time of 
the engagement the issuer did not recognize the services to be non-
audit services, and (3) the services are approved by the audit 
committee prior to the completion of the audit.\136\
---------------------------------------------------------------------------


    \135\ Section 202 of the Sarbanes-Oxley Act; section 
10A(i)(1)(B) of the Exchange Act, 15 U.S.C. 78j-1(i)(1)(B).
    \136\ Id.
---------------------------------------------------------------------------


    We also believe that as a result of the Commission's audit 
committee disclosure requirements adopted in 1999,\137\ prior 
disclosures related to the involvement of the audit committee in 
recommending or approving changes in auditors and the resolution of 
disagreements between management and the auditors,\138\ and 
professional standards that require communications between the auditor 
and audit committees on auditor independence issues,\139\ many 
companies currently have audit committees that closely monitor issues 
related to the auditor's independence and the engagement of auditors to 
perform non-audit services. Accordingly, we believe that the 
incremental costs associated with the proposals would not be 
significant.
---------------------------------------------------------------------------


    \137\ Item 306 of Regulation S-K (17 CFR 229.306), and item 306 
of Regulation S-B (17 CFR 228.306); see generally, Release No. 34-
42266 (Dec. 22, 1999) (64 FR 73389). These disclosure requirements 
are discussed supra, in section II.C. of this release.
    \138\ Item 4 of form 8-K, 17 CFR 249.308 and item 304 of 
Regulation S-K, 17 CFR 229.304, which require disclosure of 
``whether the decision to change accountants was recommended or 
approved by: (A) Any audit or similar committee of the board of 
directors, if the issuer has such a committee; or (B) the board of 
directors, if the issuer has no such committee'' and ``whether any 
audit or similar committee of the board of directors, or the board 
of directors, discussed the subject matter of each of such 
disagreements with the former accountant* * *.'' Item 
304(a)(1)(iii)(A), (iii)(B), and (iv)(B). 17 CFR 
229.304(a)(1)(iii)(A), (iii)(B) and (iv)(B). For small business 
issuers, item 304(a)(1)(iii) of Regulation S-B, 17 CFR 
228.304(a)(1)(iii) requires disclosure of ``whether the decision to 
change accountants was recommended or approved by the board of 
directors or an audit or similar committee of the board of 
directors.''
    \139\ See, e.g., American Institute of Certified Public 
Accountants (``AICPA''), ``Communications With Audit Committees,'' 
Statements on Auditing Standards No. (``SAS'') 61, as amended by SAS 
89 and 90; AICPA, Codification of Statements on Auditing Standards 
(``AU'') Sec.  380; Independence Standards Board, ``Independence 
Discussions with Audit Committees,'' Independence Standard No. 1 
(Jan. 1999).
---------------------------------------------------------------------------


    (c) Rotation of Partners on the Audit Engagement. Under the 
proposed rules, no partner would serve on an audit engagement team for 
more than five years.\140\ Current professional requirements state that 
the partner in charge of an audit engagement should be replaced at 
least once every seven years.\141\ The proposals, therefore, would 
require more partners to be rotated and the engagement partner to be 
rotated more often.
---------------------------------------------------------------------------


    \140\ See generally, section 203 of the Sarbanes-Oxley Act.
    \141\ See American Institute of Certified Public Accountants, 
SEC Practice Section, Requirements of Members, at item e. The 
membership requirements are available online at http://www.aicpa.org/members/div/secps/require.htm
.
---------------------------------------------------------------------------


    Costs associated with the periodic replacement of partners might 
include more frequent company-specific training, conducted by both the 
accounting firm and the company, as new partners join the team auditing 
that company's financial statements. For example, the new partners 
would need to learn the company's accounting and financial reporting 
procedures, controls and personnel. The proposed rules also might 
result in incremental costs related to some partners being required to 
relocate from one part of the country to another.
    The costs related to these proposed rules would vary based on the 
proximity of an accounting firm's audit clients, the concentration of 
the firm's practice within an industry, and the availability of 
partners to whom the work may be redistributed, and similar factors.
    Smaller firms that do not have sufficient partners to replace the 
partners on an audit engagement team may be particularly affected by 
the proposed rules in that they would have to accept more partners into 
the firm or lose the audit engagement.
    It is difficult to calculate the costs associated with this portion 
of the proposed rules. However, it is likely that these costs may be 
passed on to issuers in the form of higher audit fees. As noted below, 
we request comments on the anticipated costs associated with all 
aspects of the proposed rules.
    (d) One-Year Cooling Off Period. The proposed rules would indicate 
that an accounting firm is not independent with respect to an audit 
client if a former partner, principal, shareholder, or professional 
employee of an accounting firm is in a ``financial reporting oversight 
role'' at that client, unless the individual had not been a member of 
the audit engagement team for that client's financial statements during 
the one year period preceding the initiation of the audit.\142\ A 
``financial reporting oversight role'' is a role in which a person is 
in a position to or does influence the contents of financial statements 
or anyone who prepares them.\143\ Such persons would include directors, 
chief executive officers, chief financial officers, chief accounting 
officers, controllers, and others.\144\
---------------------------------------------------------------------------


    \142\ See section 206 of the Sarbanes-Oxley Act.
    \143\ See 17 CFR 210.2-01(f)(3) and proposed rule 2-01(f)(3)(B).
    \144\ Id.
---------------------------------------------------------------------------


    Currently, when a former professional employee of an accounting 
firm joins an audit client within one year of leaving the firm, and the 
individual has significant interaction with the accounting firm's audit 
engagement team, professional standards require the accounting firm to 
perform procedures to assure that the individual's knowledge of, or 
relationships with, the accounting firm do not adversely influence the 
quality of the audit.\145\ These procedures include modifying the audit 
plan to adjust for the risk that the individual would be able to 
circumvent key aspects of the audit, and assuring that the people on 
the audit engagement team have the stature and objectivity not to be 
influenced by their former partner or co-employee and to be have the 
appropriate level of skepticism when evaluating the individual's 
representations and views. Because the proposed rules would limit the 
situations in which this situation could occur, accounting firms and 
audit


[[Page 76807]]


clients would not have to pay for the performance of these procedures.
---------------------------------------------------------------------------


    \145\ Independence Standards Board, ``Independence Standard No. 
3: Employment with Audit Clients'' (July 2000).
---------------------------------------------------------------------------


    Costs might occur, however, from the company being required to 
delay the hiring, or not being able to hire, the individual that it 
believes is the most qualified person to perform a ``financial 
reporting oversight role'' at the company. This may add to recruitment 
costs or less efficient operations. Such costs are difficult to 
estimate and would vary from one company to another.
    (e) Compensation. The proposed rules would provide that an auditor 
is not independent with respect to an audit client if a partner, 
principal or shareholder of an accounting firm, who is a member of the 
audit engagement team conducting an audit of that client's financial 
statements, earns or receives compensation based on the performance of, 
or in consideration of procuring, engagements to provide any services 
to that client other than audit, review, or attest services. This 
provision might affect the compensation plans of those firms that 
currently reward partners, principals, and shareholders of the firm for 
generating sales of non-audit services to their respective audit 
clients. If the proposed rules were adopted, those revenues would be 
allocated to other persons within the accounting firm. Absent this 
incentive, auditors may be less inclined to inform issuers of ways to 
improve their performance or condition through non-audit services. We 
do not expect, however, that there would be any incremental costs to 
the firm or to the client.
2. Auditor Reports to Audit Committees
    Under the proposed rules, each public accounting firm registered 
with the Public Company Accounting Oversight Board that audits an 
issuer's financial statements must report to the issuer's audit 
committee (1) all critical accounting policies and practices used by 
the issuer, (2) alternative accounting treatments within GAAP that have 
been discussed with management, including the ramifications of the use 
of the alternative treatments and the treatment preferred by the 
accounting firm, and (3) other material written communications between 
the accounting firm and management of the issuer such as any management 
letter or schedule of ``unadjusted differences.'' \146\ The required 
reports need not be in writing but the report would be required to be 
presented to the audit committee before the auditor's report is filed 
with the Commission.
---------------------------------------------------------------------------


    \146\ See section 204 of the Sarbanes-Oxley Act.
---------------------------------------------------------------------------


    Because of existing GAAS and legal provisions,\147\ we believe that 
adoption of the proposed rules regarding auditor reports to audit 
committees will not significantly increase costs for accounting firms 
or registrants. Any such costs may arise from the timing of the 
communications, which, under the proposed rules, must occur before the 
auditor's report is filed with the Commission.
---------------------------------------------------------------------------


    \147\ See item 303 of Regulation S-K, 17 CFR 229.303; Release 
No. 33-8040 (Dec. 12, 2001); and SAS 61, AU Sec.  380, 
``Communication with Audit Committees or Others with Equivalent 
Authority and Responsibility.''
---------------------------------------------------------------------------


3. Enhanced Disclosures About the Services Provided by Auditors to 
Registrants
    The existing proxy disclosure rules require disclosure of all 
professional fees billed by the principal auditor in the last fiscal 
year, with the fees broken down into three categories: audit fees, 
financial information systems design and implementation fees, and all 
other fees. The proposals would divide the disclosure into two more 
categories--tax fees and audit-related fees--and add disclosure of one 
more year of these fees while eliminating separate disclosure of fees 
related to financial information systems design and implementation. The 
proposals also would require companies that do not file proxy 
statements to file this information with the Commission in their annual 
reports on forms 10-K and 10-KSB, foreign private issuers to file the 
information on form 20-F, certain Canadian issuers to file the 
information on form 40-F, and registered management investment 
companies to file the information on proposed form N-CSR.\148\
---------------------------------------------------------------------------


    \148\ Form 10-K is the annual report that registrants file with 
the Commission pursuant to section 13 or 15(d) of the Exchange Act, 
if no other annual reporting form has been prescribed. Small 
business issuers may use abbreviated form 10-KSB. A ``small business 
issuer'' is an entity that (1) has revenues of less than 
$25,000,000, (2) is a U.S. or Canadian issuer, (3) is not an 
investment company, and (4) if a majority owned subsidiary, the 
parent corporation is also a small business issuer. An entity is not 
a ``small business issuer,'' however, if the aggregate market value 
of its outstanding voting and non-voting common stock held by non-
affiliates is $25,000,000 or more. See 17 CFR 240.12b-2. Registered 
management investment companies would use proposed form N-CSR to 
file certified shareholder reports with the Commission under the 
Sarbanes-Oxley Act of 2002. See Investment Company Act Release No. 
25723 (Aug. 30, 2002) (67 FR 57298 (Sept. 9, 2002)).
---------------------------------------------------------------------------


    Registrants also would be required to disclose the audit 
committee's policies and procedures for approval of auditor 
engagements, and the percentage of fees in each of the four categories 
noted above (audit, audit-related, tax, and all other) that were pre-
approved by the audit committee during each of the last two fiscal 
years.
    Based on the staff's experience, we believe that the additional 
disclosure contemplated by the proposed rules would require, on 
average, approximately one-half of a page in a company's proxy 
statement or annual report. A financial printing company informed the 
staff that adding one-half of a page in the proxy statement would not 
be likely to increase the printing cost to the company because that 
much more text normally can be incorporated without increasing the page 
length by reformatting the document.\149\ Accordingly, based on our 
preliminary estimates, there should be little, if any, additional 
printing costs from these additional disclosures.
---------------------------------------------------------------------------


    \149\ See Release No. 34-41987 (Oct. 7, 1999) (64 FR 55648, at 
55658).
---------------------------------------------------------------------------


    For the purposes of the Paperwork Reduction Act, we have estimated 
that the incremental disclosure of fees, the disclosure of the audit 
committees policies and procedures for approval of audit engagements, 
and the percentage of fees pre-approved by the audit committee would 
impose, on average, two additional burden hours for each of the 7,661 
filers of schedule 14A, or an aggregate annual burden of 15,322 
additional burden hours. We estimate that most of this time would 
relate to consideration and review of the disclosures of the audit 
committee's policies and procedures. We further estimate that 
approximately 75% of the extra burden hours, or approximately 11,492 
hours, would be expended by internal staff and the remaining 25%, or 
3,830 hours, would be for outside legal costs associated with reviewing 
the proposed disclosures. Assuming that the internal staff costs the 
company an average of $125 per hour,\150\ the aggregate annual cost for 
internal staff assistance would be approximately $1,436,500. If we 
assume that outside legal costs would be an average of $300 per hour, 
the aggregate annual legal costs would be $1,149,000. The total annual 
paperwork costs associated with the proposed disclosures, therefore, 
would be approximately $2,585,500. Similarly, we estimated that the 464 
filers of schedule 14C would incur an additional annual burden of 928 
hours, or which 696 hours would be imposed on the company itself and 
232 would represent a cost for outside legal assistance. Based on these 
numbers, we estimate that the annual internal cost would be $87,000 
(696 hours x $125 per


[[Page 76808]]


hour) and the annual external cost would be $69,600 (232 hours x $300 
per hour), for a total annual cost of $156,600.
---------------------------------------------------------------------------


    \150\ This cost estimate is based on data obtained from The SIA 
Report on Management and Professional Earnings in the Securities 
Industry (Oct. 2001).
---------------------------------------------------------------------------


    For those registrants who would be providing the information on 
form 10-K, we estimated for the purposes of the Paperwork Reduction Act 
that the incremental disclosure of fees, the audit committee's policies 
and procedures for approval of audit engagements, and the percentage of 
fees pre-approved by the audit committee, would impose, on average, two 
additional burden hours per year on each of the 8,484 filers of form 
10-K.\151\ Six thousand six hundred and seventy-six (6,676) of those 
filers, however, would provide the information under schedule 14A and 
209 of those filers would provide the information under schedule 14C. 
The burden hours for the disclosure by these filers therefore has been 
assigned to schedule 14A and schedule 14C, respectively. The burden 
imposed on the remaining 1,599 filers is being assigned to form 10-K. 
This results in 3,198 (2 hours x 1,599 filers) additional burden hours. 
We estimate that most of this time would relate to consideration and 
review of the disclosures of the audit committee's policies and 
procedures. We further estimate that approximately 75% of the extra 
burden hours, or approximately 2,399 hours, would be expended by 
internal staff and the remaining 25%, or 799 hours, would be for 
outside legal costs associated with reviewing the proposed disclosures. 
Assuming a cost of $125 per hour for internal costs results in 
aggregate internal costs of $299,875. Assuming that outside legal costs 
would be an average of $300 per hour, the aggregate annual legal costs 
would be $239,700. The total annual paperwork costs associated with the 
proposed disclosures, therefore, would be approximately $539,575.
---------------------------------------------------------------------------


    \151\ As noted previously, the proposed rules also would amend 
forms 20-F and 40-F. However, because the number of registrants 
which use these forms is very small, it is not expected to have a 
significant burden increase.
---------------------------------------------------------------------------


    For smaller companies that file forms 10-KSB \152\ we estimated for 
the purposes of the Paperwork Reduction Act that the incremental 
disclosure of fees, the audit committee's policies and procedures for 
approval of audit engagements, and the percentage of fees pre-approved 
by the audit committee, would impose, on average, two additional burden 
hours per year on each of the 2,590 filers of form 10-KSB that do not 
file either schedule 14A or schedule 14C, or 5,180 additional burden 
hours. We estimate that most of this time would relate to consideration 
and review of the disclosures of the audit committee's policies and 
procedures. We further estimate that internal staff would expend 
approximately 75% of the extra burden hours, or approximately 3,885 
hours. Assuming a cost $125 per hour for internal staff, the aggregate 
internal costs would be approximately $485,625. The remaining 25%, or 
1,295 hours, would be for outside legal costs associated with reviewing 
the proposed disclosures. Assuming that outside legal costs would be an 
average of $300 per hour, the aggregate annual legal costs would be 
$388,500. The total annual paperwork costs associated with the proposed 
disclosures, therefore, would be approximately $874,125.
---------------------------------------------------------------------------


    \152\ 17 CFR 240.12b-2.
---------------------------------------------------------------------------


    Using a similar analysis, we estimated an increase of 2,388 burden 
hours and $537,300 in annual legal costs (2,388 x .75 x $300) for form 
20-F. This produces an estimate of $298,500 (2,388 hours x $125 per 
hour) for internal costs, or a total cost of $835,800 ($537,300 + 
$298,500) for such filers. For form 40-F filers, we estimated an 
increase of 268 burden hours and $60,300 in annual legal costs (200 x 
.25 x $300). This produces an estimate of $33,500 (268 hours x $125 per 
hour) for internal costs, or a total cost of $93,800 ($60,300 + 
$33,500).
    Proposed form N-CSR. We issued a release proposing form N-CSR on 
August 30, 2002, pursuant to section 30 of the Investment Company Act 
(15 U.S.C. 80a-29) and sections 13 and 15(d) of the Exchange Act (15 
U.S.C. 78m and 78o(d)). For registered management investment companies 
that would be providing the information on proposed form N-CSR, we 
estimate that the incremental disclosure of fees, the audit committee's 
policies and procedures for approval of audit engagements, and the 
percentage of fees pre-approved by the audit committee, would impose, 
on average, two additional burden hours per year on each of the 
estimated 3,700 filers of proposed form N-CSR. This results in 7,400 (2 
hours x 3,700 filers) additional burden hours. We estimate that most of 
this time would relate to consideration and review of the disclosures 
of the audit committee's policies and procedures. We further estimate 
that approximately 75% of the extra burden hours, or approximately 
5,550 hours, would be expended by internal staff and the remaining 25%, 
or 1,850 hours, would be for outside legal costs associated with 
reviewing the proposed disclosures. We estimate a cost of $40 per hour 
for internal staff review, resulting in aggregate internal costs of 
$222,000. Further, we estimate that outside legal costs would be an 
average of $300 per hour, resulting in aggregate annual legal costs of 
$555,000. The total annual paperwork costs associated with the proposed 
disclosures, therefore, would be approximately $1,004,550.


D. Request for Comments


    As noted above, we request comments on all aspects of this cost-
benefit analysis, including the identification of any additional costs 
or benefits. We encourage commenters to identify and supply relevant 
data concerning the costs or benefits of the proposed amendments. We 
request comments, including supporting data, on the magnitude of the 
costs and benefits mentioned in this section.
    [sbull] Are there any other costs or benefits that we have not 
identified? For example, would the additional duties on audit 
committees increase the cost of maintaining those committees? Would the 
amount of compensation demanded by audit committee members increase? 
Would there be a shortage of potential audit committee members that 
would lead to higher costs related to finding and retaining such 
members? Would the cost of officer/director liability insurance 
increase? Please describe any such costs and provide relevant data.
    [sbull] Are there additional costs related to the proposed 
disclosures? If there are, please identify them and provide supporting 
data.
    [sbull] We request comments on the reasonableness of the burden 
hour, cost estimates, and underlying assumptions related to the 
proposed disclosures.
    [sbull] Will the prohibition of certain non-audit services impose 
greater costs on companies? If so, what will those costs be and how 
significant will those costs be?
    [sbull] How much cost will issuers incur from not being able to 
retain their preferred providers of non-audit service, when that 
preferred provider happens to also be their auditor?
    [sbull] What will be the impact, if any, on audit fees from the 
proposal to prohibit certain non-audit services?
    [sbull] Are there any economies of scope that will be lost due to 
implementation of the auditor independence rules?
    [sbull] Are there any economies of scale that will be lost due to 
implementation of the auditor independence rules?


VI. Consideration of Impact on the Economy, Burden on Competition, and 
Promotion of Efficiency, Competition, and Capital Formation


    For purposes of the Small Business Regulatory Enforcement Fairness 
Act of


[[Page 76809]]


1996,\153\ the Commission is requesting information regarding the 
potential impact of the proposals on the economy on an annual basis. 
Commentators should provide empirical data to support their views.
---------------------------------------------------------------------------


    \153\ Pub. L. 104-121, tit. II, 110 Stat. 857 (1996).
---------------------------------------------------------------------------


    Section 23(a)(2) of the Exchange Act \154\ requires the Commission, 
when adopting rules under the Exchange Act, to consider the anti-
competitive effects of any rule it adopts. In this regard, we note that 
it may be possible that some small accounting firms would not have 
professionals, other than those working on the audit of a client's 
financial statements, with the expertise to provide non-audit services 
to that client. Because, under the proposed rules, receipt of fees by 
that professional from the provision of non-audit services would impair 
the auditor's independence, the accounting firm might not be in a 
position to provide non-audit services to that client. This proposal, 
therefore, could result in some companies seeking new providers of non-
audit services. In addition, some companies that engage accounting 
firms for non-audit services permitted under the current rules, but not 
allowed under the Sarbanes-Oxley Act and the proposed rules, would be 
required to switch vendors for those services. This may have an impact 
on competition for those services, although to the extent the new 
vendor is another accounting firm, the result may a redistribution of 
services among firms rather than an increase or decrease in services. 
Small accounting firms also may be disadvantaged by the prohibition on 
partners providing auditing services to the issuer for more than five 
consecutive years, since they may not have other partners available to 
retain the client.
---------------------------------------------------------------------------


    \154\ 15 U.S.C 78w(a)(2).
---------------------------------------------------------------------------


    [sbull] Given that only larger clients have more than two partners 
as part of the audit process, would this provision impose higher costs 
on mid-tier firms?
    In addition, section 2(b) of the Securities Act of 1933,\155\ 
section 3(f) of the Exchange Act,\156\ and section 2(c) of the 
Investment Company Act \157\ require the Commission, when engaging in 
rulemaking that requires it to consider or determine whether an action 
is necessary or appropriate in the public interest, to consider whether 
the action will promote efficiency, competition, and capital formation.
---------------------------------------------------------------------------


    \155\ 15 U.S.C. 77b(b).
    \156\ 15 U.S.C. 78c(f).
    \157\ 15 U.S.C. 80a-2(c).
---------------------------------------------------------------------------


    One possible adverse impact on capital formation may come from 
additional costs related to audit committees. Although the proposed 
rules do not require companies to have audit committees, many companies 
may choose to establish such committees to facilitate application of 
the rules. Additional costs may be associated with forming such 
committees and, if necessary, recruiting and retaining independent 
directors to serve on those committees.
    We believe, however, that investors need to have confidence in the 
independence of auditors and in the integrity of the financial 
information that fuels our securities markets. The proposals are 
designed to bolster investor confidence in the securities markets by 
strengthening auditor independence, improving the transparency of the 
role of corporate audit committees, and enhancing the reliability and 
credibility of financial statements of public companies. Accordingly, 
on the whole, the proposals should promote capital formation and market 
efficiency.
    [sbull] We request comment on the anti-competitive effects of the 
proposals.
    [sbull] The possible effects of our rule proposals on efficiency, 
competition, and capital formation are difficult to quantify. We 
request comment on these matters in connection with our proposed rules.


VII. Initial Regulatory Flexibility Act Analysis


    This Initial Regulatory Flexibility Act Analysis has been prepared 
in accordance with 5 U.S.C. 603. It relates to proposed revisions to 
Regulation S-X and to item 9 of schedule 14A, and to forms 10-K, 10-
KSB, 20-F, 40-F and proposed form N-CSR. The proposals would strengthen 
the Commission's requirements regarding the independence of auditors 
and related disclosures.


A. Reasons for the Proposed Action


    The proposed rules generally implement a congressional mandate. 
Some of the proposals, although not specifically required by the 
statute, are designed to implement the intent of the Sarbanes-Oxley Act 
and to assure investors that independent auditors critically are 
examining reported financial information. The proposed rules should 
provide greater assurance to investors that independent auditors are 
performing their public responsibilities and that the financial 
information published by registrants and issuers is reliable.
    The proposed rules, in general, would:
    [sbull] Revise the Commission's regulations related to the non-
audit services that, if provided to an audit client, would impair an 
accounting firm's independence;\158\
---------------------------------------------------------------------------


    \158\ See section 201 of the Sarbanes-Oxley Act.
---------------------------------------------------------------------------


    [sbull] Require that an issuer's audit committee pre-approve all 
audit and non-audit services provided to the issuer by the auditor of 
an issuer's financial statements;\159\
---------------------------------------------------------------------------


    \159\ See section 202 of the Sarbanes-Oxley Act.
---------------------------------------------------------------------------


    [sbull] Prohibit any partner on the audit engagement team from 
providing audit services to the issuer for more than five consecutive 
years;\160\
---------------------------------------------------------------------------


    \160\ See section 203 of the Sarbanes-Oxley Act.
---------------------------------------------------------------------------


    [sbull] Prohibit an accounting firm from auditing an issuer's 
financial statements if certain members of management of that issuer 
had been members of the accounting firm's audit engagement team within 
the one-year period preceding the commencement of audit 
procedures;\161\
---------------------------------------------------------------------------


    \161\ See section 206 of the Sarbanes-Oxley Act.
---------------------------------------------------------------------------


    [sbull] Require that the auditor of an issuer's financial 
statements report certain matters to the issuer's audit committee, 
including ``critical'' accounting policies used by the issuer;\162\ and
---------------------------------------------------------------------------


    \162\ See section 204 of the Sarbanes-Oxley Act.
---------------------------------------------------------------------------


    [sbull] Require disclosures to investors of information related to 
the audit and non-audit services provided by, and fees paid by the 
issuer to, the auditor of the issuer's financial statements.\163\
---------------------------------------------------------------------------


    \163\ See generally, section 202 of the Sarbanes-Oxley Act; 
section 10A(i)(2) of the Exchange Act, 15 U.S.C. 78j-1(i)(2).
---------------------------------------------------------------------------


    In addition, under the proposed rules, an accountant would not be 
independent from an audit client if any partner, principal or 
shareholder of the accounting firm who is a member of the engagement 
team received compensation based on any service provided or sold to 
that client other than audit, review and attest services.


B. Objectives


    Our objectives are to implement title II of the Sarbanes-Oxley Act 
in order to increase investor confidence in the independence of 
auditors, in the audit process, and in the reliability of reported 
financial information.\164\ This would be accomplished by having: (1) 
Clearer auditor independence regulations that would provide investors 
with comfort that auditors are placing the interests of investors over 
financial or personal incentives, (2) rules mandating that auditors 
communicate certain matters to audit committees, which should enhance 
the opportunities for meaningful audit committee oversight of the 
financial reporting process, and (3) enhanced disclosure of


[[Page 76810]]


the non-audit services provided by, and fees paid to, the accounting 
firm that audits and reviews the company's financial statements, and 
from better disclosure of the audit committee's role in approving the 
provision of non-audit services by the accounting firm that audits the 
company's financial statements. We believe that these factors may 
improve the efficiency of the markets and result in a lower cost of 
capital.
---------------------------------------------------------------------------


    \164\ See section 208 of the Sarbanes-Oxley Act.
---------------------------------------------------------------------------


C. Legal Basis


    We are proposing amendments to Regulation S-X and item 9 of 
schedule 14A and to forms 10-K, 10-KSB, 20-F, 40-F and proposed form N-
CSR under the authority set forth in sections 3(a) and 208 of the 
Sarbanes-Oxley Act; schedule A and sections 7, 8, 10, 19 and 28 of the 
Securities Act, sections 3, 10A, 12, 13, 14, 17, 23 and 36 of the 
Exchange Act, sections 5, 10, 14 and 20 of the Public Utility Holding 
Company Act of 1935, sections 8, 30, 31 and 38 of the Investment 
Company Act of 1940, and sections 203 and 211 of the Investment 
Advisers Act of 1940.


D. Small Entities Subject to the Proposed Rules


    The proposals would affect small registrants and small accounting 
firms that are small entities. Exchange Act rule 0-10(a) \165\ and 
Securities Act rule 157 \166\ define a company to be a ``small 
business'' or ``small organization'' if it had total assets of $5 
million or less on the last day of its most recent fiscal year. We 
estimate that approximately 2,500 companies were small entities, other 
than investment companies.
---------------------------------------------------------------------------


    \165\ 17 CFR 240.0-10(a).
    \166\ 17 CFR 230.157.
---------------------------------------------------------------------------


    For purposes of the Investment Company Act, rule 0-10 \167\ defines 
``small business'' to be an investment company with net assets of $50 
million or less as of the end of its most recent fiscal year. We 
estimate that approximately 225 investment companies met this 
definition.
---------------------------------------------------------------------------


    \167\ 17 CFR 270.0-10.
---------------------------------------------------------------------------


    Our rules do not define ``small business'' or ``small 
organization'' for purposes of accounting firms. The Small Business 
Administration defines small business, for purposes of accounting 
firms, as those with under $6 million in annual revenues.\168\ We have 
only limited data indicating revenues for accounting firms, and we 
cannot estimate the number of firms with less than $6 million in 
revenues that practice before the Commission. We request comment on the 
number of accounting firms with revenue under $6 million.
---------------------------------------------------------------------------


    \168\ 13 CFR 121.201.
---------------------------------------------------------------------------


E. Reporting, Recordkeeping and Other Compliance Requirements


1. Auditor Independence
    The vast majority of registrants are audited by one of the four 
largest accounting firms, which clearly are not small entities. 
Nonetheless, changes in the auditor independence regulations may impose 
compliance requirements, recordkeeping and reporting requirements on 
small accounting firms and on any small registrant that engages, or 
would like to consider engaging, the auditor of an issuer's financial 
statements to perform non-audit services.
    (a) Non-audit services. The current auditor independence rules 
state that the performance of certain non-audit services will impair an 
auditor's independence. The proposed rules, in some cases, would 
redefine the limits of those services and would add one more item, 
``expert services,'' to the list of prohibited services. These changes 
could impact the competitive markets for these services. In particular, 
the Commission is considering withdrawing the specific exemption in the 
current rules that allows audit clients with less than $200 million in 
total assets to engage the auditors of their financial statements to 
perform internal audit services.\169\ Under the proposed rules, small 
issuers also would be precluded from engaging auditors to perform 
certain services in the categories of financial systems design and 
implementation services, appraisal and valuation services, actuarial 
services, and others, that may be performed under the current rules. 
Small registrants, therefore, may have to use a separate vendor for 
such services. Small accounting firms may lose one or more sources of 
revenue if the proposed rules are adopted because they would no longer 
be able to sell certain non-audit services to their audit clients.
---------------------------------------------------------------------------


    \169\ 17 CFR 210.2-01(c)(4)(v)(A).
---------------------------------------------------------------------------


    According to the information available to the staff in 2000, 
however, approximately 12,600 registrants did not purchase any 
consulting services from the auditor of their financial statements, and 
4,100 registrants reported purchasing such services.\170\ Based on the 
attention that has been drawn to this area over the past year, the 
Commission staff believes that the number of small registrants 
purchasing non-audit services from their auditor, and the amount of 
small accounting firms providing services to audit clients that are 
Commission registrants, might have decreased significantly. Also, to 
the extent non-audit services are merely redistributed among the firms, 
there would be no net loss of revenue to public accounting firms as a 
whole.
---------------------------------------------------------------------------


    \170\ Id.; 65 FR at 43185.
---------------------------------------------------------------------------


    (b) Audit Committee Pre-approval of Services. Under the proposed 
rules, all auditing and non-audit services to be provided by the 
auditor of an issuer's financial statements must be pre-approved by the 
issuer's audit committee.\171\ The definition of audit committee in the 
Sarbanes-Oxley Act, which is cited in the proposed rules, however, 
indicates that if no such committee exists, the entire board of 
directors of the issuer may perform this function.\172\ The rules, 
therefore, would not require a small company to form an audit 
committee.
---------------------------------------------------------------------------


    \171\ Section 301 of the Sarbanes-Oxley Act of 2002 requires the 
Commission to direct the national securities exchanges and national 
securities associations to prohibit the listing of any security of 
an issuer that does not meet certain criteria, including having an 
audit committee that performs certain functions. See section 10A(m) 
of the Exchange Act, 15 U.S.C. 78j-1(m). The Sarbanes-Oxley Act 
defines ``audit committee'' to be ``(A) a committee (or equivalent 
body) established by and amongst the board of directors of an issuer 
for the purpose of overseeing the accounting and financial reporting 
processes of the issuer and audits of the financial statements of 
the issuer; and (B) if no such committee exists with respect to an 
issuer, the entire board of directors of the issuer.'' Section 
205(a) of the Sarbanes-Oxley Act, which, among other things, adds 
section 3(a)(58) to the Exchange Act.
    \172\ Id.
---------------------------------------------------------------------------


    There are reasons to believe that many small entities currently 
have audit committees.\173\ Any small entity that does not have such a 
committee and would form one to facilitate operation of the proposed 
rules, however, would incur costs to establish such a committee and, if 
necessary, to recruit and retain the required number of independent 
directors. Small entities also might spend time and incur costs to 
document the audit committee's activities in the areas covered by the 
proposed rules, including drafting and maintaining the audit 
committee's policies and procedures related to engaging the auditor to 
perform non-audit services. Small entities also might incur costs in 
seeking the help of outside experts, particularly outside legal 
counsel, in drafting the audit committee's policies and procedures.
---------------------------------------------------------------------------


    \173\ See, e.g., NACD, 2001-2002 Public Company Governance 
Survey (Nov. 2001).
---------------------------------------------------------------------------


    (c) Rotation of Partners on the Audit Engagement. Under the 
proposed rules, no partner would serve on an audit engagement team for 
more than five


[[Page 76811]]


years.\174\ Current professional requirements state that the partner in 
charge of an audit engagement should be replaced at least once every 
seven years.\175\ The proposals, therefore, would require more partners 
to be rotated and the engagement partner to be rotated more often.
---------------------------------------------------------------------------


    \174\ See generally, section 203 of the Sarbanes-Oxley Act.
    \175\ See American Institute of Certified Public Accountants, 
SEC Practice Section, Requirements of Members, at item e. The 
membership requirements are available online at http://www.aicpa.org/members/div/secps/require.htm
.
---------------------------------------------------------------------------


    Costs associated with the periodic replacement of partners might 
include more frequent company-specific training because new partners 
joining the audit engagement team would need to learn the company's 
accounting and financial reporting procedures, controls and personnel. 
The proposed rules also might result in incremental costs related to 
some partners being required to relocate from one part of the country 
to another.
    Smaller firms that do not have sufficient partners to make the 
required replacements of the partners on an audit engagement team may 
be particularly affected by the proposed rules. These small accounting 
firms might have to accept more qualified partners into the firm or 
lose the audit engagement.
    (d) One-Year Cooling Off Period. The proposed rules would deem an 
accounting firm as not independent with respect to an audit client if a 
former partner, principal, shareholder, or professional employee of an 
accounting firm is in a ``financial reporting oversight role'' at that 
client, unless the individual had not been a member of the audit 
engagement team for that client's financial statements during the one 
year period preceding the initiation of the audit.\176\ A ``financial 
reporting oversight role'' is a role in which a person is in a position 
to or does influence the contents of financial statements or anyone who 
prepares them.\177\ Such persons would include directors, chief 
executive officers, chief financial officers, chief accounting 
officers, controllers, and others.\178\ A small registrant might incur 
costs from a delay in hiring, or not being able to hire, the individual 
that it believes is the most qualified person to perform a ``financial 
reporting oversight role'' at the company. This may add to recruitment 
costs or less efficient operations. We have solicited comment and are 
considering alternatives to minimize the impact of this proposed rule 
on small entities.
---------------------------------------------------------------------------


    \176\ See section 206 of the Sarbanes-Oxley Act.
    \177\ See 17 CFR 210.2-01(f)(3) and proposed rule 2-01(f)(3)(B).
    \178\ Id.
---------------------------------------------------------------------------


    (e) Compensation. Under the proposed rules, an accounting firm's 
independence would be impaired if any partner, principal or shareholder 
of the firm, who is a member of an engagement team auditing a client's 
financial statements, receives any compensation directly based on any 
service provided or sold to that client other than audit, review and 
attest services. Thus, accounting firms would have to discontinue 
compensating these individuals for ``cross-selling'' services.
    Some small accounting firms might have a relatively small number of 
partners, principals or shareholders of the firm available to serve 
each client. Such firms might not have personnel, other than the 
partner in charge of the audit of a small company's financial 
statements, with sufficient expertise to market and provide non-audit 
services to that company. In such cases, the proposed rule might result 
in a small company being forced to find another provider for those 
services. This might result in increased costs related to small 
entities locating and engaging additional service providers, and might 
decrease revenues to small accounting firms.
2. Auditor Reports to Audit Committees
    Under the proposed rules, each public accounting firm registered 
with the Public Company Accounting Oversight Board that audits an 
issuer's financial statements must report to the issuer's audit 
committee (1) all critical accounting policies and practices used by 
the issuer, (2) alternative accounting treatments within GAAP that have 
been discussed with management, including the ramifications of the use 
of the alternative treatments and the treatment preferred by the 
accounting firm, and (3) other material written communications between 
the accounting firm and management of the issuer such as any management 
letter or schedule of ``unadjusted differences.'' \179\ The required 
reports need not be in writing, but must be provided to the audit 
committee before the auditor's report on the financial statements if 
filed with the Commission.
---------------------------------------------------------------------------


    \179\ See section 204 of the Sarbanes-Oxley Act.
---------------------------------------------------------------------------


    Auditing standards currently require discussions between the 
auditors and the audit committee of significant unusual, controversial, 
or emerging accounting policies, of the process used by management to 
select certain estimates, and of disagreements over certain accounting 
matters. Further, audit committees generally are aware of management's 
letter making representations to the auditors, which the auditor uses 
in conducting the audit of the issuer's financial statements, and the 
auditors' letters to management on reportable conditions in internal 
controls and other matters. Also, due to enactment of section 401 of 
the Sarbanes-Oxley Act, all material adjustments identified by the 
auditor should be reflected in the issue's financial statements and, 
therefore, there should be no material ``unadjusted differences.''
    Because of these GAAS and legal provisions, we believe that 
adoption of the proposed rules regarding auditor reports to audit 
committees will not significantly increase costs, including costs for 
small accounting firms and small registrants. Some costs may be 
incurred, however, to the extent communications would be required 
before the auditor's report is filed with the Commission.
3. Enhanced Disclosures About the Services Provided by Auditors to 
Registrants
    Currently, disclosure is required in proxy and information 
statements of the fees billed in the most recent fiscal year under the 
categories of audit fees, information systems design and implementation 
fees, and all other fees. The proposals would require disclosure of the 
fees billed in each of the two most recent years, instead of the 
current requirement for disclosure of only the most recent year's fees. 
The proposals also would add the categories of tax fees and audit-
related fees but eliminate separate disclosure of information systems 
design and implementation form the current list of audit fees, 
information systems design and implementation fees, and all other fees. 
The proposed rules also would require disclosure of the percentage of 
fees in each category that were pre-approved by the audit committee as 
opposed to being entered into under the audit committee's policies and 
procedures. Finally, the proposals would extend the disclosure 
requirements to all entities filing forms 10-K, 10-KSB, 20-F, 40-F and 
proposed form N-CSR.\180\
---------------------------------------------------------------------------


    \180\ Form 10-K is the annual report that registrants file with 
the Commission pursuant to section 13 or 15(d) of the Exchange Act, 
if no other annual reporting form has been prescribed. Small 
business issuers may use abbreviated form 10-KSB. A ``small business 
issuer'' is an entity that (1) has revenues of less than 
$25,000,000, (2) is a U.S. or Canadian issuer, (3) is not an 
investment company, and (4) if a majority owned subsidiary, the 
parent corporation is also a small business issuer. An entity is not 
a ``small business issuer,'' however, if the aggregate market value 
of its outstanding voting and non-voting common stock held by non-
affiliates is $25,000,000 or more. See 17 CFR 240.12b-2. Registered 
management investment companies would use proposed form N-CSR to 
file certified shareholder reports with the Commission under the 
Sarbanes-Oxley Act of 2002. See Investment Company Act Release No. 
25723 (Aug. 30, 2002) (67 FR 57298 (Sept. 9, 2002)).


---------------------------------------------------------------------------


[[Page 76812]]


    The proposed rules would require all entities filing forms 10-K, 
10-KSB, 20-F, 40-F and proposed form N-CSR to include the disclosure 
either in the proxy or information statement or, if the company does 
not issue a proxy or information statement, in forms 10-K, 10-KSB, 20-
F, 40-F or proposed form N-CSR. The proposed rules, therefore, might 
require small entities to spend additional time and incur additional 
costs in preparing disclosures. Small entities also might incur costs 
to set up procedures to monitor the activities of the audit committee 
in order to collect and record the information to be disclosed under 
the proposed rules.


F. Duplicative, Overlapping or Conflicting Federal Rules


    The Commission is not aware of any rules that duplicate, overlap, 
or conflict with the proposed rules.


G. Significant Alternatives


    The Regulatory Flexibility Act directs us to consider significant 
alternatives that would accomplish the stated objective, while 
minimizing any significant adverse impact on small entities. In 
connection with the proposed amendments, we considered the following 
alternatives:
    1. The establishment of differing compliance or reporting 
requirements or timetables that take into account the resources of 
small entities;
    2. The clarification, consolidation, or simplification of 
compliance and reporting requirements under the rule for small 
entities;
    3. The use of performance rather than design standards; and
    4. An exemption from coverage of the proposed amendments, or any 
part thereof, for small entities.
    We do not propose to exempt small business issuers from the 
proposals because Congress indicated that any exemptions should be on a 
case-by-case basis and not by categories. We, nevertheless, are 
considering whether any exception or classifications for small 
businesses would be appropriate and consistent with the Sarbanes-Oxley 
Act. We believe investors in small companies, however, just as 
investors in large companies, would want and benefit from the proposed 
revisions in the auditor independence rules and enhanced communications 
between the auditor and the audit committee.
    The proposed rules are designed to enhance auditors' independence 
and the reliability and credibility of financial statements for all 
public companies. Currently, we do not believe that it is feasible to 
further clarify, consolidate, or simplify the proposed rules for small 
entities. We are particularly mindful of the implications of our 
proposed rules on the provision of bookkeeping and internal controls 
services, as well as auditor rotation and cooling-off period 
requirements for small firms. We invite comments on these and all other 
issues.


H. Solicitation of Comments


    We encourage the submission of comments with respect to any aspect 
of this Initial Regulatory Flexibility Analysis. Specifically, we 
request comments regarding the number of small entities that may be 
affected by the proposed rules, and the existence or nature of the 
potential impact on those small entities. We also seek comments on how 
to quantify the number of small accounting firms that would be affected 
by the proposals, and how to quantify the impact of the proposed rules 
on those firms.
    Commenters are requested to describe the nature of any impact and 
provide empirical data supporting the extent of the impact. Such 
comments will be considered in the preparation of the Final Regulatory 
Flexibility Analysis, if the proposed rules are adopted, and will be 
placed in the same public file as comments on the proposed rules.


VIII. Codification Update


    The Commission proposes to amend the ``Codification of Financial 
Reporting Policies'' announced in Financial Reporting Release No. 1 
(April 15, 1982):
    By amending section 602 to add a new discussion at the end of that 
section under the Financial Reporting Release Number (FR-64) assigned 
to the adopting release and including the text in the adopting release 
that discusses the final rules, which, if the proposals are adopted, 
would be substantially similar to section III of this release.
    The Codification is a separate publication of the Commission. It 
will not be published in the Code of Federal Regulations.


IX. Statutory Bases and Text of Amendments


    We are proposing amendments to rules 2-01 and 2-07 of Regulation S-
X, item 9 of schedule 14A, forms 10-K, 10-KSB, 20-F and 40-F, and 
proposed form N-CSR under the authority set forth in schedule A and 
sections 7, 8, 10, 19 and 28 of the Securities Act, sections 3, 10A, 
12, 13, 14, 17, 23 and 36 of the Exchange Act, sections 5, 10, 14 and 
20 of the Public Utility Holding Company Act of 1935, sections 8, 30, 
31 and 38 of the Investment Company Act of 1940, and sections 203 and 
211 of the Investment Advisers Act of 1940 and sections 3(a) and 208 of 
the Sarbanes-Oxley Act.


List of Subjects


17 CFR Part 210


    Accountants, Accounting.


17 CFR Part 240


    Broker-dealers, Issuers, Securities.


17 CFR Part 249


    Reporting and recordkeeping requirements, Securities.


17 CFR Part 274


    Investment companies, Reporting and recordkeeping requirements, 
Securities.


Text of Proposed Amendments


    In accordance with the foregoing, title 17, chapter II of the Code 
of Federal Regulations is proposed to be amended as follows:


PART 210--FORM AND CONTENT OF AND REQUIREMENTS FOR FINANCIAL 
STATEMENTS, SECURITIES ACT OF 1933, SECURITIES EXCHANGE ACT OF 
1934, PUBLIC UTILITY HOLDING COMPANY ACT OF 1935, INVESTMENT 
COMPANY ACT OF 1940, INVESTMENT ADVISERS ACT OF 1940 AND ENERGY 
POLICY AND CONSERVATION ACT OF 1975


    1. The authority citation for part 210 continues to read as 
follows:


    Authority: 15 U.S.C. 77f, 77g, 77h, 77j, 77s, 77z-2, 77z-3, 
77aa(25), 77aa(26), 78c, 78j-1, 78l, 78m, 78n, 78o(d), 78q, 78u-5, 
78w(a), 78ll, 78mm, 79e(b), 79j(a), 79n, 79t(a), 80a-8, 80a-20, 80a-
29, 80a-30, 80a-37(a), 80b-3, 80b-11 unless otherwise noted.


    2. Section 210.2-01 is amended by:
    a. Revising paragraph (c)(2)(iii);
    b. Revising paragraph (c)(4);
    c. Adding paragraph (c)(6);
    d. Adding paragraph (c)(7);
    e. Adding paragraph (c)(8);
    f. Revising paragraph (f)(1);
    g. Revising paragraph (f)(3); and
    h. Adding paragraph (f)(17).
    The revisions and additions read as follows:




Sec.  210.2-01  Qualifications of accountants.


* * * * *
    (c) * * *
    (2) * * *
    (iii) Employment at audit client of former employee of accounting 
firm.
    (A) A former partner, principal, shareholder, or professional 
employee


[[Page 76813]]


of an accounting firm is in an accounting role or financial reporting 
oversight role at an audit client, unless the individual:
    (1) Does not influence the accounting firm's operations or 
financial policies;
    (2) Has no capital balances in the accounting firm; and
    (3) Has no financial arrangement with the accounting firm other 
than one providing for regular payment of a fixed dollar amount (which 
is not dependent on the revenues, profits, or earnings of the 
accounting firm):
    (i) Pursuant to a fully funded retirement plan, rabbi trust, or, in 
jurisdictions in which a rabbi trust does not exist, a similar vehicle; 
or
    (ii) In the case of a former professional employee who was not a 
partner, principal, or shareholder of the accounting firm and who has 
been disassociated from the accounting firm for more than five years, 
that is immaterial to the former professional employee.
    (B) A former partner, principal, shareholder, or professional 
employee of an accounting firm is in a financial reporting oversight 
role at an audit client, unless the individual:
    (1) Was not a member of the audit engagement team of the audit 
client during the one year period preceding the date that audit 
procedures commenced. Audit procedures are deemed to have commenced at 
the earlier of:
    (i) The date that the accountant commenced the audit for the period 
covered by the financial statements that included the date of the 
initial employment of the audit engagement team member by the audit 
client; or
    (ii) The date that the accountant commenced review procedures for 
the period covered by the financial statements that included the 
initial employment of the audit engagement team member by the audit 
client.
* * * * *
    (4) Non-audit services. An accountant is not independent if, at any 
point during the audit and professional engagement period, the 
accountant provides the following non-audit services to an audit 
client:
    (i) Bookkeeping or other services related to the accounting records 
or financial statements of the audit client. Any service, where it is 
reasonably likely that the results of these services will be subject to 
audit procedures during an audit of the audit client's financial 
statements, including:
    (A) Maintaining or preparing the audit client's accounting records;
    (B) Preparing the audit client's financial statements that are 
filed with the Commission or form the basis of financial statements 
filed with the Commission; or
    (C) Preparing or originating source data underlying the audit 
client's financial statements.
    (ii) Financial information systems design and implementation. (A) 
Directly or indirectly, operating, or supervising the operation of, the 
audit client's information system or managing the audit client's local 
area network.
    (B) 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.
    (iii) 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, where it is reasonably likely that the 
results of these services will be subject to audit procedures during an 
audit of the audit client's financial statements.
    (iv) Actuarial services. Any actuarially-oriented advisory service 
involving the determination of amounts recorded in the financial 
statements and related accounts for the audit client, where it is 
reasonably likely that the results of these services will be subject to 
audit procedures during an audit of the audit client's financial 
statements.
    (v) Internal audit outsourcing services. Any internal audit 
services related to the internal accounting controls, financial 
systems, or financial statements, for an audit client.
    (vi) 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.
    (vii) Human resources. (A) Searching for or seeking out prospective 
candidates for managerial, executive, or director positions;
    (B) Engaging in psychological testing, or other formal testing or 
evaluation programs;
    (C) Undertaking reference checks of prospective candidates for an 
executive or director position;
    (D) 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
    (E) 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).
    (viii) Broker-dealer, investment adviser, or investment banking 
services. Acting as a broker-dealer (registered or unregistered), 
promoter, or underwriter, on behalf of 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.
    (ix) 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.
    (x) Expert services unrelated to the audit. Providing expert 
opinions for an audit client in connection with legal, administrative, 
or regulatory proceedings or acting as an advocate for an audit client 
in such proceedings.
* * * * *
    (6) Partner rotation. An accountant is not independent of an audit 
client that is:
    (i) An issuer as defined in section 10A(f) of the Securities 
Exchange Act of 1934 (15 U.S.C. 78j-1(f)) when an audit engagement team 
partner, principal or shareholder performs audit, review or attest 
services for that issuer or any significant subsidiaries as defined in 
17 CFR 210.1-02(w), as a partner, principal or shareholder in each of 
the five previous fiscal years of the issuer or any significant 
subsidiaries and continues to serve as a partner, principal or 
shareholder on the audit engagement team. Following five consecutive 
years where audit, review or attest services have not been provided to 
that issuer or any significant subsidiaries by the aforementioned 
partners, principals or shareholders such partners, principals or 
shareholders again may perform audit, review or attest services for the 
audit client.
    (ii) An entity that is part of an investment company complex as 
defined in 17 CFR 210.2-01(f)(14) when any audit engagement team 
partner, principal or shareholder performs audit, review or attest 
services for any entity in the investment company complex, as a 
partner, principal or shareholder in


[[Page 76814]]


each of the five previous fiscal years of the entity and continues to 
serve as a partner, principal or shareholder on the audit engagement 
team. Following five consecutive years where audit, review or attest 
services have not been provided to any entity in the investment company 
complex by the aforementioned partners, principals or shareholders such 
partners, principals or shareholders again may perform audit, review or 
attest services for the audit client.
    (7) Audit committee administration of the engagement. An accountant 
is not independent of an issuer (as defined in section 10A(f) of the 
Securities Exchange Act of 1934 (15 U.S.C. 78j-1(f))), other than an 
issuer that is an Asset-Backed Issuer as defined in Sec.  240.13a-14(g) 
and Sec.  240.15d-14(g) of this chapter, or an investment company 
registered under section 8 of the Investment Company Act of 1940 (15 
U.S.C. 80a-8), other than a unit investment trust as defined by section 
4(2) of the Investment Company Act of 1940 (15 U.S.C. 80a-4(2)), 
unless:
    (i) In connection with audit, review and attest reports required 
under the securities laws, the issuer's or registered investment 
company's audit committee pre-approves all such engagements;
    (ii) For engagements other than those specified in paragraph 
(c)(7)(i) of this section, in accordance with section 10A(i) of the 
Securities Exchange Act of 1934, either:
    (A) Before the accountant is engaged by the issuer or its 
subsidiaries, or the registered investment company or its subsidiaries, 
to render the service, the engagement is approved by the issuer's or 
registered investment company's audit committee; or
    (B) The engagement to render the service is entered into pursuant 
to pre-approval policies and procedures established by the audit 
committee of the issuer or registered investment company, provided the 
audit committee is informed of each service.
    (C) Notwithstanding paragraphs (c)(7)(ii)(A) and (B) of this 
section, the pre-approval requirement is waived with respect to the 
provision of services covered under paragraph (c)(7)(ii) of this 
section provided:
    (1) The aggregate amount of all such services provided constitutes 
no more than five percent of the total amount of revenues paid by the 
audit client to its accountant during the fiscal year in which the 
services are provided;
    (2) Such services were not recognized by the issuer or registered 
investment company at the time of the engagement to be non-audit 
services; and
    (3) Such services are promptly brought to the attention of the 
audit committee of the issuer or registered investment 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;
    (iii) In addition, a registered investment company's audit 
committee pre-approves its accountant's engagements under paragraph 
(c)(7)(ii) of this section with the registered investment company's 
investment adviser (not including a sub-adviser whose role is primarily 
portfolio management and is sub-contracted or overseen by another 
investment adviser) and any entity controlling, controlled by, or under 
common control with the investment adviser that provides services to 
the registered investment company in accordance with paragraphs 
(c)(7)(ii)(A) through (C) of this section, except that with respect to 
paragraph (c)(7)(ii)(C)(1) of this section, the aggregate amount of all 
services provided constitutes no more than five percent of the total 
amount of revenues paid to the registered investment company's 
accountant by the registered investment company, its investment adviser 
and any entity controlling, controlled by, or under common control with 
the investment adviser that provides services to the registered 
investment company during the fiscal year in which the services are 
provided.
    (8) Compensation. An accountant is not independent of an audit 
client if, at any point during the audit and professional engagement 
period, any partner, principal or shareholder who is a member of the 
audit engagement team earns or receives compensation based on the 
performance of, or procuring of, engagements with that audit client to 
provide any products or services other than audit, review or attest 
services.
* * * * *
    (f)(1) Accountant, as used in paragraphs (b) through (e) of this 
section, means a registered public accounting firm, certified public 
accountant or public accountant performing services in connection with 
an engagement for which independence is required. References to the 
accountant include any accounting firm with which the certified public 
accountant or public accountant is affiliated.
* * * * *
    (3)(i) Accounting role means a role in which a person is in a 
position to or does exercise more than minimal influence over the 
contents of the accounting records or anyone who prepares them.
    (ii) Financial reporting oversight role means a role in which a 
person is in a position to or does exercise influence over the contents 
of the financial statements or anyone who prepares them, such as when 
the person is a member of the board of directors or similar management 
or governing body, chief executive officer, president, 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.
* * * * *
    (17) Audit committee means a committee (or equivalent body) as 
defined in section 3(a)(58) of the Securities Exchange Act of 1934 (15 
U.S.C. 78c(a)(58)).
    3. By adding Sec.  210.2-07 to read as follows:




Sec.  210.2-07  Communication with audit committees.


    (a) Each registered public accounting firm that performs for an 
audit client that is an issuer (as defined in section 10A(f) of the 
Securities Exchange Act of 1934 (15 U.S.C. 78j-1(f))), other than an 
issuer that is an Asset-Backed Issuer as defined in Sec.  240.13a-14(g) 
and Sec.  240.15d-14(g) of this chapter, or an investment company 
registered under section 8 of the Investment Company Act of 1940 (15 
U.S.C. 80a-8), other than a unit investment trust as defined by section 
4(2) of the Investment Company Act of 1940 (15 U.S.C. 80a-4(2)), any 
audit required under the securities laws shall report, prior to the 
filing of such audit report with the Commission, to the audit committee 
of the issuer or registered investment company:
    (1) All critical accounting policies and practices to be used;
    (2) All alternative treatments of financial information within 
Generally Accepted Accounting Principles that have been discussed with 
management of the issuer or registered investment company, including:
    (i) Ramifications of the use of such alternative disclosures and 
treatments; and
    (ii) The treatment preferred by the registered public accounting 
firm;
    (3) Other material written communications between the registered 
public accounting firm and the management of the issuer or registered 
investment company, such as any management letter or schedule of 
unadjusted differences.
    (b) [Reserved]


[[Page 76815]]


PART 240--GENERAL RULES AND REGULATIONS, SECURITIES EXCHANGE ACT OF 
1934


    4. The authority citation for part 240 continues to read as 
follows:


    Authority: 15 U.S.C. 77c, 77d, 77g, 77j, 77s, 77z-2, 77z-3, 
77eee, 77ggg, 77nnn, 77sss, 77ttt, 78c, 78d, 78e, 78f, 78g, 78i, 
78j, 78j-1, 78k, 78k-1, 78l, 78m, 78n, 78o, 78p, 78q, 78s, 78u-5, 
78w, 78x, 78ll, 78mm, 79q, 79j, 79n, 79t(a), 80a-8, 80a-20, 80a-29, 
80a-30, 80a-37(a), 80b-4, 80b-11, unless otherwise noted.
* * * * *
    5. Section 240.10A-2 is added to read as follows:




Sec.  240.10A-2  Auditor independence.


    It shall be unlawful for an auditor not to be independent under 
Sec.  210.2-01(c)(2)(iii)(B), 2-01(c)(4), 2-01(c)(6), 2-01(c)(7) and 2-
07.
    6. Section 240.14a-101 is amended by revising paragraph (e) of item 
9 to read as follows:




Sec.  240.14a-101  Schedule 14A. Information required in proxy 
statement.


* * * * *
    Item 9. Independent public accountants. * * *
* * * * *
    (e)(1) Disclose, under the caption Audit Fees, the aggregate 
fees billed for each of the last two fiscal years for professional 
services rendered by the principal accountant for the audit of the 
registrant's annual financial statements and review of financial 
statements included in the registrant's form 10-Q (17 CFR 249.308a) 
or 10-QSB (17 CFR 249.308b) for those fiscal years.
    (2) Disclose, under the caption Audit-Related Fees, the 
aggregate fees billed in each of the last two fiscal years for 
assurance and related services by the principal accountant that are 
reasonably related to the performance of the audit or review of the 
registrant's financial statements and are not reported under 
paragraph (e)(1) of this section. Registrants shall describe each 
subcategory of services comprising the fees disclosed under this 
category.
    (3) Disclose, under the caption Tax Fees, the aggregate fees 
billed in each of the last two fiscal years for professional 
services rendered by the principal accountant for tax compliance, 
tax consulting, and tax planning.
    (4) Disclose, under the caption All Other Fees, the aggregate 
fees billed in each of the last two fiscal years for products and 
services provided by the principal accountant, other than the 
services reported in paragraphs (e)(1) through (e)(3) of this 
section. Registrants shall describe each subcategory of services 
comprising the fees disclosed under this category.
    (5)(i) Disclose the audit committee's pre-approval policies and 
procedures described in paragraph (c)(7)(ii) of Regulation S-X (17 
CFR 210.2-01(c)(7)(ii)).
    (ii) Disclose the percentage of fees described in each of 
paragraphs (e)(2) through (e)(4) of this section that were approved 
by the audit committee pursuant to each of the paragraphs 
(c)(7)(ii)(A), (c)(7)(ii)(B) and, (c)(7)(ii)(C), of rule 2-01 of 
Regulation S-X (17 CFR 210.2-01(c)(7)(ii)(A), (B) and (C)).
    (6) If greater than 50 percent, disclose the percentage of hours 
expended on the principal accountant's engagement to audit the 
registrant'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.
    Instruction to Item 9(e).
    For purposes of item 9(e)(2), (3), (4), and (5)(ii) registrants 
that are investment companies must disclose fees billed for services 
rendered to the registrant, the registrant's investment adviser (not 
including any sub-adviser whose role is primarily portfolio 
management and is subcontracted with or overseen by another 
investment adviser), and any entity controlling, controlled by, or 
under common control with the adviser that provides services to the 
registrant.


* * * * *


PART 249--FORMS, SECURITIES EXCHANGE ACT OF 1934


    7. The authority citation for part 249 is amended by revising the 
citations, Sec.  249.220f, Sec.  249.240f, Sec.  249.310 and Sec.  
249.310b and a citation for Sec.  249.331 is added in numerical order 
to read as follows:


    Authority: 15 U.S.C. 78a et seq., unless otherwise noted.
* * * * *
    Section 249.220f is also issued under secs. 3(a), 202, 302, 404 and 
407, Pub. L. No. 107-204, 116 Stat. 745.
    Section 249.240f is also issued under secs. 3(a), 202, 302, 404 and 
407, Pub. L. No. 107-204, 116 Stat. 745.
* * * * *
    Section 249.310 is also issued under 15 U.S.C. 78m, 78o(d) and 
78w(a) and secs. 3(a), 202 and 302, Pub. L. No. 107-204, 116 Stat. 745.
    Section 249.310b is also issued under secs. 3(a), 202 and 302, Pub. 
L. No. 107-204, 116 Stat. 745.
* * * * *
    Section 249.331 is also issued under secs. 3(a), 202, and 302, Pub. 
L. No. 107-204, 116 Stat. 745.
    8. Amend form 20-F (referenced in Sec.  249.220f) by adding 
paragraph (d) to item 15 to read as follows:


    Note: The text of form 20-F does not, and this amendment will 
not, appear in the Code of Federal Regulations.




Form 20-F


* * * * *
    Item 15. Certain Disclosures.
* * * * *
    (d) Principal Accountant Fees and Services.
    (1) Disclose, under the caption Audit Fees, the aggregate fees 
billed for each of the last two fiscal years for professional 
services rendered by the principal accountant for the audit of the 
registrant's annual financial statements and review of financial 
statements included in the registrant's form 10-Q (17 CFR 249.308a) 
or 10-QSB (17 CFR 249.308b) for those fiscal years.
    (2) Disclose, under the caption Audit-Related Fees, the 
aggregate fees billed in each of the last two fiscal years for 
assurance and related services by the principal accountant that are 
reasonably related to the performance of the audit or review of the 
registrant's financial statements and are not reported under 
paragraph (e)(1) of this section. Registrants shall describe each 
subcategory of services comprising the fees disclosed under this 
category.
    (3) Disclose, under the caption Tax Fees, the aggregate fees 
billed in each of the last two fiscal years for professional 
services rendered by the principal accountant for tax compliance, 
tax consulting, and tax planning.
    (4) Disclose, under the caption All Other Fees, the aggregate 
fees billed in each of the last two fiscal years for products and 
services provided by the principal accountant, other than the 
services reported in paragraphs (e)(1) through (e)(3) of this 
section. Registrants shall describe each subcategory of services 
comprising the fees disclosed under this category.
    (5)(i) Disclose the audit committee's pre-approval policies and 
procedures described in paragraph (c)(7)(ii) of rule 2-01 of 
Regulation S-X (17 CFR 210.2-01(c)(7)(ii)).
    (ii) Disclose the percentage of fees described in each of 
paragraphs (e)(2) through (e)(4) of this section that were approved 
by the audit committee pursuant to each of the paragraphs 
(c)(7)(ii)(A), (c)(7)(ii)(B), and (c)(7)(ii)(C), of rule 2-01 of 
Regulation S-X (17 CFR 210.2-01(c)(7)(ii)(A), (B) and (C)).
    (6) If greater than 50 percent, disclose the percentage of hours 
expended on the principal accountant's engagement to audit the 
registrant'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.
    Instructions to Item 15(d).
    1. You do not need to provide the information called for by this 
item 15(d) unless you are using this form as an annual report.
    2. A registrant that is an Asset-Backed Issuer (as defined in 
Sec.  240.13a-14(g) and Sec.  240.15d-14(g) of this chapter) is not 
required to disclose the information required by this item.
* * * * *
    9. Amend form 40-F (referenced in Sec.  249.240f) by adding 
paragraph (10) to general instruction B to read as follows:


    Note: The text of form 40-F does not, and this amendment will 
not, appear in the Code of Federal Regulations.




Form 40-F


* * * * *


[[Page 76816]]


General Instructions


* * * * *
    B. Information To Be Filed on This Form.
* * * * *
    (10) Principal Accountant Fees and Services.
    (1) Disclose, under the caption Audit Fees, the aggregate fees 
billed for each of the last two fiscal years for professional 
services rendered by the principal accountant for the audit of the 
registrant's annual financial statements and review of financial 
statements included in the registrant's form 10-Q (17 CFR 249.308a) 
or 10-QSB (17 CFR 249.308b) for those fiscal years.
    (2) Disclose, under the caption Audit-Related Fees, the 
aggregate fees billed in each of the last two fiscal years for 
assurance and related services by the principal accountant that are 
reasonably related to the performance of the audit or review of the 
registrant's financial statements and are not reported under 
paragraph (e)(1) of this section. Registrants shall describe each 
subcategory of services comprising the fees disclosed under this 
category.
    (3) Disclose, under the caption Tax Fees, the aggregate fees 
billed in each of the last two fiscal years for professional 
services rendered by the principal accountant for tax compliance, 
tax consulting, and tax planning.
    (4) Disclose, under the caption All Other Fees, the aggregate 
fees billed in each of the last two fiscal years for products and 
services provided by the principal accountant, other than the 
services reported in paragraphs (e)(1) through (e)(3) of this 
section. Registrants shall describe each subcategory of services 
comprising the fees disclosed under this category.
    (5)(i) Disclose the audit committee's pre-approval policies and 
procedures described in paragraph (c)(7)(ii) of rule 2-01 of 
Regulation S-X (17 CFR 210.2-01(c)(7)(ii)).
    (ii) Disclose the percentage of fees described in each of 
paragraphs (e)(2) through (e)(4) of this section that were approved 
by the audit committee pursuant to each of the paragraphs 
(c)(7)(ii)(A), (c)(7)(ii)(B), and (c)(7)(ii)(C), of rule 2-01 of 
Regulation S-X (17 CFR 210.2-01(c)(7)(ii)(A), (B) and (C)).
    (6) If greater than 50 percent, disclose the percentage of hours 
expended on the principal accountant's engagement to audit the 
registrant'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.
    Notes to Instruction B.(10).
    1. You do not need to provide the information called for by this 
instruction B.(10) unless you are using this form as an annual 
report.
    2. A registrant that is an Asset-Backed Issuer (as defined in 
Sec.  240.13a-14(g) and Sec.  240.15d-14(g) of this chapter) is not 
required to disclose the information required by this instruction 
B.(10).


* * * * *
    10. Amend form 10-K (referenced in Sec.  249.310) by:
    a. Redesignating item 16 of part IV as item 17 of part IV, and
    b. Adding new item 16 to part III.
    The addition reads as follows:


    Note: The text of form 10-K does not, and this amendment will 
not, appear in the Code of Federal Regulations.




Form 10-K


* * * * *


General Instructions


* * * * *


Annual Report Pursuant to Section 13 or 15(d) of the Securities 
Exchange Act of 1934


* * * * *


Part III


* * * * *
    Item 16. Principal Accountant Fees and Services.
    Furnish the information required by item 9(e) of schedule 14A 
(Sec.  240.14a-101 of this chapter).
    (1) Disclose, under the caption Audit Fees, the aggregate fees 
billed for each of the last two fiscal years for professional 
services rendered by the principal accountant for the audit of the 
registrant's annual financial statements and review of financial 
statements included in the registrant's form 10-Q (17 CFR 249.308a) 
or 10-QSB (17 CFR 249.308b) for those fiscal years.
    (2) Disclose, under the caption Audit-Related Fees, the 
aggregate fees billed in each of the last two fiscal years for 
assurance and related services by the principal accountant that are 
reasonably related to the performance of the audit or review of the 
registrant's financial statements and are not reported under 
paragraph (e)(1) of this section. Registrants shall describe each 
subcategory of services comprising the fees disclosed under this 
category.
    (3) Disclose, under the caption Tax Fees, the aggregate fees 
billed in each of the last two fiscal years for professional 
services rendered by the principal accountant for tax compliance, 
tax consulting, and tax planning.
    (4) Disclose, under the caption All Other Fees, the aggregate 
fees billed in each of the last two fiscal years for products and 
services provided by the principal accountant, other than the 
services reported in paragraphs (e)(1) through (e)(3) of this 
section. Registrants shall describe each subcategory of services 
comprising the fees disclosed under this category.
    (5)(i) Disclose the audit committee's pre-approval policies and 
procedures described in paragraph (c)(7)(ii) of rule 2-01 of 
Regulation S-X (17 CFR 210.2-01(c)(7)(ii)).
    (ii) Disclose the percentage of fees described in each of 
paragraphs (e)(2) through (e)(4) of this section that were approved 
by the audit committee pursuant to each of the paragraphs 
(c)(7)(ii)(A), (c)(7)(ii)(B), and (c)(7)(ii)(C), of rule 2-01 of 
Regulation S-X (17 CFR 210.2-01(c)(7)(ii)(A), (B) and (C)).
    (6) If greater than 50 percent, disclose the percentage of hours 
expended on the principal accountant's engagement to audit the 
registrant'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.
    Instruction to Item 16.
    A registrant that is an Asset-Backed Issuer (as defined in Sec.  
240.13a-14(g) and Sec.  240.15d-14(g) of this chapter) is not 
required to disclose the information required by this item.
* * * * *
    11. Amend form 10-KSB (referenced in Sec.  249.310b) by adding item 
16 to part III to read as follows:


    Note: The text of form 10-KSB does not, and this amendment will 
not, appear in the Code of Federal Regulations.




Form 10-KSB


* * * * *


Part III


* * * * *
    Item 16. Principal Accountant Fees and Services.
    Furnish the information required by item 9(e) of schedule 14A 
(Sec.  240.14a-101 of this chapter).
    (1) Disclose, under the caption Audit Fees, the aggregate fees 
billed for each of the last two fiscal years for professional 
services rendered by the principal accountant for the audit of the 
registrant's annual financial statements and review of financial 
statements included in the registrant's form 10-Q (17 CFR 249.308a) 
or 10-QSB (17 CFR 249.308b) for those fiscal years.
    (2) Disclose, under the caption Audit-Related Fees, the 
aggregate fees billed in each of the last two fiscal years for 
assurance and related services by the principal accountant that are 
reasonably related to the performance of the audit or review of the 
registrant's financial statements and are not reported under 
paragraph (e)(1) of this section. Registrants shall describe each 
subcategory of services comprising the fees disclosed under this 
category.
    (3) Disclose, under the caption Tax Fees, the aggregate fees 
billed in each of the last two fiscal years for professional 
services rendered by the principal accountant for tax compliance, 
tax consulting, and tax planning.
    (4) Disclose, under the caption All Other Fees, the aggregate 
fees billed in each of the last two fiscal years for products and 
services provided by the principal accountant, other than the 
services reported in paragraphs (e)(1) through (e)(3) of this 
section. Registrants shall describe each subcategory of services 
comprising the fees disclosed under this category.
    (5)(i) Disclose the audit committee's pre-approval policies and 
procedures described in paragraph (c)(7)(ii) of rule 2-01 of 
Regulation S-X (17 CFR 210.2-01(c)(7)(ii)).
    (ii) Disclose the percentage of fees described in each of 
paragraphs (e)(2) through (e)(4) of this section that were approved 
by the audit committee pursuant to each of the paragraphs 
(c)(7)(ii)(A), (c)(7)(ii)(B), and (c)(7)(ii)(C), of rule 2-01 of 
Regulation S-X (17 CFR 210.2-01(c)(7)(ii)(A), (B) and (C)).
    (6) If greater than 50 percent, disclose the percentage of hours 
expended on the


[[Page 76817]]


principal accountant's engagement to audit the registrant'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.
    Instruction to Item 16.
    A registrant that is an Asset-Backed Issuer (as defined in Sec.  
240.13a-14(g) and Sec.  240.15d-14(g) of this chapter) is not 
required to disclose the information required by this item.
* * * * *


PART 274--FORMS PRESCRIBED UNDER THE INVESTMENT COMPANY ACT OF 1940


    12. The authority citation for part 274 is revised to read as 
follows:


    Authority: 15 U.S.C. 77f, 77g, 77h, 77j, 77s, 78c(b), 78l, 78m, 
78n, 78o(d), 80a-8, 80a-24, 80a-26, and 80a-29, unless otherwise 
noted.


    Section 274.128 is also issued under secs. 3(a), 202, and 302, Pub. 
L. 107-204, 116 Stat. 745.


PART 249--FORMS, SECURITIES EXCHANGE ACT OF 1934


PART 274--FORMS PRESCRIBED UNDER THE INVESTMENT COMPANY ACT OF 1940


    13. By amending form N-CSR (referenced in Sec. Sec.  249.331 and 
274.128).
    a. By revising general instruction D;
    b. By redesignating items 5 and 6 as items 6 and 7; and
    c. By adding a new item 5.
    The revisions and additions read as follows:


    Note: The text of form N-CSR does not, and this amendment will 
not, appear in the Code of Federal Regulations.


Form N-CSR


* * * * *


General Instructions


* * * * *
    D. Incorporation by Reference.
    A registrant may incorporate by reference information required 
by items 5 and 7(b). No other items of the form shall be answered by 
incorporating any information by reference. The information required 
by item 5 may be incorporated by reference from the registrant's 
definitive proxy statement (filed or required to be filed pursuant 
to Regulation 14A (17 CFR 240.14a-1 et seq.)) or definitive 
information statement (filed or to be filed pursuant to Regulation 
14C (17 CFR 240.14c-1 et seq.)) which involves the election of 
directors, if such definitive proxy statement or information 
statement is filed with the Commission not later than 120 days after 
the end of the fiscal year covered by an annual report on this form. 
All incorporation by reference must comply with the requirements of 
this form and the following rules on incorporation by reference: 
Rule 10(d) of Regulation S-K under the Securities Act of 1933 (17 
CFR 229.10(d)) (general rules on incorporation by reference, which, 
among other things, prohibit, unless specifically required by this 
form, incorporating by reference a document that includes 
incorporation by reference to another document, and limits 
incorporation to documents filed within the last 5 years, with 
certain exceptions); rule 303 of Regulation S-T (17 CFR 232.303) 
(specific requirements for electronically filed documents); rules 
12b-23 and 12b-32 under the Securities Exchange Act of 1934 
(additional rules on incorporation by reference for reports filed 
pursuant to sections 13 and 15(d) of the Securities Exchange Act of 
1934); and rules 0-4, 8b-23, and 8b-32 under the Investment Company 
Act of 1940 (17 CFR 270.0-4, 270.8b-23, and 270.8b-32) (additional 
rules on incorporation by reference for investment companies).
* * * * *
    Item 5. Principal Accountant Fees and Services.
    (a) Disclose, under the caption Audit Fees, the aggregate fees 
billed for each of the last two fiscal years for professional 
services rendered by the principal accountant for the audit of the 
registrant's annual financial statements for those fiscal years.
    (b) Disclose, under the caption Audit-Related Fees, the 
aggregate fees billed in each of the last two fiscal years for 
assurance and related services by the principal accountant that are 
reasonably related to the performance of the audit of the 
registrant's financial statements and are not reported under 
paragraph (a) of this item. Registrants shall describe each 
subcategory of services comprising the fees disclosed under this 
category.
    (c) Disclose, under the caption Tax Fees, the aggregate fees 
billed in each of the last two fiscal years for professional 
services rendered by the principal accountant for tax compliance, 
tax consulting, and tax planning.
    (d) Disclose, under the caption All Other Fees, the aggregate 
fees billed in each of the last two fiscal years for products and 
services provided by the principal accountant, other than the 
services reported in paragraphs (a) through (c) of this item. 
Registrants shall describe each subcategory of services comprising 
the fees disclosed under this category.
    (e)(1) Disclose the audit committee's pre-approval policies and 
procedures described in paragraph (c)(7)(ii) of rule 2-01 of 
Regulation S-X (17 CFR 210.2-01(c)(7)(ii)).
    (2) Disclose the percentage of fees described in each of 
paragraphs (b) through (d) of this item that were approved by the 
audit committee pursuant to each of the paragraphs (c)(7)(ii)(A), 
(B), and (C) of rule 2-01 of Regulation S-X (17 CFR 210.2-
01(c)(7)(ii)(A), (B), and (C)).
    (f) If greater than 50 percent, disclose the percentage of hours 
expended on the principal accountant's engagement to audit the 
registrant'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.


Instructions


    1. The information required by this item 5 is only required in a 
report on this form N-CSR that is required by item 7(a) to include a 
copy of an annual report transmitted to stockholders.
    2. For purposes of paragraphs (b), (c), (d) and (e)(2) of this 
item, registrants must disclose fees billed for services rendered to 
the registrant, the registrant's investment adviser (not including 
any sub-adviser whose role is primarily portfolio management and is 
subcontracted with or overseen by another investment adviser), and 
any entity controlling, controlled by, or under common control with 
the adviser that provides services to the registrant.
* * * * *


    By the Commission.


    Dated: December 2, 2002.
Jill M. Peterson,
Assistant Secretary.
[FR Doc. 02-30884 Filed 12-12-02; 8:45 am]

BILLING CODE 8010-01-P