76008 Federal Register / Vol. 65, No. 234 / Tuesday, December 5, 2000 / Rules and Regulations

1 17 CFR 210.2–01.

2 17 CFR 240.14a–101.

3 15 U.S.C. § 78a et seq.

4The amendments were proposed in Securities

Act Release No. 7870 (June 30, 2000) (the

‘‘Proposing Release’’) [65 FR 43148].

5This release uses the terms ‘‘independent

auditor,’’ ‘‘auditor,’’ ‘‘independent public

accountant,’’ ‘‘accountant,’’ and ‘‘independent

accountant’’ interchangeably to refer to any

independent certified or independent public

accountant who performs an audit of or reviews a

public company’s financial statements or whose

report or opinion is filed with the Commission in

accordance with the federal securities laws or the

Commission’s regulations. 6 In addition to soliciting comments in the

Proposing Release, we held four days of public

hearings (July 26, Sept. 13, Sept. 20, and Sept. 21).

The public comments we received can be reviewed

in our Public Reference Room at 450 Fifth Street,

N.W., Washington, D.C., 20549, in File No. S7–13–

00. Public comments submitted by electronic mail

are on our website, www.sec.gov. The written

testimony and transcripts from each of our public

hearings (July 26, Sept. 13, Sept. 20, and Sept. 21)

are available on our website. For purposes of this

release, date references following the names of

participants at our public hearings indicate the

hearing date for which the participant submitted

written testimony and/or appeared as a witness.

7The profession’s principles of professional

conduct state, ‘‘Members should accept the

obligation to act in a way that will serve the public

interest, honor the public trust, and demonstrate

commitment to professionalism.’’ American

Institute of Certified Public Accountants (‘‘AICPA’’)

Professional Standards: Code of Professional

Conduct (‘‘AICPA Code of Professional Conduct’’),

ET § 53.

8Public companies and other public issuers and

entities registered with us must have their annual

financial statements audited by independent public

accountants. See, e.g., Items 25 and 26 of Schedule

A to the Securities Act of 1933 (the ‘‘1933 Act’’),

15 U.S.C. § 77aa(25) and (26), that expressly require

that financial statements be audited by independent

public or certified accountants. See also infra note

34.

9See, e.g., Testimony of John Whitehead, retired

Chairman, Goldman Sachs & Co. (Sept. 13, 2000)

(‘‘Financial statements are at the very heart of our

capital markets. They’re the basis for analyzing

investments. Investors have every right to be able

to depend absolutely on the integrity of the

financial statements that are available to them, and

if that integrity in any way falls under suspicion,

then the capital markets will surely suffer if

investors feel they cannot rely absolutely on the

integrity of those financial statements.’’).

SECURITIES AND EXCHANGE

COMMISSION

17 CFR Parts 210 and 240

[Release Nos. 33–7919; 34–43602; 35–

27279; IC–24744; IA–1911; FR–56; File No.

S7–13–00]

RIN 3235–AH91

Revision of the Commission’s Auditor

Independence Requirements

AGENCY: Securities and Exchange

Commission.

ACTION: Final rule.

SUMMARY: The Securities and Exchange

Commission (‘‘SEC’’ or ‘‘Commission’’)

is adopting rule amendments regarding

auditor independence. The amendments

modernize the Commission’s rules for

determining whether an auditor is

independent in light of investments by

auditors or their family members in

audit clients, employment relationships

between auditors or their family

members and audit clients, and the

scope of services provided by audit

firms to their audit clients. The

amendments, among other things,

significantly reduce the number of audit

firm employees and their family

members whose investments in audit

clients are attributed to the auditor for

purposes of determining the auditor’s

independence. The amendments shrink

the circle of family and former firm

personnel whose employment impairs

an auditor’s independence. They also

identify certain non-audit services that,

if provided by an auditor to public

company audit clients, impair the

auditor’s independence. The scope of

services provisions do not extend to

services provided to non-audit clients.

The final rules provide accounting firms

with a limited exception from being

deemed not independent for certain

inadvertent independence impairments

if they have quality controls and satisfy

other conditions. Finally, the

amendments require most public

companies to disclose in their annual

proxy statements certain information

related to, among other things, the nonaudit services provided by their auditor

during the most recent fiscal year.

DATES: Effective date: February 5, 2001.

Compliance dates: Transition Dates:

Until August 5, 2002, providing to an

audit client the non-audit services set

forth in § 210.2–01(c)(4)(iii) (appraisal

or valuation services or fairness

opinions) and § 210.2–01(c)(4)(v)

(internal audit services) will not impair

an accountant’s independence with

respect to the audit client if performing

those services did not impair the

accountant’s independence under preexisting requirements of the SEC, the

Independence Standards Board, or the

accounting profession in the United

States. Until May 7, 2001, having the

financial interests set forth in § 210.2–

01(c)(1)(ii) or the employment

relationships set forth in § 210.2–

01(c)(2) will not impair an accountant’s

independence with respect to the audit

client if having those financial interests

or employment relationships did not

impair the accountant’s independence

under pre-existing requirements of the

SEC, the Independence Standards

Board, or the accounting profession in

the United States. Until December 31,

2002, § 210.2–01(d)(4) shall not apply to

offices of the accounting firm located

outside of the United States. Registrants

must comply with the new proxy and

information statement disclosure

requirements for all proxy and

information statements filed with the

Commission after the effective date.

FOR FURTHER INFORMATION CONTACT: John

M. Morrissey, Deputy Chief Accountant,

or Sam Burke, Assistant Chief

Accountant, Office of the Chief

Accountant, at (202) 942–4400, or with

respect to questions about investment

companies, John S. Capone, Chief

Accountant, Division of Investment

Management, at (202) 942–0590,

Securities and Exchange Commission,

450 Fifth Street, N.W., Washington, D.C.

20549.

SUPPLEMENTARY INFORMATION: The

Commission today is adopting

amendments to Rule 2–01 of Regulation

S–X 1 and Item 9 of Schedule 14A 2

under the Securities Exchange Act of

1934 (the ‘‘Exchange Act’’).3

I. Executive Summary

We are adopting amendments to our

current rules regarding auditor

independence.4 The final rules advance

our important policy goal of protecting

the millions of people who invest their

savings in our securities markets in

reliance on financial statements that are

prepared by public companies and other

issuers and that, as required by

Congress, are audited by independent

auditors.5 We believe the final rules

strike a reasonable balance among

commenters’ differing views about the

proposals while achieving our

important public policy goals.6

Independent auditors have an

important public trust.7 Investors must

be able to rely on issuers’ financial

statements.8 It is the auditor’s opinion

that furnishes investors with critical

assurance that the financial statements

have been subjected to a rigorous

examination by an objective, impartial,

and skilled professional, and that

investors, therefore, can rely on them. If

investors do not believe that an auditor

is independent of a company, they will

derive little confidence from the

auditor’s opinion and will be far less

likely to invest in that public company’s

securities.9

One of our missions is to protect the

reliability and integrity of the financial

statements of public companies. To do

so, and to promote investor confidence,

we must ensure that our auditor

independence requirements remain

relevant, effective, and fair in light of

significant changes in the profession,

structural reorganizations of accounting

firms, and demographic changes in

Federal Register / Vol. 65, No. 234 / Tuesday, December 5, 2000 / Rules and Regulations 76009

10As stated by Baxter Rice, President of the

California Board of Accountancy, ‘‘[I]n this everrevolving economy and business environment, it’s

important that we go back and take a look at these

regulations and see whether they are really

applicable, and whether or not what we do is going

to in any way interfere with or is going to enhance

auditor independence, including the public

perception of auditor independence.’’ Testimony of

Baxter Rice (Sept. 13, 2000).

11Financial Reporting Release (‘‘FRR’’) No. 10

(Feb. 25, 1983).

12 In 1999, an estimated 48.2%, or 49.2 million,

U.S. households owned equities either in mutual

funds or individually, up from 19% in 1983.

Investment Company Institute and Securities

Industry Association, ‘‘Bull Market, Other

Developments Fuel Growth in Equity Ownership’’

(available at www.sia.com/html/pr834.html.).

13See, e.g., Testimony of Senator Howard

Metzenbaum (Ret.), Chairman, Consumer

Federation of America (Sept. 20, 2000) (‘‘Our

nation’s current prosperity and future financial

security are tied up as never before in our financial

markets. For that reason, whether they know it or

not, Americans are enormously dependent on

independent auditors, both to * * * ensure the

reliability of the information they use to make

individual investment decisions and to ensure the

efficiency of the marketplace in assigning value to

stocks.’’); Testimony of Ralph Whitworth, Managing

Member, Relational Investors LLC (Sept. 13, 2000)

(‘‘[A]uditor independence goes to the very essence

of our capital markets, and it’s linked inextricably

to the efficiencies of our capitalist system.’’).

14See discussion in Proposing Release, Section

II.B.

15See, e.g., Written Testimony of Dennis Paul

Spackman, Chairman, National Association of State

Boards of Accountancy (Sept. 13, 2000) (The four

principles ‘‘set a sensible baseline that is simply

stated, easy to understand, useable, and square on

the mark. They also serve as an exceptional

foundation to the other elements of the proposed

revision. * * * [T]hey can serve as a bright beacon

giving much needed guidance to members of the

profession * * *’’); Written Testimony of Robert L.

Ryan, Chief Financial Officer, Medtronic, Inc. (Sept.

20, 2000); Written Testimony of John C. Bogle,

Member, Independence Standards Board (July 26,

2000).

16See, e.g., Letter of Arthur Andersen LLP (Sept.

25, 2000) (‘‘Arthur Andersen Letter’’); Written

Testimony of the New York Society of Certified

Public Accountants (Sept. 13, 2000).

17See, e.g., Letter of Ernst & Young LLP (Sept. 25,

2000) (‘‘Ernst & Young Letter’’); Written Testimony

of James J. Schiro, Chief Executive Officer

PricewaterhouseCoopers (Sept. 20, 2000); Written

Testimony of the New York State Society of

Certified Public Accountants (Sept. 13, 2000);

Written Testimony of James E. Copeland, Chief

Executive Officer, Deloitte & Touche LLP (Sept. 20,

2000); Arthur Andersen Letter.

18Some commenters, for example, believed that

the amendments went too far. See, e.g., Written

Testimony of J. Michael Cook, former Chairman and

Chief Executive Officer, Deloitte & Touche (July 26,

2000) (supporting proposed rule changes in this

area but stating that no partner in an accounting

firm should have a financial interest in any of the

firm’s audit clients); Written Testimony of Ray J.

Groves, former Chairman and CEO, Ernst & Young

(July 26, 2000) (agreeing with proposals but stating

preference to retain current proscription of direct

investment in an audit client by all partners,

principals, and shareholders of an accounting firm);

Testimony of Paul B.W. Miller, Professor,

University of Colorado at Colorado Springs (July 26,

2000) (‘‘I want to direct my attention * * * to the

ownership [provisions], and my language is plain.

It simply says don’t do it’’); Written Testimony of

Ronald Nielsen and Kathleen Chapman, Iowa

Accountancy Examining Board (Sept. 20, 2000).

While supporting the goals of the modernization,

others provided suggestions to address their

concerns about possible unintended consequences.

See, e.g., Ernst & Young Letter; Letter of

PricewaterhouseCoopers LLP (Sept. 25, 2000)

(‘‘PricewaterhouseCoopers Letter’’).

society.10 There have been important

developments in each of these areas

since we last amended our auditor

independence requirements in 1983.11

More and more individual investors

participate in our markets, either

directly or through mutual funds,

pension plans, and retirement plans.

Nearly half of all American households

are invested in the stock market.12 As

technology has advanced, investors

increasingly have direct access to

financial information, and they act

decisively upon relatively small changes

in an issuer’s financial results. These

and other market changes highlight the

importance to the market and to

investor confidence of financial

information that has been audited by an

auditor whose only master is the

investing public.13

As discussed in the Proposing Release

and below, the accounting industry has

been transformed by significant changes

in the structure of the largest firms.

Accounting firms have woven an

increasingly complex web of business

and financial relationships with their

audit clients. The nature of the nonaudit services that accounting firms

provide to their audit clients has

changed, and the revenues from these

services have dramatically increased. In

addition, there is more mobility of

employees and an increase in dualcareer families.

We proposed changes to our auditor

independence requirements in response

to these developments. As more fully

discussed below, we are adopting rules,

modified in response to almost 3,000

comment letters we received on our

proposal, written and oral testimony

from four days of public hearings (about

35 hours of testimony from almost 100

witnesses), academic studies, surveys

and other professional literature.

The Independence Standard.

Independence generally is understood

to refer to a mental state of objectivity

and lack of bias.14 The amendments

retain this understanding of

independence and provide a standard

for ascertaining whether the auditor has

the requisite state of mind. The first

prong of the standard is direct evidence

of the auditor’s mental state:

independence ‘‘in fact.’’ The second

prong recognizes that generally mental

states can be assessed only through

observation of external facts; it thus

provides that an auditor is not

independent if a reasonable investor,

with knowledge of all relevant facts and

circumstances, would conclude that the

auditor is not capable of exercising

objective and impartial judgment. The

proposed amendments to Rule 2–01

included in the rule four principles for

determining whether an accountant is

independent of its audit client. While

some commenters supported our

inclusion of the four principles in the

rule,15 others expressed concerns about

the generality of these principles and

raised questions concerning their

application to particular

circumstances.16 In response, we have

included the four principles instead in

a Preliminary Note to Rule 2–01 as

factors that the Commission will

consider, in the first instance, when

making independence determinations in

accordance with the general

independence standard in Rule 2–01(b).

The amendments identify certain

relationships that render an accountant

not independent of an audit client

under the standard in Rule 2–01(b). The

relationships addressed include, among

others, financial, employment, and

business relationships between auditors

and audit clients, and relationships

between auditors and audit clients

where the auditors provide certain nonaudit services to their audit clients.

Financial and Employment

Relationships. Current requirements

attribute to an auditor ownership of

shares held by every partner in the

auditor’s firm, certain managerial

employees, and their families. We

believe that independence will be

protected and the rules will be more

workable by focusing on those persons

who can influence the audit, instead of

all partners in an accounting firm.

Accordingly, we proposed to narrow

significantly the application of these

rules. Commenters generally supported

our efforts to modernize the current

rules because they restrict investment

and employment opportunities available

to firm personnel and their families in

ways that may no longer be relevant or

necessary for safeguarding auditor

independence and investor

confidence.17 Not all commenters

agreed with all aspects of the

proposals.18 We have modified the

proposal in some respects, but the final

rule, like the proposal, shrinks

significantly the circle of firm personnel

whose investments are imputed to the

auditor. The rule also shrinks the circle

of family members of auditors and

former firm personnel whose

employment with an audit client

impairs the auditor’s independence.

76010 Federal Register / Vol. 65, No. 234 / Tuesday, December 5, 2000 / Rules and Regulations

19See infra Section III.C; see also Proposing

Release, Section II.C.

20The Panel on Audit Effectiveness: Report and

Recommendations (the ‘‘O’Malley Panel Report’’),

at ¶ 5.6 (Aug. 31, 2000). The Chairman of the Public

Oversight Board (‘‘POB’’) similarly warned about

the ‘‘uncontrolled expansion’’ of management

advisory services to audit clients. Letter from John

J. McCloy, Chairman, POB (former Chairman of the

Board of Chase Manhattan Bank and former

President of The World Bank), to Walter E. Hanson,

Chairman, Executive Committee, SEC Practice

Section (‘‘SECPS’’) (Mar. 9, 1979).

21See, e.g., Testimony of Robert E. Denham,

Member, Independence Standards Board (‘‘ISB’’)

(July 26, 2000) (‘‘I think [the proposals] represent

a very thoughtful, rational, coherent set of

proposals.’’); Letter of Michael McDaniel (Aug. 14,

2000) (supporting SEC proposal and disagreeing

with a Form Letter from the AICPA to its members

(‘‘AICPA Form Letter’’) urging them to write to the

SEC to oppose the scope of services proposal);

Letter of Randie Burrell, CPA (Aug. 14, 2000)

(same); Letter of Leland D. O’Neal, CPA (Aug. 15,

2000) (same); Letter of David A. Storhaug, CPA

(Aug. 21, 2000) (same); Letter of Arthur Gross (Sept.

10, 2000); Letter of Kristian Holvoet (Sept. 8, 2000);

Letter of Bettina B. Menzel (Sept. 9, 2000); Letter

of Robert Hanseman (Sept. 10, 2000); Written

Testimony of Thomas S. Goodkind, CPA (Sept. 13,

2000); Testimony of Senator Howard Metzenbaum

(Ret.), Chairman, Consumer Federation of America

(Sept. 20, 2000); Written Testimony of Bill

Patterson, Director, Office of Investments, AFL–CIO

(Sept. 20, 2000); Written Testimony of Frank Torres,

Consumers Union (Sept. 20, 2000); Testimony of

Nimish Patel, Attorney, Pollet & Richardson (July

26, 2000). See also Senator George J. Mitchell (Ret.),

‘‘How to Keep Investor Confidence,’’ Editorial,

Boston Globe, pg. A15 (Oct. 28, 2000) (‘‘The

commission’s proposal is well-reasoned and

appropriate. * * * [T]he commission should adopt

this rule to protect investor confidence and

strengthen the most vibrant financial market system

in the world.’’).

22See, e.g., Written Testimony of Kayla J. Gillan,

General Counsel, California Public Employees’

Retirement System (‘‘CalPERS’’), which is the

largest public retirement system in the United

States with over 1.2 million participants (Sept. 13,

2000) (‘‘The SEC should consider simplifying its

Proposal and drawing a bright-line test: no nonaudit services to an audit client.’’); Written

Testimony of John H. Biggs, Chairman and CEO of

TIAA–CREF, which has 2.2 million participants

(July 26, 2000) (‘‘[I]ndependent public audit firms

should not be the auditors of any company for

which they simultaneously provide other services.

It’s that simple,’’); Written Testimony of Alan P.

Cleveland, the New Hampshire Retirement System,

with 52,000 members (Sept. 13, 2000) (‘‘We regard

the concurrent performance by the company’s

external auditor of non-auditor services at the

direction and under the control of management to

be inherently corrosive and fundamentally

incompatible with that duty of independence and

fidelity owed by the auditor to the investing

public’’); Testimony of Jack Ciesielski, accounting

analyst (July 26, 2000) (‘‘I think the single best way

to improve auditor independence and the

appearance of auditor independence is to call for

an exclusionary ban on non-audit services to audit

clients.’’); Letter of Carson L. Eddy, CPA, (Aug. 22,

2000) (‘‘It is my opinion that the general public

would be better served if Certified Public

Accountants providing the attest function for a

client were unable to do any other consulting work

for that client, with the exception for the ability to

prepare tax returns.’’); Letter of William V. Allen,

Jr., CPA (Aug. 22, 2000); Letter of Terry Guckes

(Sept. 9, 2000); Letter of Art Koolwine (Sept. 8,

2000); Letter of Elliot M. Simon (Sept. 9, 2000);

Letter of Melvin Schupack (Sept. 9, 2000); Letter of

William Odendahl (Sept. 5, 2000).

23See, e.g., Letter of the AICPA (Sept. 25, 2000)

(‘‘AICPA Letter’’); Letter of KPMG (Sept. 25, 2000)

(‘‘KPMG Letter’’); Letters of Robert Roy Ward,

Chairman and Chief Executive Officer, Horne CPA

Group (Sept. 20, 2000), Douglas R. Ream, CPA

(undated), Jack W. Palmer (Sept. 9, 2000), Sherry

Wilson, CPA (Aug. 28, 2000), and Nathaniel Boyle,

CPA (Aug. 16, 2000) (each reiterating concerns

expressed in the AICPA’s Form Letter).

24See, e.g., Ernst & Young Letter;

PricewaterhouseCoopers Letter.

25Commenters generally agreed that disclosure

would be useful to investors. See, e.g., Written

Testimony of James W. Barge, Vice President and

Controller, Time Warner (Sept. 20, 2000); Letter of

The Institute of Internal Auditors (Sept. 5, 2000);

Written Testimony of Dennis Paul Spackman,

Chairman of the National Association of State

Boards of Accountancy (Sept. 13, 2000); Letter of

Marsha Payne, President, Association of College &

University Auditors (Sept. 25, 2000); Letter of Keith

Johnson, Chief Legal Counsel, State of Wisconsin

Board (Sept. 20, 2000); Letter of Peter C. Clapman,

Senior Vice President and Chief Counsel,

Investments, TIAA–CREF (Sept. 21, 2000).

26See, e.g., Written Testimony of Clarence E.

Lockett, Vice President and Corporate Controller,

Johnson & Johnson (Sept. 20, 2000); Written

Testimony of Philip A. Laskawy, Chairman, Ernst

& Young LLP (Sept. 20, 2000).

Non-Audit Services. As we discuss

below,19 there has been growing

concern on the part of the Commission

and users of financial statements about

the effects on independence when

auditors provide both audit and nonaudit services to their audit clients.

Dramatic changes in the accounting

profession and the types of services that

auditors are providing to their audit

clients, as well as increases in the

absolute and relative size of the fees

charged for non-audit services, have

exacerbated these concerns. As the

Panel on Audit Effectiveness (the

‘‘O’Malley Panel’’) recently recognized,

‘‘The potential effect of non-audit

services on auditor objectivity has long

been an area of concern. That concern

has been compounded in recent years

by significant increases in the amounts

of non-audit services provided by audit

firms.’’ 20

We considered a full range of

alternatives to address these concerns.

Our proposed amendments identified

certain non-audit services that, when

rendered to an audit client, impair

auditor independence. The proposed

restrictions on non-audit services

generated more comments than any

other aspect of the proposals. Some

commenters agreed with our

proposals.21 Others believed that the

proposals were not restrictive enough

and recommended a total ban on all

non-audit services provided by auditors

to their audit clients.22 Still other

commenters opposed any Commission

rule on non-audit services.23 After

careful consideration of the arguments

on all sides, and for the reasons

discussed below, we have determined

not to adopt a total ban on non-audit

services, despite the recommendations

of some, and instead to identify certain

non-audit services that, if provided to

an audit client, render the auditor not

independent of the audit client.

In response to public comments,24 in

several instances we have conformed

the restrictions to the formulations set

forth in the professional literature or

otherwise modified the final rule to

better describe, and in some cases

narrow, the types of services restricted.

For example, the final rule does not ban

all valuation and appraisal services; its

restrictions apply only where it is

reasonably likely that the results of any

valuation or appraisal, individually or

in the aggregate, would be material to

the financial statements, or where the

results will be audited by the

accountant. The rule also provides

several exceptions from the restrictions,

such as when the valuation is performed

in the context of certain tax services, or

the valuation is for non-financial

purposes and the results of the

valuation do not affect the financial

statements. These changes are

consistent with our approach to adopt

only those regulations that we believe

are necessary to preserve investor

confidence in the independence of

auditors and the financial statements

they audit.

We recognize that not all non-audit

services pose the same risk to

independence. Accordingly, under the

final rule, accountants will continue to

be able to provide a wide variety of nonaudit services to their audit clients. In

addition, they of course will be able to

provide any non-audit service to nonaudit clients.

Quality Controls. The quality controls

of accounting firms play a significant

role in helping to detect and prevent

auditor independence problems. The

final rule recognizes this role by

providing accounting firms a limited

exception from being deemed not

independent for certain independence

impairments that are cured promptly

after discovery, provided that the firm

has certain quality controls in place.

Disclosure of Non-Audit Services.

Finally, we continue to believe that

disclosures that shed light on the

independence of public companies’

auditors assist investors in making

investment and voting decisions.

Accordingly, we proposed and are

adopting requirements for disclosures

that we believe will be useful to

investors.25 In response to commenters’

concerns about the breadth of the

proposed disclosure requirements,26

Federal Register / Vol. 65, No. 234 / Tuesday, December 5, 2000 / Rules and Regulations 76011

27See written testimony and transcripts from

each of our hearings.

28A Proposal by the Securities and Exchange

Commission to Modernize Its Rules That Govern the

Independence of Accountants that Audit Public

Companies, Before the Subcomm. On Securities of

the Senate Comm. On Banking, Housing, and Urban

Affairs, 95th Cong. 2d Sess. (Sept. 28, 2000).

29See, e.g., Letter of KPMG; Written Testimony of

Robert K. Elliott, Chairman, AICPA (Sept. 13, 2000)

(‘‘There is no reason * * * for a rush to judgment

on these critical issues. We have the time to get it

right, and the public is entitled to nothing less.’’);

Written Testimony of Barry Melancon, President

and Chief Executive Officer, AICPA (Sept. 13,

2000); Letters of Richard W. Hammel, CPA (Sept.

25, 2000), Roland H. Flyge II, CPA (Sept. 23, 2000),

and Daniel P. Naragon, CPA (Sept. 25, 2000) (each

reiterating concerns expressed in the AICPA Form

Letter).

30See Written Testimony of Bevis Longstreth,

former SEC Commissioner and member of the Panel

on Audit Effectiveness (Sept. 13, 2000) (‘‘The SEC

acting upon the need for greater independence, a

need long recognized by virtually every group

assigned the task of considering the issue (and there

have been many), has proposed a rule to meet this

need.’’); Testimony of Senator Howard Metzenbaum

(Ret.), Chairman, Consumer Federation of America

(Sept. 20, 2000); Written Testimony of Douglas

Scrivner, General Counsel, Andersen Consulting

(Sept. 20, 2000) (‘‘This issue is not new. The issue

has been debated within the profession and by

others for over 20 years. The only thing that has

changed, in my opinion, is that the risks to the

system have increased.’’); Written Testimony of

Dennis Paul Spackman, Chairman of the National

Association of State Boards of Accountancy (Sept.

13, 2000) (‘‘[A]ction is needed. Indeed, I believe it

is long over due. While further study may enhance

the finer points of the issues, it would do nothing

to resolve the larger concerns. They have been

deliberated far too long.’’); Testimony of Larry

Gelfond, CPA, CVA, CFE, former President of the

Colorado State Board of Accountancy (Sept. 13,

2000) (‘‘I firmly believe the SEC is taking a correct

position in this long debated area of concern to the

profession.’’).

31Congress itself considered the issue of scope of

services in the 1970s. See Report on Improving the

Accountability of Publicly Owned Corporations and

Their Auditors, Subcomm. on Reports, Accounting

and Management of the Senate Comm. on

Governmental Affairs, 95th Cong., 1st Sess. (Comm.

Print Nov. 1977).

32 In the late 1980s, for example, several of the

large public accounting firms filed a petition with

us seeking to enter into joint ventures, limited

partnership agreements, and other similar

arrangements with audit clients. See Letter from

Jonathan G. Katz, Secretary, SEC, to Duane R.

Kullberg, Arthur Andersen & Co. (Feb. 14, 1989)

(denying the petition).

33See Richard C. Breeden, Roderick M. Hills,

David S. Ruder and Harold M. Williams (former

Chairmen of the SEC), Editorial, ‘‘Accounting for

Conflicts,’’ Wash. Post, at A31 (July 21, 2000) (‘‘This

initiative is timely and necessary. * * * [T]he time

has come to chart a surer path to preserving the allimportant principle of auditor independence from

commercial client relationships.’’); James J. Schiro,

Chief Executive Officer, PricewaterhouseCoopers

LLP, ‘‘Auditor Independence: It’s Time to Change

the Rules,’’ Wall St. J. (Oct. 10, 2000) (‘‘New rules

are needed now. Working together, we can devise

rules that will protect the public interest today and

for decades to come. The need for change is upon

us. Further delay will only prolong confusion at a

time when greater clarity is needed.’’) (emphasis in

original); Written Testimony of Senator Howard

Metzenbaum (Ret.), Chairman, Consumer

Federation of America (Sept. 20, 2000) (‘‘[A] more

compelling question is, why wait? * * * Speaking

for consumers across the country, we urge the

Commission to move forward expeditiously with

this important rule proposal.’’); Testimony of

Professor John C. Coffee, Columbia University (July

26, 2000) (‘‘Right now you have the appropriate

moment because the vast majority of firms aren’t

purchasing dual services. If you wait ten years, that

will change, and [it’s] much harder to change an

existing reality rather than an approaching change.

So I think this is the time for action. * * *’’);

Testimony of J. Michael Cook, former Chairman and

Chief Executive Officer, Deloitte & Touche (July 26,

2000) (‘‘[T]he Commission’s consideration of this

issue at this time is both warranted and necessary.

The status quo is not an acceptable answer.’’);

Written Testimony of Professor Curtis C. Verschoor,

DePaul University (July 26, 2000) (stating that the

question is ‘‘[n]ot why so fast, but what took so

long?’’); Letter of John S. Coppel, CPA, CFO,

Electric Power Equipment Company (Aug. 16, 2000)

(‘‘I view this rule as a long overdue, greatly needed

response to the practices now taking place within

the profession.’’).

34For example, Items 25 and 26 of Schedule A

to the Securities Act, 15 U.S.C. 77aa(25) and (26),

and Section 17(e) of the Exchange Act, 15 U.S.C.

78q, expressly require that financial statements be

audited by independent public or certified

accountants. Sections 12(b)(1)(J) and (K) and

13(a)(2) of the Exchange Act, 15 U.S.C. 78l and

78m, Sections 5(b)(H) and (I), 10(a)(1)(G), and 14 of

the Public Utility Holding Company Act of 1935

(‘‘PUHCA’’), 15 U.S.C. 79e(b), 79j, and 79n, Sections

8(b)(5) and 30(e) and (g) of the Investment Company

Act of 1940 (‘‘ICA’’), 15 U.S.C. 80a–8 and 80a–29,

and Section 203(c)(1)(D) of the Investment Advisers

Act of 1940 (‘‘Advisers Act’’), 15 U.S.C. 80b–3(c)(1),

authorize the Commission to require the filing of

financial statements that have been audited by

independent accountants. Under this authority, the

Commission has required that certain financial

statements be audited by independent accountants.

See, e.g., Article 3 of Regulation S–X, 17 CFR

210.3–01, et seq. In addition, public companies

must have their quarterly reports reviewed by

independent accountants. Article 10 of Regulation

S–X, 17 CFR 210.10–01(d) and Item 310(b) of

Regulation S–B, 17 CFR 228.310(b). The federal

securities laws also grant the Commission the

authority to define the term ‘‘independent.’’ Section

19(a) of the Securities Act, 15 U.S.C. 77s(a), Section

3(b) of the Exchange Act, 15 U.S.C. 78c(b), Section

20(a) of PUHCA, 15 U.S.C. 79t(a), and Section 38(a)

of the ICA, 15 U.S.C. § 80a–37(a), grant the

Commission the authority to define accounting,

technical, and trade terms used in each Act. Section

17 of the Exchange Act, 15 U.S.C. 78q, and Section

31 of the Investment Company Act, 15 U.S.C. 80a–

30, grant the Commission authority to prescribe

accounting principles to be used in the preparation

of financial statements required.

35Steven M. H. Wallman, ‘‘The Future of

Accounting and Disclosure in an Evolving World:

The Need for Dramatic Change,’’ Accounting

Horizons, at 81 (Sept. 1995).

however, we have modified them in the

final rule.

II. Background

Our Proposing Release generated

significant comment and broad debate.

We received nearly 3,000 comment

letters. In addition to soliciting

comments in the Proposing Release, we

held four days of public hearings,

including one day in New York City, so

that we could engage in a public

dialogue with interested parties. At the

hearings, we heard from almost 100

witnesses, representing investors,

investment professionals, large and

small public companies, the Big Five

accounting firms, smaller accounting

firms, the AICPA, banking regulators,

consumer advocates, state accounting

board officials, members of the

Independence Standards Board (‘‘ISB’’),

academics, and others.27 In addition, the

Subcommittee on Securities of the

Senate Committee on Banking, Housing,

and Urban Affairs held a hearing about

our proposal.28

We received thoughtful and

constructive input from a broad

spectrum of interested parties. That

input helped us to understand better the

sincere and strongly-held views on all

sides and to shape final rule

amendments that incorporate these

views to the extent consistent with our

public policy goals. As discussed

specifically below, the final rule

amendments, particularly those related

to non-audit services, have been

modified from the proposals.

Nevertheless, some commenters

expressed concern that we have ‘‘rushed

to regulate,’’ 29 and they asked that we

take more time before addressing

auditor independence issues generally,

and especially the issues regarding the

provision of non-audit services to audit

clients. As many commenters noted,

however, the issues presented by this

rulemaking are not new, 30 and recent

and accelerating changes in the

accounting profession and in society

have made resolution of these issues

more pressing. For many years the

profession has been discussing

modernization of the financial and

employment relationship rules, and the

scope of services issue has been on the

horizon even longer.31 Many previous

Commissions have studied these

issues.32 Against this backdrop, in light

of the comments that our proposals

generated, and informed by our

experience and expertise in these

matters, we believe that it is appropriate

to act now.33

III. There Is a Need for Commission

Rulemaking

A. The Independence Requirement

Serves Important Public Policy Goals

The federal securities laws require, or

permit us to require, that financial

information filed with us be certified or

audited by ‘‘independent’’ public

accountants.34 To a significant extent,

this makes independent auditors the

‘‘gatekeepers’’ to the public securities

markets.35 This statutory framework

gives auditors both a valuable economic

franchise and an important public trust.

Within this statutory framework, the

76012 Federal Register / Vol. 65, No. 234 / Tuesday, December 5, 2000 / Rules and Regulations

36See generally Codification of Financial

Reporting Policies (the ‘‘Codification’’) § 601.01

(‘‘An investor’s willingness to commit his capital to

an impersonal market is dependent on the

availability of accurate, material and timely

information regarding the corporations in which he

has invested or proposes to invest.’’). Use of the

term ‘‘Codification’’ means the Codification that

existed prior to the Commission’s adoption of the

rule amendments in this release. For a list of

changes to the Codification resulting from the rule

amendments, see infra Section IX.

37See, e.g., Testimony of Laurence H. Meyer,

Governor, Board of Governors of the Federal

Reserve System (Sept. 13, 2000) (‘‘High quality

accounting standards * * * can potentially be

nullified if there is a perception that auditors lack

independence and objectivity in their enforcement

role * * * I think if the perception didn’t have any

basis in reality, it would not necessarily last very

long, so there has to be some interconnection

between them, but the perception is an important

one.’’); Testimony of David A. Brown, QC, Chair,

Ontario Securities Commission (Sept. 13, 2000)

(‘‘The reality of independence is difficult, if not

impossible. Perceptions of independence, therefore,

become almost equal to reality in importance.’’);

Testimony of Kayla Gillan, General Counsel,

CalPERS (Sept. 13, 2000) (‘‘It’s not only the reality

of biased auditing, but also the perception that a

biased practice is possible that erodes investor

confidence.’’). 38AICPA SAS No. 1, AU § 220.03. As explained

in SAS No. 1, ‘‘Public confidence would be

impaired by evidence that independence was

actually lacking, and it might also be impaired by

the existence of circumstances which reasonable

people might believe likely to influence

independence.’’ See also Testimony of Robert K.

Elliott, Chairman, AICPA (Sept. 13, 2000) (‘‘[The

AICPA] believe[s] that appearances are very

important and capital markets require confidence in

financial statements and audit reports, and the

member firms of the AICPA are basing their

business of auditing on their reputations, and that

is heavily affected by appearance. There is no

question about that. We are not disputing that

appearance is important.’’); Public Oversight Board

(‘‘POB’’), Scope of Services by CPA Firms, at 27

(Mar. 1979) (‘‘1979 POB Report’’) (citing A. Arens

and J. Loebbecke, Auditing: An Integrated

Approach (Prentice-Hall 1976)) (‘‘[The appearance

of independence is] a key ingredient to the value

of the audit function, since users of audit reports

must be able to rely on the independent auditor. If

they perceive that there is a lack of independence,

whether or not such a deficiency exists, much of

that value is lost.’’); Earnscliffe Research and

Communications (‘‘Earnscliffe’’), Report to the

United States Independence Board: Research into

Perceptions of Auditor Independence and

Objectivity—Phase II, at 11 (July 2000) (‘‘Earnscliffe

II’’) (‘‘Perhaps the most overwhelming consensus

was the belief that the perception of auditor

independence is as critical to the integrity of the

financial system, as is the reality.’’).

39United States v. Arthur Young and Co., 465

U.S. 805, 819 n.15 (1984) (emphasis in original).

See also Article IV of the AICPA’s Standards of

Professional Conduct, which provides, ‘‘Objectivity

is a state of mind. * * * Independence precludes

relationships that may appear to impair a member’s

objectivity. * * *’’ AICPA Code of Professional

Conduct, ET § 55.01 (emphasis added). Elsewhere,

the AICPA’s SAS No. 1 states that auditors should

‘‘avoid situations that may lead outsiders to doubt

their independence.’’ SAS No. 1, AU § 220.03

(emphasis added). 40See Codification § 601.01.

41Belverd E. Needles, Jr. (ed.) Comparative

International Accounting Standards 26 (1985)

(comparing France, Netherlands, Switzerland, U.K.,

Germany, Jordan, Kuwait, Canada, Mexico, U.S.,

and Japan).

42 Institute of Chartered Accountants of Ontario,

Rules of Professional Conduct Rule 204.1

(Objectivity: audit engagements); see also Institute

of Chartered Accountants of British Columbia,

Rules of Professional Conduct. Rule 204.1,

Objectivity—Assurance and Specified Auditing

Procedure Engagements.

43Testimony of David A. Brown, QC, Chair,

Ontario Securities Commission (Sept. 13, 2000).

Principles in Hong Kong regarding the conduct of

accountants provide that ‘‘a member must at all

times perform his work objectively and impartially

and free from influence by any consideration which

might appear to be in conflict with this

requirement.’’ Hong Kong Society of Accountants,

Fundamental Principles ¶ 10 (revised April 1999).

In addition, a Statement of Professional Ethics in

that country provides that an auditor ‘‘should be,

and be seen to be, free in each professional

assignment he undertakes of any interest which

might detract from objectivity.’’ Hong Kong Society

of Accountants, Statement 1.203, Professional

Ethics (Integrity, Objectivity and Independence) ¶ 2

(revised June 2000).

44Letter of Helene Bon, President, Federation of

European Accountants (Sept. 25, 2000).

45 In 1998, the European Parliament approved a

resolution broadly supporting the Green Paper.

independence requirement is vital to

our securities markets.

The independence requirement serves

two related, but distinct, public policy

goals. One goal is to foster high quality

audits by minimizing the possibility

that any external factors will influence

an auditor’s judgments. The auditor

must approach each audit with

professional skepticism and must have

the capacity and the willingness to

decide issues in an unbiased and

objective manner, even when the

auditor’s decisions may be against the

interests of management of the audit

client or against the interests of the

auditor’s own accounting firm.

The other related goal is to promote

investor confidence in the financial

statements of public companies.

Investor confidence in the integrity of

publicly available financial information

is the cornerstone of our securities

markets. Capital formation depends on

the willingness of investors to invest in

the securities of public companies.

Investors are more likely to invest, and

pricing is more likely to be efficient, the

greater the assurance that the financial

information disclosed by issuers is

reliable.36 The federal securities laws

contemplate that that assurance will

flow from knowledge that the financial

information has been subjected to

rigorous examination by competent and

objective auditors.

The two goals—objective audits and

investor confidence that the audits are

objective—overlap substantially but are

not identical. Because objectivity rarely

can be observed directly, investor

confidence in auditor independence

rests in large measure on investor

perception.37 For this reason, the

professional literature, such as the

AICPA’s Statement on Auditing

Standards (SAS) No. 1, has long

emphasized that auditors ‘‘should not

only be independent in fact; they should

also avoid situations that may lead

outsiders to doubt their

independence.’’ 38 The Supreme Court

has emphasized the importance of the

connection between investor confidence

and the appearance of independence:

The SEC requires the filing of audited

financial statements in order to obviate the

fear of loss from reliance on inaccurate

information, thereby encouraging public

investment in the Nation’s industries. It is

therefore not enough that financial

statements be accurate; the public must also

perceive them as being accurate. Public faith

in the reliability of a corporation’s financial

statements depends upon the public

perception of the outside auditor as an

independent professional. . . . 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.39

The Commission’s independence

requirements have always included

consideration of investor perceptions.40

Many foreign countries have similar

requirements. A comparative analysis of

the independence requirements of

eleven countries concluded, ‘‘With the

possible exception of Switzerland, most

of the countries stress both the

appearance and the fact of

independence.’’ 41 In Canada, Rules of

Professional Conduct require that the

auditor be free of influence that would

impair its judgment ‘‘or which, in the

view of a reasonable observer, would

impair * * * professional judgment or

objectivity.’’ 42 David A. Brown, Chair of

the Ontario Securities Commission,

testified that the importance of the

perception of auditor independence

‘‘cannot be overstated.’’ 43

International organizations and

standard setters also stress the

appearance of independence. In its

comment letter, the Federation of

European Accountants stated, ‘‘In

dealing with independence, one must

address both: Independence of mind

* * * and Independence in appearance,

[i].e. the avoidance of facts and

circumstances, which are so significant

that an informed third party would

question the statutory auditor’s

objectivity.’’ 44 Although the European

Union has not defined independence for

auditors, a Green Paper from 1996

provides, ‘‘In dealing with

independence, it is necessary to address

both independence in mind * * * and

independence in appearance, i.e. the

avoidance of facts and circumstances

which are so significant that an

informed third party would question the

statutory auditor’s objectivity.’’ 45

Federal Register / Vol. 65, No. 234 / Tuesday, December 5, 2000 / Rules and Regulations 76013

Green Paper, The Role, The Position and the

Liability of the Statutory Auditor Within the

European Union § 4.8 (July 24, 1996), available at

http://europa.eu.int. Communication from the

Commission, The Statutory Audit in the European

Union: The Way Forward (May 7, 1998), C143

8.05.1988–EN, available at http://europa.eu.int.

46See infra Section IV.C.

47Some firms are seeking to provide expanded

services through joint ventures with audit clients or

their affiliates. As noted above, as early as 1988,

large public accounting firms were looking to enter

into joint ventures, limited partnership agreements,

and other similar arrangements with audit clients.

See Letter from Jonathan G. Katz to Duane R.

Kullberg, Arthur Andersen & Co. (Feb. 14, 1989).

48See Proposing Release, App. A, for a list of

services that auditors provide to their audit and

non-audit clients. The list was prepared by the ISB.

See also Beverly Gordon, ‘‘KPMG spies rapid

growth in ‘shared services,’ ’’ Accounting Today, at

12 (June 3, 1996); ‘‘KPMG Restructures to

Reposition Outsourcing,’’ Public Accounting

Report, at 1 (May 15, 1996); websites of Deloitte &

Touche (http://www.deloitte.com) and KPMG

(http://www.us.kpmg.com).

49Management advisory services (‘‘MAS’’) are a

subset of non-audit services.

50See Proposing Release, Table 1 in Appendix B.

The underlying data are derived from data in

‘‘Special Supplement: Annual Survey of National

Accounting Firms—2000,’’ Public Accounting

Report (Mar. 31, 2000), annual reports filed with the

AICPA Division for CPA Firms by public

accounting firms, and from reports prepared by the

AICPA Division for CPA firms.

51See Proposing Release, Tables 1 and 2 in

Appendix B.

52See Proposing Release, Table 2 in Appendix B.

53See Proposing Release, Table 1 in Appendix B.

54See Proposing Release, Table 3 in Appendix B.

55 Id.

56 Id.

57See Proposing Release, Table 4 in Appendix B.

58See Proposing Release, Table 3 in Appendix B.

Taken together, the data from Tables 1, 3, and 4

indicate that in 1999 more than 12,700 clients of the

five largest public accounting firms paid

approximately $9.150 billion for accounting and

auditing services.

59See, e.g., Rick Telberg, ‘‘Anybody can do it!

says small-firm consolidator,’’ Accounting Today, at

5 (Jan. 4–24, 1999).

60 ‘‘Done Deal: HRB acquires M&P for $240

million cash, pension obligation,’’ Public

Accounting Report, at 1 (July 15, 1999); ‘‘Amex and

Checkers Close The Deal,’’ Public Accounting

Report, at 1 (Mar. 31, 1997).

61 ‘‘Cap Gemini and Ernst & Young Have Agreed

to Terms for the Acquisition of Ernst & Young

Consulting’’ (Feb. 29, 2000) (press release of Ernst

& Young).

62As clarified by the amended S–1 filed by KPMG

Consulting, Inc., in connection with the initial

public offering, Cisco may sell up to about half of

its stake in that entity. See KPMG Consulting, Inc.,

Form S–1, Amend. No. 3 (Sept. 25, 2000).

63 Id.

64Albert B. Crenshaw, ‘‘Audit Firm Sells

Consulting Unit,’’ Wash. Post, Oct. 26, 2000, at E2;

see also news release at www.grantthornton.com/

esannounce/index.html.

65See Earnscliffe, Report to the United States

Independence Board: Research into Perceptions of

Auditor Independence and Objectivity (‘‘Earnscliffe

I’’) at 16 (Nov. 1999) (finding increased pressure

and threat of earnings management in the

technology sector); see also Testimony of Jay W.

Eisenhofer, Partner, Grant & Eisenhofer (Sept. 13,

2000) (‘‘[I]n the current environment where

Continued

The concept of ‘‘appearance’’ as used

in the final rule is not unbounded.

‘‘Appearance’’ as used in our operative

legal standards is not a reference to

what anyone might think under any

circumstances. Rather, as explained

below,46 it is an objective test, keyed to

the conclusions of reasonable investors

with knowledge of all relevant facts and

circumstances.

B. Recent Developments Have Brought

the Independence Issues to the

Forefront

The accounting industry is in the

midst of dramatic transformation. Firms

have merged, resulting in increased size,

both domestically and internationally.

They have expanded into international

networks, affiliating and marketing

under a common name. Increasingly,

accounting firms are becoming multidisciplinary service organizations and

are entering into new types of business

relationships with their audit clients.

Accounting professionals have become

more mobile, and geographic location of

firm personnel has become less

important due to advances in

telecommunications. In addition, there

are more dual-career families, and audit

clients are increasingly hiring firm

partners, professional staff, and their

spouses for high level management

positions.

In conjunction with these changes,

accounting firms have expanded

significantly the menu of services

offered to their audit clients, and the list

continues to grow.47 Companies are

turning to their auditors to perform their

internal audit, pension, financial,

administrative, sales, data processing,

and marketing functions, among many

others.48

As we noted in the Proposing Release,

U.S. revenues for management advisory

and similar services 49 for the five

largest public accounting firms (the ‘‘Big

Five’’) amounted to more than $15

billion in 1999.50 Moreover, revenues

for these service lines are now estimated

to constitute half of the total revenues

for these firms.51 In contrast, these

service lines provided only thirteen

percent of total revenues in 1981.52

From 1993 to 1999, the average annual

growth rate for revenues from

management advisory and similar

services has been twenty-six percent;

comparable growth rates have been nine

percent for audit and thirteen percent

for tax services.53

For the largest firms, the growth in

management advisory and similar

services involves both audit clients and

non-audit clients. For the largest public

accounting firms, MAS fees from SEC

audit clients have increased

significantly over the past two decades.

In 1984, only one percent of SEC audit

clients of the eight largest public

accounting firms paid MAS fees that

exceeded the audit fee.54 For the Big

Five firms, the percentage of SEC audit

clients that paid MAS fees in excess of

audit fees did not exceed 1.5% until

1997.55 In 1999, 4.6% of Big Five SEC

audit clients paid MAS fees in excess of

audit fees,56 an increase of over 200%

in two years. For the Big Five firms,

average MAS fees received from SEC

audit clients amounted to ten percent of

all revenues in 1999.57 Almost threefourths of Big Five SEC audit clients

purchased no MAS from their auditors

in 1999. This means that purchases of

MAS services by one-fourth of firms’

SEC audit clients account for ten

percent of all firm revenues.58

Some smaller firms are consolidating

their audit practices and seeking public

investors in the resulting company.59

Other firms are entering into agreements

to sell all of their assets, except their

audit practices, to established financial

services companies. As part of these

agreements, the financial services

companies hire the employees, and in

some cases the partners, of the

accounting firm, and then lease back the

majority or all of the assets and audit

personnel to the ‘‘shell’’ audit firm.

These lease arrangements allow the

financial services firm to pay the

professional staff for ‘‘nonprofessional’’

services for the corporate organization

as well as professional attest services

rendered for the audit firm.60

Recently, Ernst & Young sold its

management-consulting business to Cap

Gemini Group SA, a large and publicly

traded computer services company

headquartered in France.61 KPMG has

sold an equity interest in KPMG

Consulting to Cisco Corporation 62 and

is in the process of registering

additional shares in its consulting

business to sell to the public in an

initial public offering.63 In addition,

PricewaterhouseCoopers has publicly

announced an intention to sell portions

of its consulting businesses. Also, Grant

Thornton recently sold its e-business

consulting practice.64

Simultaneous with this

metamorphosis of the accounting

profession, public companies have come

under increasing pressure to meet

earnings expectations. Observers suggest

that this pressure has intensified in

recent years, especially for companies

operating in certain sectors of the

economy.65 The extent of the pressure

76014 Federal Register / Vol. 65, No. 234 / Tuesday, December 5, 2000 / Rules and Regulations

company stock prices are increasingly dependent

on showing growth and on meeting or exceeding

the expectations of Wall Street investment analysts

[, e]ven one missed profit number can have a

significant negative effect on stock price. This

places great pressure on company executives to

insure that each quarter the profits are in the

expected range, regardless of whether the quarter

has been as good as the analyst expected. In order

to meet these expectations, we often find that

corporations will sometimes make questionable

assumptions.’’).

66Ann Grimes, ‘‘Former McKesson Officials are

Charged,’’ Wall St. J., at B6 (Sept. 29, 2000); Sarah

Schafer and David S. Hilzenrath, ‘‘Orbital to Settle

Shareholder Suit,’’ Wash. Post, at E1 (July 18, 2000);

Paul Sweeney, ‘‘Accounting Fraud: Learning from

the Wrongs,’’ Fin. Exec. (Sept./Oct. 2000); Mike

McNamee, ‘‘Accounting Wars,’’ Bus. Wk., 157, 160

(Sept. 25, 2000); Bernard Condon, ‘‘Pick a Number,

Any Number, Forbes (Mar. 23, 1998).

67See O’Malley Panel Report, supra note 20, ¶

1.10 (‘‘The growth in equity values over the past

decade has introduced extreme pressures on

management to achieve earnings, revenue or other

targets. These pressures are exacerbated by the

unforgiving nature of the equity markets as

securities valuations are drastically adjusted

downward whenever companies fail to meet ‘street’

expectations.* * * These pressures on

management, in turn, translate into pressures on

how auditors conduct audits and in their

relationship with audit clients.’’).

68See supra notes 21–23.

69See Proposing Release, Section II.C.2; O’Malley

Panel Report, supra note 20, at App. D (chronicling

the debate since 1957); The Commission on

Auditors’ Responsibilities, Report, Conclusions and

Recommendations 95–96 (1978). See also infra

notes 92, 98 (citing recent studies).

70Report on Improving the Accountability of

Publicly Owned Corporations and Their Auditors,

Subcomm. On Reports, Accounting and

Management of the Senate Comm. on Governmental

Affairs, 95th Cong., 1st Sess. (Comm. Print Nov.

1977). In the Report, the Subcommittee stated that

it ‘‘agrees with the Cohen Commission and many

others that the accounting profession must improve

its procedures for assuring independence in view of

the public’s needs and expectations. Several

activities of independent auditors have raised

questions. Among them are public advocacy on

behalf of a client, receiving gifts and discounts from

clients, and maintaining relationships that detract

from the appearance of arm’s-length dealings with

clients. Such activities are not appropriate.’’ Id. at

16. The Subcommittee also stated that ‘‘[t]he best

policy . . . is to require that independent auditors

of publicly owned corporations perform only

services directly related to accounting. Nonaccounting management services . . . should be

discontinued.’’ Id. at 16–17. In a letter to Harold

Williams, Chairman, SEC, Senator Thomas F.

Eagleton, Chairman, Subcomm. on Governmental

Efficiency and the District of Columbia, of the

Senate Comm. on Governmental Affairs,

recommended that ‘‘[t]here must be a requirement

that independent auditors of publicly owned

corporations perform only services directly related

to accounting.’’ Letter from Senator Thomas F.

Eagleton to Harold Williams (Apr. 6, 1978)

(attached list of recommendations) (reprinted in

Securities and Exchange Commission Report to

Congress on the Accounting Profession and the

Commission’s Oversight Role (July 1978)).

71Letter from John J. McCloy, Chairman, POB

(former Chairman of the Board of Chase Manhattan

Bank and former President of The World Bank), to

Walter E. Hanson, Chairman, Executive Committee,

SECPS (Mar. 9, 1979).

72Special Committee on Financial Reporting,

AICPA, Improving Business Reporting—A Customer

Focus: Meeting the Information Needs of Investors

and Creditors, at 104 (1994).

73Advisory Panel on Auditor Independence,

Strengthening the Professionalism of the

Independent Auditor: Report to the Public

Oversight Board of the SEC Practice Section,

AICPA, at 9 (Sept. 13, 1994).

74Office of the Chief Accountant, SEC, Staff

Report on Auditor Independence (Mar. 1994) (‘‘Staff

Report’’). Between 1979 and 1981, public

companies were required to disclose in their proxy

statements certain information about non-audit

services provided by their auditors. See infra

Section IV.G. (discussing these disclosure

requirements).

becomes apparent each time a company

loses a significant percentage of its

market capitalization after failing to

meet analysts’ expectations.66 These

intense pressures on companies lead to

enhanced pressure on auditors to enable

their clients to meet expectations.67

As discussed below, the changes in

the accounting profession, combined

with increasing pressures on companies,

raise questions about auditor

independence and investor confidence

in the financial statements of public

companies that those auditors audit. To

respond to some of these questions, we

proposed, and are now adopting, new

rules relating to the financial and

employment relationships independent

auditors may have with their audit

clients, business and financial

relationships between accounting firms

and audit clients, and the non-audit

services that auditors can provide to

audit clients without impairing their

independence.

C. Independence Concerns Warrant

Restrictions on the Scope of Services

Provided to Audit Clients

The rules that we adopt today include

provisions restricting the scope of

services that an auditor may provide to

an audit client without impairing the

auditor’s independence with respect to

that client. The proposed restrictions on

non-audit services generated most of the

public comment on our proposals, both

in written comment letters and in

testimony provided during our public

hearings. Commenters expressed a range

of views from full support to staunch

opposition.68

After careful consideration of the

arguments on various sides, we have

determined that it is in the public

interest for us to adopt certain

restrictions on the provision of nonaudit services to audit clients. We act on

the basis of our evaluation of the

potential impact of non-audit

relationships on audit objectivity and

also on the basis of indications that

investor confidence is in fact affected by

reasonable concerns about non-audit

services compromising audit objectivity.

1. The Expansion of Non-Audit Service

Relationships with Audit Clients Has

Long Been Viewed as a Potential Threat

to Auditor Independence

It has long been recognized that an

unchecked expansion of non-audit

relationships between auditors and their

audit clients could affect both an

auditor’s objectivity and investor

confidence in financial statements.69 In

the 1970s, Congress seriously

considered limiting the types of nonaudit services that independent auditors

could provide. Even though non-audit

services did not constitute a large

percentage of audit firms’ revenues at

that time, and Congress ultimately

determined not to take legislative

action, the deliberations highlighted

significant concerns bearing on the

independence issue.70

These concerns gradually became the

subject of increasing debate and study.

In 1979, the then-Chairman of the POB

expressed concern about the expansion

of non-audit services to audit clients:

The [POB] believes that there is a

possibility of damage to the profession and

the users of the profession’s services in an

uncontrolled expansion of MAS

[management advisory services] to audit

clients. Investors and others need a public

accounting profession that performs its

primary function of auditing financial

statements with both the fact and the

appearance of competence and

independence. Developments which detract

from this will surely damage the professional

status of CPA firms and lead to suspicions

and doubts that will be detrimental to the

continued reliance of the public upon the

profession without further and more drastic

governmental intrusion.71

A 1994 Report of the AICPA Special

Committee on Financial Reporting

noted that users of financial statements

believed that non-audit service

relationships could ‘‘erode auditor

independence’’ and that those users

were ‘‘concerned that auditors may

accept audit engagements at marginal

profits to obtain more profitable

consulting engagements.’’72 A separate

1994 report of the Advisory Panel on

Auditor Independence noted the

increased basis for investor concerns,

describing the trend toward non-audit

services as ‘‘worrisome’’ because

‘‘[g]rowing reliance on nonaudit

services has the potential to

compromise the objectivity or

independence of the auditor.’’ 73

In 1994, the SEC staff also studied the

issues and issued a Staff Report.74 While

concluding that no action was

warranted at the time, the staff

recognized the need ‘‘to be alert’’ to

independence problems that may be

Federal Register / Vol. 65, No. 234 / Tuesday, December 5, 2000 / Rules and Regulations 76015

75See Staff Report, supra note 74, at 84;

Proposing Release, notes 40–42.

76 GAO, THE ACCOUNTING PROFESSION—

Major Issues: Progress and Concerns, at 8 (GAO/

AIMD–96–98, Sept. 1996).

77See supra Section III.B.; Proposing Release,

Section II.C.2(b).

78See, e.g., Testimony of Kayla Gillan, General

Counsel, CalPERS (Sept. 13, 2000) (‘‘The concept

that an auditor who has a greater financial incentive

to please management than to criticize it will tend

to find ways to avoid negative comment is intuitive

and obvious.’’); Letter of B. Raymond Dunham (‘‘I

understand that actual hard evidence may not be

apparent on the surface. However, it becomes

obvious that auditing judgment may be clouded

when large sums of potential revenues are

dependent upon an auditing decision from any firm

that derives great revenues from consulting services

to the same organizations it is responsible for

auditing.* * * The separation of consulting and

auditing is intuitive if a firm is to maintain

independence in its auditing procedures.’’); Letter

of David T. DeMonte, CPA (‘‘The conflict of interest

potential is so patently obvious.’’).

79See, e.g., Testimony of Thomas C. DeFazio,

Executive Vice President and Chief Financial

Officer, VirtualCom, Inc. (Sept. 13, 2000) (‘‘[T]he

provision of non-audit services does not pressure

the audit firms to look the other way.’’); Testimony

of Thomas M. Rowland, Senior Vice President,

Fund Business Management Group, Capital

Research & Management Co. (Sept. 20, 2000) (‘‘[A]t

no time during my career did I feel pressure from

other partners in the firm * * * not to do the right

thing.’’).

80See, e.g., Testimony of Robert K. Elliott,

Chairman, AICPA (Sept. 21, 2000).

81See, e.g., Letter of Financial Accounting

Standards Committee, American Accounting

Association (Oct. 12, 2000),

82See O’Malley Panel Report, supra note 20, ¶ 4.4

at 99 (‘‘Focus group participants often indicated

that not only clients, but also engagement partners

and firm leaders, treat the audit negatively—as a

commodity.’’).

83AICPA Practice Aid Series, Make Audits Pay:

Leveraging the Audit Into Consulting Services, at 3

(1999).

84 Id. at 24.

caused by auditors’ provision of nonaudit services.75 A 1996 General

Accounting Office (GAO) study

predicted that the ‘‘concern over auditor

independence may become larger as

accounting firms move to provide new

services that go beyond traditional

services.’’ 76

2. The Growth of Certain Non-Audit

Services Jeopardizes Independence

A common theme running through

the reports described above is concern

that future expansion of non-audit

services may make regulatory action

necessary. We believe that the

circumstances about which the

Commission was warned are coming to

pass. An auditor’s interest in

establishing or preserving a non-audit

services relationship raises two types of

independence concerns. First, the more

the auditor has at stake in its dealings

with the audit client, the greater the cost

to the auditor should he or she displease

the client, particularly when the nonaudit services relationship has the

potential to generate significant

revenues on top of the audit

relationship. Second, certain types of

non-audit services, when provided by

the auditor, create inherent conflicts

that are incompatible with objectivity.

a. Non-Audit Services Create

Economic Incentives that May

Inappropriately Influence the Audit. As

explained above and in the Proposing

Release, the rapid rise in the growth of

non-audit services has increased the

economic incentives for the auditor to

preserve a relationship with the audit

client, thereby increasing the risk that

the auditor will be less inclined to be

objective.77 Some commenters

supported this analysis,78 while others

took issue with it.79 The principal

criticisms were: (i) the economic stake

in the relationship with the audit client

in fact had not materially increased and

any such increase is offset by

countervailing incentives on the auditor

not to compromise his or her

independence; and (ii) there is no proof

that changing the mix of incentives has

affected auditor behavior. We have

considered each of these criticisms and

address them below.

(i) The Mix of Economic Incentives

Has Changed. Commenters generally

agreed that there has been enormous

growth in non-audit services and in

their importance to the firms that

provide them. Several commenters took

issue with whether this growth

enhanced any potential conflict of

interest. These commenters argued, in

essence, that there has always been the

potential for a conflict of interest, since

the auditor is paid by the client.80 They

argue that because Congress adopted

this arrangement in enacting the federal

securities laws, by choosing the

statutory independence requirement

rather than creating a corps of

government-paid auditors, Congress

implicitly condoned these types of

conflicts of interest.

The argument proves too much; it

assumes that because Congress

permitted one form of potential conflict

of interest, it intended to permit all

forms. Taken to its logical conclusion,

this argument, of course, would read the

independence requirement out of the

statute. If Congress believed that all

conflicts were equal in kind or degree,

it would not have required that auditors

be independent. Congress apparently

chose to tolerate a degree of potential

conflict of interest rather than supplant

the private auditing profession. Simply

because Congress chose to tolerate an

unavoidable degree of conflict inherent

in the relationship between a private

auditor and a paying client, it hardly

follows that all conflicts of interest

beyond the unavoidable minimum were

approved by Congress or that the

statutes express indifference to conflicts

of interest.

A related argument is that, despite the

rapid growth of services, the economic

stakes have not really changed for the

auditor. The argument is that, despite

the growth of non-audit services

generally, these services are rarely as

significant to the auditor, from an

economic standpoint, as maintaining

the audit relationship.81 Put another

way, while non-audit services

(excluding tax) account for as much as

fifty percent of audit firm revenue, only

ten percent of revenues come from

providing these services to audit clients.

But, as noted above, the trend of

available data suggests a rapid increase

in the provision of non-audit services to

audit clients—in 1999, 4.6% of Big Five

SEC audit clients paid MAS fees in

excess of audit fees, an increase of over

200% in two years.

The increasing importance of nonaudit services to accounting firms is

further evidenced by suggestions that

the audit has become merely a

‘‘commodity’’ and that the greater profit

opportunities for auditors come from

using audits as a platform from which

to sell more lucrative non-audit

services.82 An AICPA practice aid

entitled ‘‘Make Audits Pay: Leveraging

the Audit Into Consulting Services’’

provides a step-by-step guide for

auditors to become ‘‘business advisers’’

to their audit clients. The book quotes

an AICPA officer as follows: ‘‘We see

the greater viability of the CPA going

forward as being a strategic business

adviser, an information professional

being viewed by the public as the

person for solid big-picture business

advice—applied to a broader

information world instead of a financial

information world.’’ 83 At the same time,

the book acknowledges that ‘‘[t]he

business adviser is a client advocate.

The entire business adviser audit

process is based on understanding the

client’s business from the owner’s

perspective and acting in the owner’s

best interest,’’ 84 which, of course, is

contrary to the duty of the auditor to the

public.

At our public hearings and in

comment letters, we also heard a great

deal about the ‘‘loss leader’’

phenomenon. When an auditor uses the

audit as a loss leader, the auditor, in

essence, ‘‘low-balls’’ the audit fee—even

offering to perform it at a loss—in order

to gain entry into and build a

relationship with a potential client for

76016 Federal Register / Vol. 65, No. 234 / Tuesday, December 5, 2000 / Rules and Regulations

85See, e.g., Letter of William S. Lerach, Milberg

Weiss Bershad Hynes & Lerach LLP (Sept. 22, 2000)

(‘‘In some instances, public companies bid out

auditing work demanding low bids, while

indicating to the bidding firms that low auditing

bids will be rewarded with lucrative consulting

work’’). Texas adopted a statutory provision to

prevent the use of audits as loss leaders in order

to protect small audit firms that could not compete

in a market where audits were underpriced. Tex.

Rev. Civ. Stat. art. 41a–1, § 20A (1994). See also

Testimony of K. Michael Conaway, Presiding

Officer, Texas State Board of Accountancy (Sept.

20, 2000) (explaining that the worry was that ‘‘big

firms would predatory price their way into markets

and * * * in effect, gain a competitive advantage

over smaller firms that couldn’t discount their work

to the same extent’’); Written Testimony of Wanda

Lorenz, CPA, Lane Gorman Trubitt (Sept. 20, 2000)

(‘‘[M]ost of the problems that exist today can be tied

to fee negotiations on audits * * *. Therefore the

profession has accepted being bargained with like

a shopkeeper in some bazaar in order to perform

other more lucrative work.’’) (emphasis in original).

86See Testimony of Larry Gelfond, CPA, CVA,

CFE, former President of the Colorado State Board

of Accountancy (Sept. 13, 2000) (‘‘Audit failures

occur because auditors become careless and in the

oversight or reliance on something, they may be

taking a shortcut. Clearly, where an audit is low

bid, there is that concern.’’).

87Low-balling also sends a message to the auditor

that the audit relationship is not as valuable as the

consulting relationship. See Testimony of Roderick

Hills, former Chairman, SEC (Sept. 20, 2000). Lowballing sends a message inside the audit firm as

well. We are concerned that the shift in a firm’s

emphasis away from auditing and toward non-audit

services causes, over time, a cultural shift within

the firm. The factors that drive a high quality audit,

including the core values of the auditing profession,

may diminish in importance to the firm, as will the

influence of those firm members who exemplified

those core values in their own professional careers.

88Testimony of Professor John C. Coffee, Jr.,

Columbia University (July 26, 2000) (‘‘[T]he

expected costs facing the accountant who might be

[]tempted to shirk his duties in order to please

management have vastly declined in just the last

five or six years.’’); see also Written Testimony of

Professor Coffee.

89Securities Litigation Uniform Standards Act of

1998, Pub. L. No. 105–353, 112 Stat. 3227 (codified

in scattered sections of the U.S.C.) (requiring most

private class actions alleging fraud in the sale of

nationally traded securities to be based on federal

law and brought in federal court).

90Central Bank of Denver v. First Interstate Bank

of Denver, 511 U.S. 164 (1994).

91The Private Securities Litigation Reform Act of

1995, Pub. L. No. 104–67, 109 Stat. 737, amended

18 U.S.C. § 1964(c) to eliminate ‘‘fraud in the

purchase or sale of securities’’ as a predicate act for

RICO liability unless the defendant has been

criminally convicted.

92AICPA Letter (citing AICPA, Serving the Public

Interest: A New Conceptual Framework for Auditor

Independence (Oct. 20, 1997) (‘‘AICPA White

Paper’’)). We note that the data relied on in the

AICPA White Paper and referred to in the AICPA

Letter was collected in 1997. As we discuss

throughout this release, the magnitude of non-audit

services has increased dramatically over the past

several years.

93See Testimony of Professor Max H. Bazerman,

Northwestern University (July 26, 2000); Testimony

of Professor George F. Loewenstein, Carnegie

Mellon Institute (July 26, 2000); see also Max H.

Bazerman, Kimberly P. Morgan, and George F.

Loewenstein, ‘‘The Impossibility of Auditor

Independence,’’ Sloan Management Review at 91,

94 (Summer 1997) (reviewing empirical research

showing that ‘‘[w]hen people are called on to make

impartial judgments, those judgments are likely to

be unconsciously and powerfully biased in a

manner that is commensurate with the judge’s self

interest,’’ and concluding that, despite their best

the firm’s non-audit services.85 Lowballing creates a variety of

independence issues.86 Use of audits as

loss leaders to be made up for with more

lucrative consulting contracts further

suggests the growth in importance of

non-audit services as compared to

audits.87

Changes in legal standards have also

affected incentives. Professor John C.

Coffee, Jr. testified that the legal

constraints on accountants have

loosened considerably in recent years,

and as a result, there has been a

significant decrease in the threat of

liability. It has become much more

difficult, and less worthwhile, for

private plaintiffs to assert civil claims

against auditors even in cases where the

plaintiffs believe that an audit failure

flowed from a lack of auditor

independence.88 He specifically

described the following four significant

developments in the law since 1994 that

he believes have reduced the likelihood

of success in private lawsuits against

auditors: (i) the passage of the Private

Securities Litigation Reform Act of

1995, which affected pleading standards

and substituted proportionate liability

for joint and several liability, which

makes it less attractive to sue

accountants ‘‘because even if you’re

successful you’re only going to get a

portion of the total liability assessed

against them, and that may not justify

the cost’’; (ii) passage of the Securities

Litigation Uniform Standards Act of

1998, which preempted certain state or

common law claims in securities fraud

actions against auditors in both state

and federal court; 89 (iii) the Supreme

Court’s decision in Central Bank of

Denver in 1994,90 eliminating liability

in private litigation for aiding and

abetting a securities fraud violation,

‘‘which was the principal tool used to

sue accountants by the plaintiff’s bar’’;

and (iv) the elimination of the threat of

treble damage liability as a result of

amendment to the Racketeer Influenced

and Corrupt Organization Act.91

Professor Coffee summarized the

effect of these developments by noting

that while lawsuits involving

accounting irregularities have actually

increased since 1995, ‘‘those suits today

rarely involve * * * the outside

accountant, as a defendant, and when

they do they’re often very easily and

quickly dismissed,’’ which would

preclude relevant evidence from coming

to light. In view of these developments

in the law, he noted that an auditor

today ‘‘faces greatly increased benefits

through the existence of non-audit

advisory services that are subject to the

discretion of management, and it faces

greatly reduced liabilities.’’

In part because the risks of liability

have changed, as described by Professor

Coffee, we do not believe, as urged by

at least one commenter,92 that liability

insurance premiums are a barometer of

the extent to which non-audit services

pose a risk to audit quality. Professional

malpractice premiums reflect the risk

that the liability insurer will have to

fund a judgment or settlement imposing

money damages on the auditor. This

risk of liability is attributable to a

variety of factors, only one of which is

the risk of audit failure. The likelihood

of audit failure, in turn, is attributable

to many factors, only one of which is

auditor independence. And auditor

independence, in turn, can be

threatened in numerous ways, only one

of which is the provision of non-audit

services. In assessing overall litigation

risk, it is entirely possible, for example,

that a liability insurer would conclude

that an enhanced risk of misconduct is

offset by a small probability of

discovery, as well as a diminishing

likelihood, owing to changes in the law,

that even known misconduct would

result in a judgment or settlement that

the insurer would have to fund.

Consequently, even if insurers were to

provide auditors substantially the same

professional malpractice coverage at

approximately the same cost despite

increases in their provision of non-audit

services, that indicates at most that,

from the insurers’ perspective, overall

litigation risks have not increased.

Because there are numerous

explanations as to why auditors’

professional liability premiums might or

might not increase, we are not

persuaded that insurance premiums are

a useful measure of the effect of nonaudit services on auditor independence.

(ii) Changes in Incentives Are Likely

to Affect Behavior. In the Proposing

Release, we discussed our concern that

the enhanced incentive to perpetuate a

client relationship involving non-audit

services increases the so-called ‘‘selfserving bias’’ auditors experience in

favor of an audit client. We heard

during our public hearings from

academics who have studied the ‘‘selfserving bias,’’ including in connection

with the behavior of auditors. Two

academics presented research tending to

show that subtle but powerful

psychological factors skew the

perceptions and judgments of persons—

including auditors—who have a stake in

the outcome of those judgments.93 Other

Federal Register / Vol. 65, No. 234 / Tuesday, December 5, 2000 / Rules and Regulations 76017

intentions, ‘‘there is good reason to believe that

auditors will unknowingly misrepresent facts and

will unknowingly subordinate their judgment due

to cognitive limitations’’); Jesse D. Beeler and James

E Hunton, ‘‘Contingent Economic Rents; Insidious

Threats to Auditor Independence,’’ manuscript

(2000).

94Testimony of Don N. Kleinmuntz, Professor,

University of Illinois at Urbana-Champaign (Sept.

21, 2000); Testimony of Urton Anderson, Professor,

University of Texas at Austin (Sept. 21, 2000)

(presenting results of research commissioned by

Arthur Andersen, Deloitte & Touche, KPMG, and

the AICPA); see also Testimony of Professor Rick

Antle, Yale University (July 26, 2000) (researcher

for the AICPA presenting personal views on data).

95See supra notes 88–91.

96See infra Section III.C.5.

97At least one witness challenged the

effectiveness of the current peer review system. She

testified that, as enacted, peer review has no

‘‘teeth.’’ Testimony of Wanda Lorenz, CPA, Lane

Gorman Trubitt, LLP (Sept. 20, 2000).

98See, e.g., In the Matter of

PricewaterhouseCoopers LLP, AAER No. 1098 (Jan.

14, 1999).

99W.R. Kinney, Jr., ‘‘Auditor Independence:

Burdensome Constraint or Core Value?’’ Accounting

Horizons (March 1999); G. Trompeter, ‘‘The effect

of partner compensation schemes and generally

accepting accounting principles on audit partner

judgment,’’ Auditing: A Journal of Practice and

Theory (Fall 1994); Paul M. Clikeman, ‘‘Auditor

Independence: Continuing Controversy,’’ Ohio CPA

Journal (Apr.–Jun. 1998).

100Earnscliffe II, supra note 38, at 6. Interviewees

included chief executive officers, chief financial

officers and controllers, auditors, buy-side and sellaside analysts, audit committee chairs, and

regulators.

101The Blue Ribbon Committee on Improving the

Effectiveness of Corporate Audit Committees noted

with respect to independent directors that, even

absent objective verification, ‘‘common sense

dictates that a director without any financial,

family, or other material personal ties to

management is more likely to be able to evaluate

objectively the propriety of management’s

accounting, internal control and reporting

practices.’’ The Blue Ribbon Committee on

Improving the Effectiveness of Corporate Audit

Committees (the ‘‘Blue Ribbon Committee’’), Report

and Recommendations, at 22 (1999) (the ‘‘Blue

Ribbon Report’’). Copies of the Blue Ribbon Report

are available at www.nyse.com or www.nasd.com.

102Written Testimony of John D. Hawke, Jr. (July

26, 2000).

103Written Testimony of Paul A. Volcker

(September 13, 2000). Aggregate economic

incentives aside, non-audit services can have the

effect of aligning the accountant’s interests with

those of management. When the accountant acts as

a consultant, the accountant must answer to

management, and a ‘‘consultant . . . will be judged

by the ultimate usefulness of his advice in bringing

success to management’s efforts. He has had a hand

in shaping managerial decisions and will be judged

by management on the same basis that the

management itself will be judged.’’ R.K. Mautz and

Hussein A. Sharaf, The Philosophy of Auditing at

222 (Am. Acct. Ass’n 1961). As the auditor becomes

increasingly involved with the audit client and its

managers, the auditor is more likely to perceive

himself as a part of the management team and place

less emphasis on his or her primary loyalty to

investors. In Earnscliffe I, Earnscliffe reported that

many individuals interviewed believed that

pressures on auditors have been increasing and are

becoming problematic, and that ‘‘auditors are

developing a stronger interest in their relationship

with management, perhaps at the expense of their

responsibilities to shareholders.’’ Earnscliffe I,

supra note 65, at 9.

104Earnscliffe I, supra note 65, at 46 (Nov. 1999).

The study also found that many individuals

interviewed believed that ‘‘auditors are developing

a stronger interest in their relationship with

management, perhaps at the expense of their

responsibilities to shareholders.’’ Id. at 9.

105Earnscliffe II, supra note 38, at 5 (July 2000).

academics, by contrast, pointed out that

the issue may be more complicated

because, even where an auditor has

some stake in an outcome, the auditor

also has countervailing reputational

interests,94 and concerns about, for

example, legal liability,95 audit

committee review,96 and peer review.97

We do not question that there are

influences on the auditor and an

accounting firm beyond a ‘‘self-serving

bias.’’ We accept also that firms have

incentives to avoid situations that

expose them to liability and

reputational harm. But, again, the

argument proves too much. Even with

these disincentives, audit failures and

impairments of independence occur.98

Other studies tend to show that the

reputational interests of the audit firm

are not the same as the reputational

interests of the audit engagement

partner or the office of the partner that

performs most of the work for an audit

client. Specifically, these studies

suggest that the audit engagement

partner and the office have more to gain

by, for example, acquiescing to the

client’s aggressive accounting treatment

than they have to lose if it results in

audit failure, particularly if the client

engagement contributes substantially to

the partner’s income and the office’s

revenues. Reputational damage will be

spread across the entire firm, whereas

income from the client will be

concentrated in the partner and the

office out of which he or she works.99

In addition, in a two-phase study

commissioned by the ISB, Earnscliffe

reported that ‘‘[m]ost believe that

accounting firms today are not

indifferent about their reputation for

quality audits, but are more focused on

raising the profile, reputation, and

profitability of non-audit services.’’ 100

While we do not purport to resolve a

debate among scholars, it is plain that

there is ample basis to conclude that the

more a person, including an auditor, has

at stake in a judgment, the more likely

his or her judgment is to be affected.101

We stress that the influences that we are

concerned with can be ‘‘extremely

subtle,’’ as stated by the Comptroller of

the Currency, John D. Hawke, in

testimony supporting our proposal to

restrict internal audit outsourcing.102

Paul A. Volcker, the former Chairman of

the Federal Reserve, in his testimony

supporting our proposal, noted the real

threat posed by the ‘‘insidious, hard-topin down, not clearly articulated or

even consciously realized, influences on

audit practices’’ that flow from nonaudit relationships with audit clients.103

b. Certain Non-Audit Services

Inherently Impair Independence. Our

rule lists services that, regardless of the

size of the fees they generate, place the

auditor in a position inconsistent with

the necessary objectivity. Bookkeeping

services, for example, place the auditor

in the position of later having to audit

his or her own work and identify the

auditor too closely with the enterprise

under audit. It is asking too much of an

auditor who keeps the financial books of

an audit client to expect him or her to

be able to audit those same records with

an objective eye.

In much the same way, performing

certain valuation services for the audit

client is inconsistent with

independence. An auditor who has

appraised an important client asset at

mid-year is less likely to question his or

her own work at year-end. Similarly, an

auditor who provides services in a way

that is tantamount to accepting an

appointment as an officer or employee

of the audit client cannot be expected to

be independent in auditing the financial

consequences of management’s

decisions. And an auditor who has

helped to negotiate the terms of

employment for an audit client’s chief

financial officer is less likely to bring

quickly to the audit committee

questions about the new CFO’s

performance.

3. The Expansion of Non-Audit Service

Relationships with Audit Clients Is

Affecting Investor Confidence in the

Independence of Auditors

Recent studies indicate that there is a

growing disquiet among investors and

other users of financial statements about

auditor independence in light of the

multi-faceted relationships between

auditors and their audit clients.

Recently, Earnscliffe found that most

interviewees ‘‘felt that the evolution of

accounting firms to multi-disciplinary

business service consultancies

represent[ed] a challenge to the ability

of auditors to maintain the reality and

the perception of independence.’’ 104 In

Phase II of its study, Earnscliffe reported

that interviewees generally had

confidence in and are satisfied with the

current standard of financial reporting

in the U.S. Nonetheless, the study

noted, ‘‘[m]ost [interviewees] felt that

the risks of unfavorable perceptions of

auditor independence are growing, due

largely to the provision of non-audit

services to auditees.’’ 105

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106The O’Malley Panel Report, supra note 20, at

¶ 5.20.

107Brand Finance plc, The future of audit—‘‘Back

to the Future,’’ ch. 1 (June 2000).

108 Id.

109Written Testimony of Mauricio Kohn, CFA,

CMA, CFM, AIMR (Sept. 20, 2000) (submitting

survey). AIMR is a global, non-profit organization

of investment professionals.

110The results were published by the A.J.

Palumbo School of Business Administration at

Duquesne University (‘‘Duquesne Poll’’).

PricewaterhouseCoopers provided funding for the

poll.

111The 800 adults had incomes greater than

$50,000.

112 Duquesne Poll, supra note 110, Question 12.

113 Duquesne Poll, supra note 110, Question 13.

The Poll also found that 37% of respondents

thought the new rule was ‘‘somewhat important,’’

6% thought it ‘‘not very important,’’ and 3%

thought it ‘‘not at all important.’’

114Mr. Stadler is Dean of the John F. Donahue

Graduate School of Business and the A.J. Palumbo

School of Business Administration.

115For written comments, see, e.g., Letter of

Samuel Fleishman (Sept. 9, 2000) (‘‘My confidence

in the audits is greatly decreased by knowing that

the same company is or could be doing consulting

work for the company they are auditing.’’); Letter

of George R. Jensen (Sept. 8, 2000) (‘‘Investors have

a right to expect that sanctity [of the audit] as it is

promised without having to wonder about the same

firm monkeying with the audit to preserve or

enhance their consulting business.’’); Letter of

Goran LindeOlsson (Sept. 9, 2000) (‘‘The mere

possibility that audits may not be 100% objective

is reason enough to toughen the rules and keep

accounting and consulting services separate.’’);

Letter of Vivian D. Kilgore Jr. (‘‘No public

confidence should be given to any report of any

firm that engages in this practice.’’); Letter of John

Dossing (Sept. 10, 2000) (‘‘Common sense tells me

and other indivi[d]ual invest[o]rs this conflict of

interests will lead to at the very least the

appearance of conflict of interest. How can we trust

any audits with the appearance of a conflict of

interest. Why invest if we can’t trust the figures

presented to us in the financial statements?’’).

116See Testimony of John H. Biggs, Chairman and

CEO of TIAA–CREF (July 26, 2000); Testimony of

Kayla J. Gillan, General Counsel, CalPERS (Sept. 13,

2000); Testimony of Alan P. Cleveland, New

Hampshire Retirement System (Sept. 13, 2000);

Testimony of Bill Patterson, Director, Office of

Investment, AFL–CIO (Sept. 20, 2000).

117Testimony of Paul A. Volcker (Sept. 13, 2000).

118Written Testimony of Richard Blumenthal

(Sept. 20, 2000).

119Testimony of Manuel H. Johnson (July 26,

2000). See also Testimony of William T. Allen,

Chairman, ISB (July 26, 2000) (‘‘[T]he evolution of

the auditing profession into multi-service

professional firms has given rise to reasonable

concerns that the integrity of financial data is being

or may be adversely affected or at least that markets

may become suspicious of that fact and impose an

additional risk premium.’’).

120Written Testimony of John H. Biggs before the

Subcommittee on Securities of the Senate

Though the O’Malley Panel did not

reach consensus on whether changes to

the independence rules are needed, over

the past year it surveyed preparers and

users of financial statements, auditors,

regulators, academics, lawyers, and

analysts about the provision of nonaudit services, and heard from witnesses

at the Panel’s public hearings. The Panel

found that,

[M]any people continue to be concerned—

some very concerned—that the performance

of non-audit services could impair

independence, or that there is at least an

appearance of the potential for impairment.

Almost two-thirds of the respondents to the

Panel’s survey from outside the profession

who addressed non-audit services expressed

such concerns.106

In a June 2000 study, Brand Finance

plc surveyed analysts and

representatives of companies listed on

the London Stock Exchange. Brand

Finance reported,

Analysts are concerned that the acceptance of

non-audit fees by auditors is likely to result

in the independence of the audit being

compromised. 94% of analysts stating an

opinion believe that significant non-audit

fees are likely to compromise audit

independence. 76% of companies stating an

opinion felt that auditor independence is

likely to be compromised where significant

non-audit fees are received from audit

clients.107

Brand Finance also found that ‘‘83% of

analysts who expressed an opinion

believe objectivity is threatened even

when the non-audit fee is less than the

audit fee.’’ 108

In another recent survey, the

Association for Investment Management

and Research (‘‘AIMR’’) surveyed its

members and certified financial analyst

candidates regarding auditor

independence issues. AIMR reported

that ‘‘[p]otential threats to auditor

independence, resulting from audit

firms providing non-audit services to

their audit clients [were] troublesome to

many . . . respondents.’’ 109

A recent poll was conducted by

Public Opinion Strategies 110 to

determine, among other things, how the

investing public views our proposed

rules.111 The results showed that eighty

percent of investors surveyed favor

(forty-nine percent strongly favor; thirtytwo percent somewhat favor) an SEC

rule that generally would require

restrictions on the types of consulting

services accounting firms can provide

their audit clients, 112 and fifty-one

percent thought the new rule was ‘‘very

important’’ to protecting individual

stock market investors.113 As

summarized by James C. Stadler of

Duquesne University, ‘‘The results of

our national poll indicate that average

American investors, in fact,

overwhelmingly support the need for

some new rulemaking in this area.’’ He

further stated, ‘‘The survey results

confirm what most practitioners have

felt for decades—that large consulting

engagements for audit clients can raise

serious concerns regarding audit

independence.’’ 114

Witnesses at our public hearings and

written comments on our proposed

rules supplied additional indications

that investor confidence in auditor

independence is in fact being

undermined by non-audit relationships

between auditors and audit clients.115

For example, representatives of TIAA–

CREF, CalPERS, the New Hampshire

Retirement System, and the AFL–CIO,

organizations with responsibilities for

the sound investment of hundreds of

billions of dollars for the benefit of

millions of participants, all came

forward to express precisely that

concern and to urge us to adopt the

restrictions we proposed, or even more

stringent restrictions.116

Paul Volcker, former Chairman of the

Federal Reserve Board, testified as

follows about investors’ perceptions of a

conflict of interest when auditors

provide non-audit services to audit

clients:

The perception is there because there is a real

conflict of interest. You cannot avoid all

conflicts of interest, but this is a clear,

evident, growing conflict of interest, given

the relative revenues and profits from the

consulting practice, and a conflict of interest

is there.117

Richard Blumenthal, the Attorney

General of Connecticut stated in his

testimony before us, ‘‘The tough-minded

questions and vigorous standards that

the public has traditionally associated

with the term ‘‘independent auditor’’

have been compromised by the

interdependent business relationship

between the auditors and the

audited.’’ 118 Manuel H. Johnson, a

public member of the ISB and the

former Vice Chairman of the Federal

Reserve Board, testified that,

[T]he growing complexity of financial and

economic relationships and the extent of

non-audit services provided to audit clients

by major accounting firms have significantly

increased the perception and the potential for

conflicts of interest and threatens the

integrity of the independent audit

function. 119

At a Congressional subcommittee

hearing regarding our proposals, John H.

Biggs, Chairman, President, and Chief

Executive Officer of TIAA–CREF, said,

The concern about auditor independence in

the presence of substantial management

consulting fees has been with us for years,

and has caused much questioning and study

in the profession. Investor uneasiness and

suspicion of the quality of audited financial

statements is growing rapidly along with the

dramatic rise in the percentage of audit firm

revenues that come from cross-sold

services.120

Federal Register / Vol. 65, No. 234 / Tuesday, December 5, 2000 / Rules and Regulations 76019

Committee on Banking, Housing and Urban

Development (Sept. 28, 2000).

121See, e.g., Testimony of John Guinan, Partner,

KPMG (Sept. 13, 2000) (‘‘There’s no fundamental

unease within the marketplace on this subject.’’);

Testimony of Richard J. Stegemeier, Chairman

Emeritus, Unocal Corp. (Sept. 13, 2000) (‘‘I do not

believe that [a clear and present danger to investors]

exists.’’).

122Earnscliffe I, supra note 65, at 8.

123Earnscliffe II, supra note 38, at 44. At the

request of the AICPA, Gary Orren, a professor at the

John F. Kennedy School of Government, reviewed

and evaluated Earnscliffe I and II. Memorandum

from Gary Orren to AICPA (Sept. 19, 2000). Mr.

Orren concluded that the findings do not support

our proposals, and that the studies were

methodologically flawed. At the same time, he

acknowledged that among the respondents in the

studies, ‘‘[a] larger number, about half, thought that

a perception problem might develop in the future,’’

that the majority of groups interviewed perceived

a ‘‘slight appearance problem’’ today, that the

respondents registered ‘‘mild misgivings’’ about the

effects of non-audit services on independence, and

that the respondents were ‘‘mildly worried’’ about

a possible appearance problem in the future. Id. at

3, 4, and 7.

124 J. Gregory Jenkins and K. Krawczyk, North

Carolina State University, Perceptions of the

Relationship Between Nonaudit Services and

Auditor Independence, manuscript (2000)

(synopsis). In this study, the researchers

interviewed 289 users of financial statements,

including business professionals, graduate business

students, and accounting professionals at Big Five

firms and Non-Big Five firms.

125Penn Schoen & Berland Associates, Inc.,

National Investors Survey (Sept. 12, 2000) (‘‘Penn

Schoen Survey’’).

126 Id. at 4. What the Penn Schoen Survey did not

report, but what we believe to be equally important,

however, is that among all investors surveyed, only

54% said that they believe audited financial

statements are ‘‘very credible,’’ 37% believe they

are only ‘‘somewhat credible,’’ 5% believe they are

‘‘not credible,’’ and the remaining 3% do not know

if they are credible. See Judith Burns, ‘‘Investors

Unconcerned About Auditor Independence,’’ Dow

Jones New Service (Sept. 12, 2000). We do not

believe that investors or the accounting profession

are well-served by a situation in which 37% of

investors in a survey think public companies’

audited financial statements are only ‘‘somewhat

credible.’’ In addition, according to the Penn

Schoen Survey, 23% of investors surveyed believed

that regulators should play a bigger role than they

do now in prohibiting accounting firms from

offering a range of services (id. at 10) and 33% of

investors surveyed disagreed that if our rules

proposals were implemented audit firms will know

less about the companies they audit and the quality

of the audit will suffer (id. at 13).

127Some have suggested that perception is not an

appropriate basis for regulation. See AICPA White

Paper, at App. A (paper by Gary Orren, ‘‘The

Appearance Standard for Auditor Independence:

What We Know and Should Know’’ (Oct. 20. 1997)).

Others believe that ‘‘investor perceptions constitute

an economically legitimate and theoretically sound

basis for regulatory intervention.’’ See, e.g., Written

Testimony of Rajib Doogar (Sept. 20, 2000).

128See supra Section III.C.1; see also Arthur A.

Schulte, Jr., ‘‘Compatibility of Management

Consulting and Auditing,’’ Accounting Rev. 586

(July 1965) (survey of four respondent groups—

research and financial analysts of brokerage firms,

commercial loan and trust officers of banks,

investment officers of insurance companies, and

investment officers of domestic mutual funds—

indicated a third of all respondents believed that

the provision of both audit and non-audit services

was a conflict of interest); Abraham J. Briloff, ‘‘Old

Myths and New Realities in Accountancy,’’

Accounting Rev. 490–94 (July 1996) (finding that a

significant number of academics, members of

financial community, and accountants believed that

an auditor’s provision of management-advisory

services detracted from the quality of the audit);

Pierre L. Titard, ‘‘Independence and MAS—

Opinions of Financial Statement Users,’’ J.

Accountancy 47 (July 1971) (finding that a

significant number of parties who represented

major investment concerns believed that an

auditor’s provision of management advisory

services impaired auditor independence).

129Letter of Deloitte & Touche (Sept. 25, 2000)

(‘‘Deloitte & Touche Letter’’).

130 In this regard, our rule addresses potential

conflicts in a way that is similar to rules regarding

the conduct of federal judges. For example, § 455

of title 28 of the federal code provides that a federal

judge is to disqualify himself (and may be

disqualified by the appellate court) in any

proceeding where the judge’s ‘‘impartiality might

reasonably be questioned.’’ 28 U.S.C. § 455(a). The

courts have explained that ‘‘disqualification is

required if a reasonable person who knew the

circumstances would question the judge’s

impartiality, even though no actual bias or

prejudice has been shown.’’ Gray v. University of

Arkansas, 883 F.2d 1394, 1398 (8th Cir. 1989).

131 ‘‘The Ties That Bind Auditors,’’ The

Economist at 63 (Aug. 12, 2000) (‘‘Usually there is

a train wreck or a stock market crash prompting this

sort of radical legislation.’’).

We recognize there are different views

as to whether investor confidence is

being undermined.121 For example, in

Phase I of its study, Earnscliffe reports

‘‘The vast majority of respondents

believe that auditors are currently

performing audits, which meet a high

standard of objectivity and

independence.’’ 122 In Phase II,

Earnscliffe reports that with respect to

the investing public surveyed, ‘‘Most

had a high degree of confidence in the

quality and reliability of the information

that was available for them to use in

making investment decisions.’’ 123 In

addition, two professors from North

Carolina State University submitted a

study tending to suggest that ‘‘non-audit

services had a positive influence on

participants’’ perceptions of auditor

independence, consistent with the

contention that nonaudit services

enhance auditor independence.’’ 124

Some commenters also cited a survey

commissioned by the AICPA and

conducted by Penn Schoen & Berland

Associates,125 which found that ninetyone percent of investors surveyed

believe audited financial statements are

credible.126

We take seriously the indications of

investor unease, along with indications

that investor opinion may be divided.

We focus on degrees of investor

confidence, and we cannot take lightly

suggestions that even a minority portion

of the population is ‘‘mildly worried’’

about a possible appearance problem or

that their confidence is being

undermined.127 We also take into

account the durability of investor

concerns. For decades there have been

some who were troubled at the growth

of non-audit services.128 Those who

were troubled remain troubled, only

more so, and they have been joined by

new voices from disparate quarters. We

also consider whether the concerns that

we hear will likely persist, or are merely

transitory and unreasonable fears that

inevitably will be allayed. In this

instance, we believe that the indications

of unease are reasonably based and thus

likely to endure and increase, absent

preventive action by the Commission.

4. The Rules Are Appropriately

Prophylactic

Some commenters and witnesses

argue that there is ‘‘no empirical

evidence to support the notion that

providing non-audit services to audit

clients has had any adverse effect on the

quality of audits.’’ 129 This argument

fails to take into account not only the

extensive body of research and

comments discussed above that

document investor concerns, but also

the extent to which our approach is, and

must be, prophylactic. Moreover, as we

explain below, the asserted absence of

conclusive empirical evidence on this

point is not particularly telling.

a. The Commission’s Independence

Rules Must Be Prophylactic. Our

approach to auditor independence

traditionally has been, as it must be,

prophylactic. Independence rules are

similar, though not identical, to conflict

of interest rules. To minimize the risks

of bias, the independence rules, like

conflict of interest rules, proscribe

certain relationships or circumstances,

whether or not one can show that biased

behavior inevitably results from the

conflict.130 The independence rules are

preventive both because of the difficulty

in proving the link from circumstance to

state of mind, as discussed below, and

because of the need to act in the public

interest and protect investor confidence

before it has been significantly

undermined.

The Commission’s obligation to

protect investors requires it to act before

there has been a serious erosion of

confidence in our nation’s securities

markets. Our view on this point is quite

different from the suggestion from the

CEO of an accounting firm that we

should wait to adopt restrictions on

non-audit services until there has been

‘‘a train wreck or a stockmarket

crash.’’ 131 Our mission is not to pick up

the pieces of such a ‘‘train wreck,’’ but

to prevent one.

76020 Federal Register / Vol. 65, No. 234 / Tuesday, December 5, 2000 / Rules and Regulations

132Notice of Proposed Rule Change by the

Municipal Securities Rulemaking Board Relating to

Political Contributions and Prohibitions on

Municipal Securities Business, Exchange Act

Release No. 33482 (Jan. 14, 1994) [59 FR 3389]; see

also ‘‘Exceptions to Rules 10b–6, 10b–7, and 10b–

8 Under the Securities Exchange Act of 1934 for

Distributions of Foreign Securities to Qualified

Institutional Buyers, Securities Act Rel. No. 6999

(May 5, 1993) [58 FR 27686)] (‘‘Rules 10b–6, 10b–

7, and 10b–8 (‘Trading Rules’) are prophylactic in

nature and designed to protect investors purchasing

a security in a distribution from paying a price that

has been artifically influenced (i.e., raised or

supported) by those persons who have the greatest

incentive to engage in manipulative activity.

Because the Trading Rules protect investors against

artificial price movements, they promote the

integrity of the pricing process and public

confidence in the U.S. securities markets.’’).

133 ‘‘Selective Disclosure and Insider Trading,’’

Release No. 33–7881 (Aug. 15, 2000) [65 FR 51715].

134 Id.

135 61 F.3d 938 (D.C. Cir. 1994).

136 Id. at 945. Similarly, even in the First

Amendment context of restrictions on campaign

contributions, the Supreme Court has upheld the

validity of prophylactic rules. Nixon v. Shrink

Missouri Government, 528 U.S. 377 (2000) (relying

on the seminal case of Buckley v. Valeo, 424 U.S.

1 (1976)).

137The widespread perception among

sophisticated members of the financial community

that non-audit services are jeopardizing audit

reliability at the very least suggests that there is in

fact a problem. Moreover, at least one published

study has found a statistical link between the

provision of non-audit services and the frequency

of audit qualifications. Graeme Wines, ‘‘Auditor

Independence, Audit Qualifications and the

Provision of Non-Audit Services: A Note,’’ 34 Acc.

& Fin. 76 (May 1994). The author analyzed the audit

reports put out between 1980 and 1989 by 76

companies publicly listed on the Australian Stock

Exchange. He found that ‘‘the auditors of companies

not receiving an audit qualification of any type over

the period derived a significantly higher proportion

of their remuneration from non-audit services fees

than the auditors of companies receiving at least

one audit qualification.’’ Id. at 76. While the author

acknowledges that his research is by no means

conclusive, it does corroborate the common-sense

expectation that ‘‘auditors are less likely to qualify

a given company’s financials statements when

higher levels of non-audit fees are derived.’’ Id. at

83.

138See Testimony of Robert L. Ryan, CFO,

Medtronic, Inc. (Sept. 20, 2000) (‘‘[T]o my mind one

of the most sacred things in the whole audit process

is judgment.* * * [T]here is so much judgment that

goes into a financial statement and I want to feel

that if I’m sitting across from a partner * * * that

audit is the primary thing.* * *’’).

139Richard C. Breeden, Roderick M. Hills, David

S. Ruder and Harold M. Williams, Editorial, supra

note. 33.

140See, e.g., Written Testimony of J. Michael

Cook former Chairman and Chief Executive Officer,

Deloitte & Touche (July 26, 2000) (‘‘I do not share

the view that proof of such a linkage is the only

appropriate basis for regulatory action. To the

contrary, I believe the most independence rules

today are the result of appearance-based rather than

fact-based concerns. Further, I agree with the

Commission that the absence of ‘‘proof’’ does not

justify inaction, particularly when such evidence

cannot be expected to be demonstrable.’’); Paul

B.W. Miller, Ph.D., CPA, Professor, University of

Colorado at Colorado Springs, and Paul R. Bahnson,

‘‘The Spirit of Accounting’’ (draft column to appear

in Accounting Today, submitted as Addendum to

Written Testimony of Paul Miller (July 31, 2000)

(‘‘[A]udit failure is the wrong factor to

consider.* * * The issue is not whether the auditor

We have adopted other rules with a

similar attentiveness to the need to

sustain investor confidence in the

public securities markets. For example,

in our Order regarding rule changes by

the Municipal Securities Rulemaking

Board to address ‘‘pay to play’’ practices

in the municipal securities market, we

stated that the proposed rule changes

were intended, among other things, ‘‘to

bolster investor confidence in the

integrity of the market by eliminating

the opportunity for abuses in

connection with the awarding of

municipal securities business.’’132

Regulation FD provides another

example of our acting to protect investor

confidence.133 There, our concern was,

among other things, that ‘‘the practice of

selective disclosure leads to a loss of

investor confidence in the integrity of

our capital markets.’’134

The courts have specifically rejected

the need for proof of prior harm as an

antecedent to government action

designed to safeguard public confidence

in the integrity of public actors and

processes. For example, the court in

Blount v. Securities and Exchange

Commission,135 articulated this

principle in the context of those rules

limiting ‘‘pay to play’’ practices in the

municipal securities markets, stating,

‘‘Although the record contains only

allegations, no smoking gun is needed

where, as here, the conflict of interest is

apparent, the likelihood of stealth great,

and the legislative purpose

prophylactic.’’136

In promulgating rules concerning

auditor independence, we are making

judgments about incremental

probabilities. We must make judgments

about the circumstances that render a

loss of auditor objectivity more or less

likely. ‘‘Objectivity’’ is not merely the

absence of a conscious intention to skew

audit results in a client’s favor; it is a

willingness to go without reluctance

wherever the data lead. For us, the

question is not whether an auditor who

otherwise would be without bias will

inevitably become biased and then

intentionally disregard a false statement

in a client’s financial statements. We do

not believe the appropriate benchmark

for action is whether new rules are

needed to make ‘‘bad’’ auditors good,

malleable ones stronger, or salesoriented ones focus solely on the audit.

Rather, the actual issue is whether

providing these services makes it

unacceptably likely that there will be an

effect on the auditor’s judgment,

whether or not the auditor is aware of

it.

Similarly, our mandate to enhance

investor confidence in our securities

markets requires us to make judgments

as to effects on degrees of confidence.

Investor confidence in the securities

markets arises from a multiplicity of

sources. Investor confidence is currently

high. We must consider not whether

otherwise confident investors will lose

confidence in our markets, but whether

there is a significant enough probability

that enough investors will lose enough

confidence if we fail to act. In our

judgment, the risk is present, and we

should address it.

b. The Commission Should Not Delay

Action to Engage in Further Study. In

any event, the assertion that no

empirical evidence conclusively links

audit failures to non-audit services

misses the point.137 First, ‘‘audit

quality,’’ which we seek to protect, is

about more than just avoiding major

audit failures or financial fraud.

Auditing, we are often reminded, is not

mechanical, but requires numerous

subtle judgments.138 It is important that

these judgments be made fairly and

objectively, whether or not they relate to

matters that are material to the financial

statements. As four previous SEC

Chairmen stated,

Some will say that action now is premature

or unwarranted. They argue that there’s no

harm unless you can directly tie a firm’s

nonaudit services to a failed audit. But this

claim belies the environment in which many

tough business decisions are made. It is

rarely the black-and-white issues that an

auditor faces. The danger lies in the gray

area—where the pressure to bend to client

interest is subtle, but no less deleterious.139

The number of ‘‘audit failures’’ says

nothing about misjudgments in the gray

area.

‘‘Audit failures’’ in all likelihood also

demonstrate relatively little about the

incidence of auditor error. An ‘‘audit

failure,’’ as we use the term, refers to an

instance in which the issuer’s financial

statements are materially misstated and

in which the auditor either failed to

discover the misstatement or acquiesced

in the inclusion of the misstatement in

the issuer’s financial statements. The

Commission is aware of only those audit

failures it discovers or that are made

public; presumably there are more. And,

presumably, every error by an auditor

does not lead to an audit failure.

Moreover, audit failures arise from a

multiplicity of causes, of which an

impairment of independence is but one.

To demand, as a predicate for

Commission action, evidence that each

loss of independence produces an audit

failure is a bit like demanding proof that

every violation of a fire safety code

results in a catastrophic fire.140

Federal Register / Vol. 65, No. 234 / Tuesday, December 5, 2000 / Rules and Regulations 76021

can avoid catastrophic failure but whether the audit

can increase the credibility of the statements

enough to make investors perceive a lower risk of

being misled.’’); Testimony of Robert E. Denham,

Member, ISB (July 26, 2000) (‘‘[I]t’s a mistake to

focus too much on the cases of major audit failure

and try to draw lessons from whether independence

played a role in those.* * * [T]he better question

for guiding the Commission * * * is what set of

rules is more likely to produce better accounting,

better financial reporting in the ordinary

circumstances of the good companies.* * *’’)

141See, e.g., SEC v. Jose Gomez, AAER No. 57

(May 8, 1985).

142See, e.g., SEC v. Christopher Bagdasarian and

Sam White, AAER No. 825 (Sept. 26, 1996).

143Article IV of the AICPA’s Code of Professional

Conduct provides, ‘‘Objectivity is a state of mind,

a quality that lends value to a member’s services.

It is a distinguishing feature of the profession. The

principle of objectivity imposes the obligation to be

impartial, intellectually honest, and free of conflicts

of interest. Independence precludes relationships

that may appear to impair a member’s objectivity

in rendering attestation services.’’ AICPA Code of

Professional Conduct, ET § 55.01.

144 1979 POB Report, supra note 38, at 34 n.103.

As the POB noted, ‘‘[T]he Board recognizes that the

nonexistence of such evidence does not necessarily

mean that there have not been instances where

independence may have been impaired. Not all

situations where an auditor’s objectivity is

compromised will result in a lawsuit.’’ Id. at 35. 145While we considered testimony from our

public hearings in evaluating the need for the rules

as a matter of public policy, there was no fact

finding with respect to particular cases and we have

not reached any conclusions as to the presence or

absence of securities law violations in cases

discussed by witnesses.

146Testimony of Robert M. Morgenthau (Sept. 13,

2000).

147See Testimony of Jay W. Eisenhofer, Partner,

Grant & Eisenhofer (Sept. 13, 2000) (‘‘It’s always

difficult to prove [that the auditor was influenced

by large consulting fees] as a certainty, but what

you’re attempting to do is to use that information

to demonstrate that the auditor had a motive that

in combination with other facts that you’re able to

elicit demonstrates that the auditor at least

recklessly disregarded its obligations, if not

intentionally did so.’’).

148Testimony of Charles R. Drott (Sept. 13, 2000).

149Testimony of Stuart Grant, Partner, Grant &

Eisenhofer (Sept. 20, 2000). Mr. Grant testified at

the request of his client, the Council of Institutional

Investors, although he stated that he was expressing

his own views.

150Testimony of Jay W. Eisenhofer (Sept. 13,

2000). 151But see Testimony of Barry Melancon,

President and Chief Executive Officer, AICPA (Sept.

21, 2000) (‘‘Even if there was some isolated case[s]

in which non-audit services were found to be

linked to audit failures that would not establish a

proper basis for the drastic action proposed by this

rule.’’).

152Written Testimony of Richard Blumenthal

(Sept. 20, 2000).

153Letter of William S. Lerach (Sept. 22, 2000).

See also Letter of Britton Davis (Aug. 14, 2000) (‘‘I

Continued

Second, the subtle influences that we

are addressing are, by their nature,

difficult to isolate and difficult to link

to any particular action or consequence.

The asserted lack of evidence isolating

those influences and linking them to

questionable audit judgments simply

does not prove that an auditor’s

judgment is unlikely to be affected

because of an auditor’s economic

interest in a non-audit relationship.

Indeed, it is precisely because of the

inherent difficulty in isolating a link

between a questionable influence and a

compromised audit that any resolution

of this issue must rest on our informed

judgment rather than mathematical

certainty.

Except where an auditor accepts a

payment to look the other way,141 is

found to have participated in a

fraudulent scheme,142 or admits to being

biased, we cannot know with absolute

certainty whether an auditor’s mind is,

or at the time of the audit was,

‘‘objective.’’ It is even harder to measure

the impact that a particular financial

arrangement with the audit client had

on the auditor’s state of mind.143

Similarly, it is difficult to tie a

questionable state of mind to a wrong

judgment, a failure to notice something

important, a failure to seek important

evidential matter, a failure to challenge

a management assertion, or a failure to

consider the quality ‘‘ not just the

acceptability ‘‘ of a company’s financial

reporting. As the POB noted, ‘‘Specific

evidence of loss of independence

through MAS [management advisory

services], a so-called smoking gun, is

not likely to be available even if there

is such a loss.’’144

Testimony during our hearings

provided informed, real-world

perspectives bearing on the practical

difficulty of establishing a conclusive

link between non-audit service

relationships and compromised audit

judgments. Many who provided those

perspectives nonetheless urged that we

proceed with our rule.145

Based on his thirty-three years of law

enforcement experience and several

cases involving unlawful and

questionable conduct by auditors,

Robert M. Morgenthau, the District

Attorney for the County of New York,

testified, ‘‘in most cases, it was

impossible to tell whether financial

considerations played a role in the

auditor’s issuing the opinion he did.’’146

In these instances, absent the sort of

admission referenced above, we can

look only to circumstantial evidence of

influences or incentives affecting the

auditor.147 A number of plaintiffs’

lawyers agreed that the hard evidence

opponents of the proposals seek will be

rare because even where the evidence

does exist, it is unlikely that it will be

made public. Charles Drott, a CPA and

a forensic examiner, testified that ‘‘the

only time these issues come to light

* * * is when there is significant

litigation.* * * The accounting firm[s]

[are] not sharing this information, and I

don’t know of any vehicle at the present

time that requires them to do so.’’148

Stuart Grant, an attorney who regularly

represents institutional investors in

securities litigation, stated that, based

on his experience, he thought it unlikely

that an auditor, like any party to a

lawsuit, would ever concede that it

made an accounting judgment in part to

protect its consulting business.149 Jay

W. Eisenhofer, Mr. Grant’s partner,

noted that even if a case involving

independence allegations were to

proceed to trial, any information

relevant to the alleged violation that was

produced in discovery likely would be

protected from general disclosure by a

confidentiality order.150

While these witnesses and

commenters said that, based on their

experience, we should not expect to

have an abundance of evidence showing

a direct link between the provision of

non-audit services and audit failures,

others pointed to cases where they

believed the connection was

apparent.151 Richard Blumenthal,

Attorney General of the State of

Connecticut, described a matter

investigated by his office which he

believed did involve a significant audit

failure linked to a loss of audit

objectivity caused by the auditor’s nonaudit business relationship with the

audit client. Mr. Blumenthal stated,

‘‘Connecticut residents have personally

experienced the financial hardship

occasioned by the loss of independence

and objectivity in the accounting

profession. * * * While investors

eventually recovered a portion of their

losses, many surely never recovered

their faith in * * * the accounting

profession.’’152

William S. Lerach, of Milberg Weiss

Bershad Hynes & Lerach LLP, which

represents investors in securities

litigation, provided his perspective on

this issue. He stated,

It has been asserted there is as yet no

‘‘empirical evidence’’ demonstrating a loss of

auditor independence in providing

consultant and other non-audit services. In

fact, we know otherwise.

In prosecuting securities fraud cases against

public companies and their auditors, we

obtain access to internal corporate

documents that are sealed from public view

by confidentiality orders and are never made

available to the Commission. Over the years,

we have seen repeated instances where

auditors are unable to maintain

independence from their clients. Not

infrequently, the lack of independence arises

most directly from the fact that the auditing

firm has substantial consulting relationships

with the client ‘‘ relationships that are

extremely lucrative ‘‘ much more lucrative

than the auditing work.153

76022 Federal Register / Vol. 65, No. 234 / Tuesday, December 5, 2000 / Rules and Regulations

have witnessed several instances of ‘‘rolling over’’

on issues that affected our clients, for no other

reason than the apparent conflict sticking to our

guns would have caused (thus threatening our

revenue stream).’’); see also Testimony of Charles R.

Drott, CPA, CFA (Sept. 13, 2000) (‘‘My overall

conclusion * * * has been that in most of the cases

that I have been involved in, meaning at least 50

cases that I have been involved in regarding audit

failures, that the underlying cause of most of these

situations was compromised auditor independence.

This involved auditors auditing their own work,

acting as advocates for their clients, entering into

improper business relationships with their clients,

and acting as management for their clients.’’).

154Testimony of Jack T. Ciesielski, accounting

analyst (July 26, 2000).

155See supra note 22.

156As discussed above and in the Proposing

Release (Section II.C), there have been significant

changes in the accounting profession and the

provision of non-audit services since 1982, when

we rescinded our previous proxy statement

disclosure requirement regarding non-audit

services. From 1978 to 1982, we required

companies to include in their proxy statement

disclosures about non-audit services provided by

their auditors, including the percentage of the fees

for all non-audit services compared to total audit

fees and the percentage of the fee for each non-audit

service compared to total audit fees (‘‘Disclosure of

Relationships with Independent Public

Accountants,’’ ASR No. 250 (June 29, 1978)).

Although our concerns about the provision of

consulting and other non-audit services remained

unchanged, we later determined to rescind the

proxy disclosure requirement (‘‘Rescission of

Certain Accounting Series Releases and Adoption of

Amendments to Certain Rules of Regulation S–X

Relating to Disclosure of Maturities of Long-Term

Obligations,’’ ASR No. 297 (Aug. 20, 1981)). Among

other reasons, our review of proxy disclosures

convinced us that accounting firms then, in contrast

to now, were not providing extensive non-audit

services to their audit clients. In addition, we noted

that, even without the proxy statement requirement,

investors had access to useful data provided to and

made public by the SECPS. As discussed below,

that data are no longer readily available.

157 In particular, summarized information

regarding the relationship between non-audit and

audit fees is provided to the SECPS by its member

firms. Until recently, the SECPS published

aggregate information regarding the mix of services

provided by an accounting firm to all of its clients.

Investors, however, would be primarily interested

in the receipt of non-audit services by the

companies in which they invest.

158Earnscliffe II, supra note 38 at 9.

159Penn Schoen Survey, supra note 125, at 15.

160 Id.

161See, e.g., Arthur Andersen Letter.

162Testimony of Jack Ciesielski, accounting

analyst (July 26, 2000).

Finally, we are also cognizant that

concerns about the impact of non-audit

services on independence have been

steadily with us, and growing, during

relatively prosperous times, and that

any economic downturn may heighten

concern over some of these issues. As

one analyst stated during our public

hearings,

If we’re asking hard questions about

independence and the appearance of

independence now, won’t our concerns be

magnified during times of economic distress?

It’s not hard to imagine an economic

environment where firms may be more prone

to pushing the envelope of reliable

accounting and reporting, and that’s when

you would want an auditing profession

possessing unquestionable independence. If

we have qualms about that independence

now, it will be worse in an economic

downturn, and that’s when investor

confidence may be tested on issues other

than auditor independence.154

5. Our Two-Pronged Approach

Responds to Various Aspects of Auditor

Independence

As discussed above, some non-audit

services, by their very nature, raise

independence concerns because, for

example, they place the auditor in the

position of auditing his or her own

work. We are otherwise concerned

about non-audit services because of the

overall economic incentives they create

and because of the interdependence that

develops between the auditor and the

audit client in the course of the nonaudit relationship.

The greatest assurance of auditor

independence would come from

prohibiting auditors from providing any

non-audit services to audit clients. We

solicited comment on this approach,

and some commenters strongly urged

that we adopt such an exclusionary

ban.155 That way, the auditor would

never be placed in a conflict-of-interest

position, nor would the auditor have

any economic incentive, beyond

continuation of the audit relationship,

that might give rise to a biased attitude.

We believe, however, that the better

course is for us to eschew a single bright

line and instead to draw a series of

lines, based on our assessment of

particular factual circumstances,

understanding that identifying

dangerous circumstances in this area is

more a matter of informed judgment

than measurement. We believe that the

two-pronged approach we are taking in

the final rules—requiring disclosure of

the fees billed by the auditor for the

audit, financial information systems

design and implementation services,

and other non-audit services, and

identifying particular services that are

incompatible with independence—best

protects the audit process. Our approach

also permits us to restrict non-audit

services only to the extent necessary to

protect the integrity and independence

of the audit function. Accountants will

continue to be able to provide a wide

variety of non-audit services to their

audit clients. They also will be able to

provide any non-audit service to nonaudit clients.

Under the proxy disclosure rule being

adopted, registrants will have to

disclose, among other things, the

aggregate fees billed for the audit in the

most recent fiscal year, the aggregate

fees billed for financial information

systems design and implementation,

and the aggregate fees billed for nonaudit services performed by the auditor

in the most recent fiscal year. In

addition, companies must provide

certain disclosures about their audit

committee. Investors will be able to

evaluate for themselves whether the

proportion of fees for audit and nonaudit services causes them to question

the auditor’s independence. As

discussed above, in recent years there

has been a dramatic growth in the

number of non-audit services provided

to audit clients and the magnitude of

fees paid for non-audit services.156

Moreover, there may be less information

available to investors about these

services since the SECPS has stopped

publishing information about audit

firms’ provision of non-audit

services.157

Surveys confirm that investors expect

that the information that will be

disclosed under the final rule will be

useful in making investment decisions.

In its Phase II study, Earnscliffe found

that ‘‘[m]any advocate[] a requirement of

full disclosure as a way to both deter an

unhealthy relationship between auditor

and client, and to inform investors of

any risks’’ related to the relationship.158

In addition, the Penn Schoen Survey

found that ‘‘[n]ine in ten investors want

to know if a company’s auditor also

provides other services.’’159 Eighty-nine

percent of respondents in that study

said, ‘‘It would be important for

shareholders to know if a company’s

auditor also provides consulting

services to that company.’’160

We considered a disclosure-only

approach and solicited comment on that

approach. Some commenters favored a

disclosure-only approach to the

independence issues created by

auditors’ provision of non-audit

services.161 We, however, do not believe

that such an approach is appropriate for

several reasons. First, our federal

securities laws require that auditors be

independent, and we do not believe that

disclosure can ‘‘cure’’ an impairment of

independence.162 Second, as discussed

above, by their very nature, certain nonaudit services provided by auditors can

affect an auditor’s independence,

regardless of whether investors are

made aware of the provision of the

services. As a representative of one of

the largest pension funds commented,

‘‘While we do not believe that

disclosure in and of itself is adequate to

deal with the independence problems

involved here, shareholders have a right

Federal Register / Vol. 65, No. 234 / Tuesday, December 5, 2000 / Rules and Regulations 76023

163Letter of Peter C. Clapman, Senior Vice

President and Chief Counsel, Investment, TIAA–

CREF (Sept. 21, 2000).

164The New York Stock Exchange (‘‘NYSE’’),

National Association of Securities Dealers, Inc.

(‘‘NASD’’), and the American Stock Exchange

(‘‘AMEX’’) also changed their company listing

standards to make it clear that the auditor is

ultimately accountable to the board of directors and

the audit committee, as opposed to management,

and that the audit committee and the board of

directors have the ultimate authority and

responsibility to select, evaluate and, when

appropriate, replace the auditor. See Order

Approving Proposed Rule Change by the NASD,

Exchange Act Rel. No. 42231, File No. SR–NASD–

99–48 (Dec. 14, 1999); Order Approving Proposed

Rule Change by the NYSE, Exchange Act Rel. No.

42233, File No. SR–NYSE–99–39 (Dec. 14, 1999);

and Order Approving Proposed Rule Change by the

AMEX, Exchange Act Rel. No. 42232, File No. SR–

Amex–99–38 (Dec. 14, 1999).

165 ‘‘Audit Committee Disclosure,’’ Exchange Act

Rel. No. 42266 (Dec. 22, 1999). 166 In its report, the Blue Ribbon Committee noted

that with respect to independent directors, even

absent objective verification, ‘‘common sense

dictates that a director without any financial,

family, or other material personal ties to

management is more likely to be able to evaluate

objectively the propriety of management’s

accounting, internal control and reporting

practices.’’ Blue Ribbon Report, supra note 101, at

22.

167 ISB Standard No. 1, ‘‘Independence

Discussions with Audit Committees’’ (Jan. 1999).

Copies of standards issued by the ISB are available

on the ISB’s website at www.cpaindependence.org.

168 In a letter to the SECPS, ISB Chairman

William Allen clarified the use of the auditor’s

judgment under the standard. He stated:

[I]n asking itself whether a fact or relationship is

material in this setting the auditor may not rely on

its professional judgment that such fact or

relationship does not constitute an impairment of

independence. Rather the auditor is to ask, in its

informed good faith view, whether the members of

the audit committee who represent reasonable

investors, would regard the fact in question as

bearing upon the board’s judgment of auditor

independence.

Letter from William T. Allen, Chairman, ISB, to

Michael A. Conway, Chairman, Executive

Committee, SECPS (Feb. 8, 1999). We believe that

Chairman Allen’s interpretation is appropriate.

169Blue Ribbon Report, supra note 101, at 40.

170See Testimony of Barry Melancon, President

and Chief Executive Officer, AICPA (Sept. 21, 2000)

(‘‘[I]t’s the audit firm’s responsibility to determine

that they are independent.* * * [T]he obligation is

clearly on the auditor. The auditor cannot put that

obligation off solely to the audit committee in any

form or fashion. And even if the audit committee

were to determine things were okay, the firm is still

responsible to make an independent judgment that

they are in fact independent.’’)

171See Testimony of John Whitehead, former

Chairman, Goldman Sachs & Co. (Sept. 13, 2000).

172See, e.g., Testimony of Robert L. Ryan, Chief

Financial Officer, Medtronic, Inc. (Sept. 20, 2000)

(‘‘We believe that we should continue to require our

audit committees, who are in the best position to

evaluate independence, to play an active role in this

assessment process as the proposed rule changes

outline.’’)

173Companies have differing approaches to hiring

their auditors to provide non-audit services. For

example, John H. Biggs testified that TIAA–CREF

does not hire its auditors to provide non-audit

services (Testimony of John H. Biggs (July 26,

2000)), while Judy Lewent, Senior Vice President

and CFO, Merck & Co., Inc., testified that her

company employs a set of principles and practices

for determining whether to hire their auditors to

provide non-audit services, such as rotating its lead

auditor every five years and requiring the audit

committee to approve each request to use the

Continued

to know about relationships that may

compromise the independence of audits

on which they rely.’’163

6. The Final Rules Will Assist Audit

Committees in Their Oversight Role

Issuers and other registrants have

strong incentives to promote auditor

independence. It is their financial

statements that an auditor examines.

They have the legal responsibility to file

the financial information with the

Commission, as a condition to accessing

the public securities markets, and it is

their filings that are legally deficient if

auditors who are not independent

certify their financial statements.

For most public companies, audit

committees have become an essential

means through which corporate boards

of directors oversee the integrity of the

company’s financial reporting process,

system of internal accounting control,

and the financial statements themselves.

Among other things, an audit committee

serves as the board’s principal interface

with the company’s auditors and

facilitates communications between the

company’s board, its management, and

its internal and independent auditors on

significant accounting issues and

policies.

The Commission is an advocate of

effective and independent audit

committees. Most recently, the

Commission and three major exchanges

adopted important audit committee

rules. The New York Stock Exchange,

the National Association of Securities

Dealers, Inc., and the American Stock

Exchange changed their listing

standards. These changes require listed

companies to have independent audit

committees, and require audit

committees to play a significant role in

overseeing the company’s auditors.164

Also, we adopted new disclosure

rules regarding audit committees and

auditor reviews of interim financial

information 165 in response to

recommendations of the Blue Ribbon

Committee.166 Those rules require that

companies include in their proxy

statements reports of their audit

committees that state whether, among

other things, the audit committees

received the written disclosures and the

letter from the independent auditors

required by ISB Standard No. 1,167 and

discussed with the auditors the

auditors’ independence. ISB Standard

No. 1 requires each auditor to disclose

in writing to its client’s audit committee

all relationships between the auditor

and the company that, in the auditor’s

judgment, reasonably may be thought to

bear on independence and to discuss

the auditor’s independence with the

audit committee.168

The final rule supplements those

required disclosures with an additional

disclosure as to whether the issuer’s

audit committee ‘‘has considered

whether the provision of non-audit

services] is compatible with maintaining

the principal accountant’s

independence.’’ The disclosure focuses

particularly on non-audit services and

requires disclosure of whether the audit

committee itself has focused on the

issue. We believe that our final rule, our

new audit committee disclosure rules,

and the new requirements of the NYSE,

AMEX, NASD, and ISB should

encourage auditors, audit committees,

and management to conduct robust and

probing discussion on all issues that

might affect the auditor’s independence.

According to the Blue Ribbon Report,

‘‘If the audit committee is to effectively

accomplish its task of overseeing the

financial reporting process, it must rely,

in part, on the work, guidance and

judgment of the outside auditor. Integral

to this reliance is the requirement that

the outside auditors perform their

service without being affected by

economic or other interests that would

call into question their objectivity and,

accordingly, the reliability of their

attestation.’’169

Our final rule does not impose any

new legal requirements on audit

committees.170 While the rule may serve

to direct the attention of audit

committees to the potential for

independence issues arising from nonaudit services, any action taken by audit

committees will be business judgments.

Nonetheless, the rule should help audit

committees carry out their existing

responsibilities by codifying the key

legal requirements that may bear on

audit committees’ exercise of their

business judgment.171 We believe that

audit committees, as well as

management, should engage in active

discussions of independence-related

issues with the outside auditors.172 As

with discussions over the quality and

acceptability of management’s

judgments, audit committees can be

useful in considering whether assertions

of independence rest on conservative or

aggressive readings of the independence

rules. Similarly, audit committees may

wish to consider whether to adopt

formal or informal policies concerning

when or whether to engage the

company’s auditing firm to provide nonaudit services.173

76024 Federal Register / Vol. 65, No. 234 / Tuesday, December 5, 2000 / Rules and Regulations

outside audit firm for non-audit services. She noted

that the company’s process for such determinations

has resulted in the use of their audit firm for nonaudit services only in limited circumstances

(Testimony of Judy Lewent (Sept. 13, 2000)).

174O’Malley Panel Report, supra note 20, at

¶ 5.29.

175 Id. at 116–17.

176See, e.g., Testimony of Philip D. Ameen,

Chair, Committee on Corporate Reporting, FEI–CRR

(Sept. 20, 2000); Letter of Caroline Rook, Acxiom

Corp. (Sept. 7, 2000); Letter of Allen J. Krowe,

retired Vice Chairman, Texaco, Inc. (Sept. 5, 2000).

177See, e.g., Testimony of Bill Patterson, Director

of the Office of Investment, AFL–CIO (Sept. 20,

2000).

178See, e.g., AICPA Letter.

179Letter from Michael H. Sutton, Chief

Accountant, SEC to William T. Allen, Chairman,

ISB (Dec. 11, 1997), at 6–7 (attaching SEC Staff

Analysis of AICPA White Paper).

180O’Malley Panel Report, supra note 20, at

¶ 5.11 But see Testimony of James E. Copeland,

Chief Executive Officer of Deloitte & Touche (Sept.

20, 2000) (asserting that it is the overall

competencies gained by providing non-audit

services to audit clients and non-audit clients that

improve the quality of audits).

181Written Testimony of Douglas Scrivner,

General Counsel, Andersen Consulting (Sept. 20,

2000). Scrivner also is a former partner of Arthur

In this latter connection, we note that

recently the O’Malley Panel

recommended certain guiding factors for

audit committees to consider in making

business judgments about particular

non-audit services. According to the

O’Malley Panel, one guiding principle

should be whether the ‘‘service

facilitates the performance of the audit,

improves the client’s financial reporting

process, or is otherwise in the public

interest.’’174 Other matters to be

considered are:

• Whether the service is being

performed principally for the audit

committee.

• The effects of the service, if any, on

audit effectiveness or on the quality and

timeliness of the entity’s financial

reporting process.

• Whether the service would be

performed by specialists (e.g.,

technology specialists) who ordinarily

also provide recurring audit support.

• Whether the service would be

performed by audit personnel and, if so,

whether it will enhance their knowledge

of the entity’s business and operations.

• Whether the role of those

performing the service (e.g., a role

where neutrality, impartiality and

auditor skepticism are likely to be

subverted) would be inconsistent with

the auditor’s role.

• Whether the audit firm’s personnel

would be assuming a management role

or creating a mutuality of interest with

management.

• Whether the auditors, in effect,

would be auditing their own numbers.

• Whether the project must be started

and completed very quickly.

• Whether the audit firm has unique

expertise in the service.

• The size of the fee(s) for the nonaudit service(s).175

These factors expand upon the four

factors in the Preliminary Note to Rule

2–01. Additionally, the O’Malley Panel

recommends that audit committees preapprove non-audit services that exceed

a threshold determined by the

committee. We believe that the

O’Malley Panel recommendations

represent a thoughtful and appropriate

approach to these issues by audit

committees, and we encourage audit

committees to consider the Panel’s

recommendations.

Some commenters suggested that the

Commission and investors rely

primarily on corporate audit committees

to monitor and ensure auditor

independence.176 Other commenters,

however, including investor

representatives, indicated that this

approach, without more, was

inadequate.177 While we welcome active

oversight by audit committees with

respect to auditor independence, we do

not believe that this oversight obviates

the need for the rule we adopt today.

Audit committees bring business

judgment to bear on the financial

matters within their purview. Their

purpose is not to set the independence

standards for the profession, and we are

not attempting to saddle them with that

responsibility. On the other hand, we

believe that the final rule facilitates the

work of audit committees by

establishing clear legal standards that

audit committees can use as

benchmarks against which to exercise

business judgment.

7. The Final Rules Will Not Diminish

Audit Quality

Some commenters expressed concern

that the proposed restrictions on nonaudit services would hurt audit

quality.178 These commenters assert that

the auditor gains valuable knowledge

about an audit client’s business by

providing non-audit services. The more

the auditor knows about the client,

these commenters assert, the higher the

quality of the audit. These commenters

further assert that accounting firms need

broad technical skills to provide high

quality audits and that the necessary

array of skills can be acquired only if

the accounting firm has a

multidisciplinary practice. Finally, the

commenters assert that the rules will

affect accounting firms’ ability to recruit

and hire talented professionals, which

in turn will lead to less capable

professionals performing lower quality

audits. We note that the rules we adopt

today are significantly less restrictive

than the proposed rules. We are

adopting without substantial alteration

restrictions that already appear in the

professional literature with respect to

the majority of the nine services that are

covered by our rules. In any event, we

are not persuaded by these arguments.

a. Auditors Will Continue to Have the

Expertise Necessary for Quality Audits.

The suggestion that the more the auditor

knows about the audit client, the better

its capacity to audit, is flawed. It is an

argument without limitation that takes

no account of the negative impact on

audit quality from an independence

impairment. As the former Chief

Accountant of the SEC explained

several years ago, ‘‘Arguments that more

knowledge of the audit client increases

the quality of the audit * * * taken to

the extreme, would have the auditor

keeping the books and preparing the

financial statements. Once a firm has

worked closely with a client to improve

the client’s operations or reporting

systems, it would appear that the firm

would have difficulty in providing a

‘‘critical second look’’ at those

operations and systems,’’179 as the

investing public relies on the auditor to

do.

In addition, the argument incorrectly

assumes that all additions to an

auditor’s knowledge about the client’s

business are relevant to an audit. With

respect to the full-scale non-audit

practices of some firms, however, the

O’Malley Panel said,

Audit firms’ management consulting

practices have expanded far beyond the skills

required for audit support and the traditional

areas related to financial planning and

controls. For example, some firms now offer

certain investment banking and legal

services, outsourcing of a variety of corporate

functions, strategic business planning and

business process reengineering advice.180

Further, the argument that the more

an auditor knows about an audit client,

the better the audit, assumes that

knowledge gained by an accounting

firm’s consultants is inevitably

transferred to the firm’s auditors. We are

skeptical about this claim. Some

testified that there is no sharing of firm

personnel between the consulting side

and auditing side. The General Counsel

of Andersen Consulting said, ‘‘[I]n our

experience there is no meaningful

crossover of personnel between the

audit divisions and these other business

consulting functions. The skills

necessary to perform high quality audits

are vastly different from those needed to

perform consulting services of the type

covered by the rule.’’181

Federal Register / Vol. 65, No. 234 / Tuesday, December 5, 2000 / Rules and Regulations 76025

Andersen. See also Testimony of Thomas

Goodkind, CPA (Sept. 13, 2000) (‘‘I have rarely seen

[a transference of knowledge] occur in my

experience.’’) 182See Testimony of Stephen G. Butler, Chairman

and Chief Executive Officer, KPMG (Sept. 21, 2000)

(‘‘[C]learly we don’t believe that we will not be able

to do a quality audit today in the structure that we

have,’’ with KPMG having incorporated its

consulting business and prepare for an initial

public offering of that business). Auditors of course

have a professional obligation to have the expertise

required to perform quality audits, and during the

audit process, to gather all the evidence needed to

evaluate, test, and render an opinion on the client’s

financial statements. See, e.g., General Standard No.

1 of Generally Accepted Auditing Standards

(‘‘GAAS’’) (‘‘The audit is to be performed by a

person or persons having adequate technical

training and proficiency as an auditor.’’); Standards

of Field Work No. 3 of GAAS (‘‘Sufficient

competent evidential matter is to be obtained

through inspection, observation, inquiries, and

confirmations to afford a reasonable basis for an

opinion regarding the financial statements under

audit.’’). Au § 150.02. Where auditors do not have

the requisite expertise in house, they can hire

others outside the firm to provide the skills needed.

As observed by Jack Ciesielski, ‘‘Auditors have

always had to call in specialists when matters are

outside their understanding.’’ Testimony of Jack

Ciesielski, accounting analyst (July 26, 2000). See

also Testimony of John J. Costello, Senior Director

of Litigation, Gursey, Schneider & Co., LLP (Sept.

20, 2000) (‘‘[I]n my experience over the years, many

times have we had to go and get an independent

consultant that was not part of the firm. * * * It

is not something that’s new. It’s been there for a

long time and could be done again.’’).

183See Proposing Release, Table 3 in Appendix

B.

184Written Testimony of J. Michael Cook, former

Chairman and Chief Executive Officer, Deloitte &

Touche (July 26, 2000). See also Written Testimony

of Philip A. Laskawy, Chairman, Ernst & Young

(Sept. 20, 2000) (‘‘[T]he argument that you have to

have 30,000 consultants to do an audit is not real,

it never was real, because * * * what percentage

of clients are you doing consulting for and it is

usually in the 20 to 30 percent range. So, the other

70 percent, I hope, are getting good audits.’’).

185Written Testimony of Philip A. Laskawy,

Chairman, Ernst & Young (Sept. 20, 2000).

186See, e.g., KPMG Letter; Deloitte & Touche

Letter; Arthur Andersen Letter.

187O’Malley Panel Report, supra note 20, at

¶ 5.18. Some of the eight members of the Panel,

however, issued a separate statement calling for an

outright ban (with very limited exceptions) on

auditors providing non-audit services to audit

clients because of their belief in the ‘‘central

importance of independence to the profession of

auditing in general, and to the effectiveness of the

audit process in particular,’’ and ‘‘the severe and

growing challenges to independence that the audit

profession faces in the current environment.’’ Id.,

¶ 5.32.

188Written Testimony of Laurence H. Meyer

(Sept. 13, 2000). Moreover, it has been suggested

that these efficiencies can ‘‘be partially

appropriated as rents to the CPA firm supplier, and

hence can themselves create a threat to

independence.’’ Dan A. Simunic, ‘‘Auditing,

Consulting, and Auditor Independence,’’ 22 J.

Accounting Research 679, 681 (Autumn 1984).

189E.g., Letter of Ronald J. Marek, CPA (Aug. 17,

2000) (‘‘Over the past twenty to thirty years, the big

accounting firms started placing a higher value on

selling skills and less on being ‘a good accountant.’

This change is appropriate if the goal is generating

more fees. This change has resulted in a

deterioration of audit quality.’’); Letter of Mike

McDaniel, CPA (Aug. 14, 2000) (‘‘[T]he focus was

sharper and firm operations had many fewer

conflicts during the period when consulting

services were not a central profit center for the

Firms.’’).

190See Testimony of Douglas Scrivner, General

Counsel, Andersen Consulting (Sept. 20, 2000)

(‘‘What is necessary to maintain audit quality is a

sustained focus and investment in the audit

profession rather than in non-audit services in order

to keep up with the complexity and sophistication

of business in a rapidly changing environment.’’).

191See, e.g., Letter of John L. Marty, CPA (Sept.

9, 2000) (‘‘If the practice of ‘cross-selling’ of services

were constrained, it may cause a renewed emphasis

on effective auditing and thereby, enhance the

reliability of audited financial statements and

protect the investing public.’’); Testimony of Larry

Gelfond, CPA, CVA, CFE, former President of the

Colorado State Board of Accountancy (Sept. 13,

2000) (‘‘Partners are measured by the amount of

business that they generate, the referrals that they

bring in, and the jobs that they handle. Obviously,

their ability to generate more fees has a direct

relationship in many of these firms, including my

own, to their compensation.’’); Testimony of Wanda

Lorenz, CPA, Lane Gorman Trubitt, LLP (Sept. 20,

2000) (acknowledging the ‘‘pressure on [audit

partners] to sell—pressure on them to retain the

client, pressure on them to build fees’’).

192O’Malley Panel Report, supra note 20, ¶ 4.4.

Available evidence suggests that even

without the opportunity to provide nonaudit services to audit clients, auditors

will have the expertise to perform

quality audits.182 First, under the final

rules, auditors will be able to continue

to provide non-audit services to nonaudit clients. They can gain the

technical and other expertise that they

believe they need by providing the nonaudit services to all of their other clients

who are not also audit clients. Second,

the great majority of companies do not

purchase any non-audit services from

their auditors in any given year. In the

most recent year for which data are

available, approximately seventy-five

percent of the public company clients of

the Big Five accounting firms received

no non-audit services from their

auditor.183 This would mean that the

financial statements of thousands of

public companies were audited by firms

who provided no non-audit services to

them in that year. We do not believe

that the lack of non-audit services

resulted in inadequate audits of the

financial statements of seventy-five

percent of all public companies. As J.

Michael Cook, former Chairman and

Chief Executive Officer of Deloitte &

Touche said, ‘‘Some suggest that

consulting services are essential to the

performance of a quality audit. That

assertion, in my opinion, is incorrect.

The vast majority of all audits are for

companies who purchase little or no

consulting services from the audit firm,

and those audits are of high quality and

always have been.’’184

We also note that accounting firms

that do not provide consulting can focus

more readily on the audit function,

which could in turn improve audits. As

the Chairman of Ernst & Young said

regarding his firm’s recent sale of its

consulting practice,

[N]ow that we have sold this practice, we

have not discovered that we are somehow

enfeebled, unable to perform effective audits

or to maintain a top-notch audit and tax

practice. In fact, we have found the opposite

to be true: without a large consulting practice

to manage, we are now more targeted and

more focused on our core audit and tax

business. * * * We have had a greater string

of ‘‘wins’’ in obtaining new audit clients

since we sold our management consulting

practice than we have had at any time in

recent history—four new Fortune 500 clients,

including two Fortune 50 companies, just

within the last six months.185

Some commenters 186 have cited the

O’Malley Panel Report as evidence that

the provision of non-audit services

positively affects audit quality, reciting

the statement from the Report that ‘‘[o]n

about a quarter of the engagements in

which non-audit services had been

provided * * * those services had a

positive impact on the effectiveness of

the audit.’’187 It may well be that—

independence concerns aside—

providing certain non-audit services can

be said to enhance the ‘‘efficiency’’ of

the audit. But, as Laurence H. Meyer, a

Governor of the Federal Reserve Board,

said in support of our proposed

restriction on internal audit

outsourcing, ‘‘auditor independence is

more valuable than these asserted

efficiencies.’’188

Furthermore, we are concerned that as

non-audit services become more

important, firms may care less about

auditing and more about expanding

their service lines, which itself may

have a negative effect on audit

quality.189 The factors that drive a highquality audit, including the core values

of the auditing profession, may

diminish in importance to the firm, as

will the influence of those firm

members who exemplify those core

values.190 Equally important, the

training and compensation that auditors

receive may stress the importance of

cross-selling at the expense of

auditing.191 The O’Malley Panel, for

example, noted a sense that accounting

firms ‘‘treat the audit negatively—as a

commodity.’’192 The O’Malley Panel

also agreed that, ‘‘[i]n their zeal to

emphasize the array of services that

CPAs offer, audit firms and the AICPA

scarcely acknowledge auditing services

in the public images that they portray.

This serves to exacerbate the

independence issue and to downplay

76026 Federal Register / Vol. 65, No. 234 / Tuesday, December 5, 2000 / Rules and Regulations

193O’Malley Panel Report, supra note 20, ¶ 5.23.

See also Testimony of Jack Ciesielski, accounting

analyst (July 26, 2000) (‘‘[The] accounting

profession * * * increasingly seeks to distance

itself from the public image as auditor in favor of

one that positions accountants in the public’s

collective mind as business enhancing

consultants.’’).

194Testimony of Robert Fox, Chair, New York

State Board of Public Accountancy (Sept. 13, 2000).

195See Testimony of Paul Volcker, former

Chairman, Board of Governors of the Federal

Reserve System (Sept. 13, 2000) (‘‘I suspect that

many of the traditional professions are feeling

under some pressure from the lure of Wall Street

incomes, and the dot com world, and I suspect the

Federal Reserve feels that, and auditing firms feel

it. It is a fact of life. I don’t think you cure that

problem by creating a conflict of interest in your

own firm.’’).

196See supra note 53.

197U.S. Census Bureau, Statistical Abstract of the

United States: The National Data Book (119th ed.

1999).

198Taylor Research & Consulting Group Study

(2000) (commissioned by the AICPA); see generally

AICPA Letter (noting trend); see also Letter of W.

Steve Albrecht, Professor and Associate Dean,

Marriott School of Management, Brigham Young

University (Aug. 29, 2000) (noting trends and

expressing concern that the proposal regarding nonaudit services would cause ‘‘further and dramatic

declines in the quality and quantity of students

wanting to become accountants and auditors’’

because the accounting field will be narrower).

199 In the 1991–1992 academic school year, the

firms hired 22,520 graduates with bachelor and

master degrees in accounting. In 1995–1996, that

number had fallen to 20,470. AICPA: Supply/

Demand Study 1997 (‘‘AICPA Supply/Demand

Study’’) presented to the O’Malley Panel (Aug. 31,

1999).

200See, e.g., Arthur Andersen Letter; KPMG

Letter; Testimony of Joseph F. Berardino, Managing

Partner, Assurance and Business Advisory Services,

Arthur Andersen (Sept. 20, 2000).

201See Testimony of David A. Brown, QC, Chair,

Ontario Securities Commission (Sept. 13, 2000)

(‘‘[F]irms will continue to have difficulty recruiting

new talent for the audit department, particularly if

new recruits get a sense that other areas of the firm

are more highly valued by firm management. . . .

I think [the difficulty of recruiting on the audit side

is] a very real issue, but I think the issue is clearly

exacerbated by the messages being telegraphed to

young recruits, and that is that there’s a faster

partnership track on the consulting side.’’).

202We also cannot overlook the extent to which

the challenge of recruiting auditors partially may be

a result of the firms’ own business decisions. As the

General Counsel of Andersen Consulting testified at

our hearings, ‘‘Some of the firms have diverted

investment and resources out of the audit function

and into non-audit services, thereby reducing the

attractiveness of the audit function as a career

path.’’ Testimony of Douglas Scrivner, General

Counsel, Andersen Consulting (Sept. 20, 2000);

Letter of John S. Coppel, CPA, CFO, Electric Power

Equipment Company (Aug. 16, 2000) (‘‘Promising

young staff are exiting the audit area, the

professions[’] most important training ground, after

a[ss]essing accurately, that career growth

opportunities lie elsewhere within the practice.’’).

203Testimony of Dennis Paul Spackman (Sept. 13,

2000).

204 Id. (‘‘The profession to a great extent is doing

it to itself and it’s doing it when it gives up audits

in very competitive low ball kinds of bidding

processes.’’); see also Testimony of Thomas

Goodkind, CPA (Sept. 13, 2000) (stating, in

response to a question from Chairman Levitt about

why the profession is having a hard time recruiting

auditors, ‘‘They’re not offering enough money’’).

205W. Steve Albrecht & Robert J. Sack,

Accounting Education: Charting the Course

Through a Perilous Future 9 (Aug. 2000).

206 Id. (showing that the number of accounting

degrees awarded in the 1998–99 academic year

declined 20% compared to those awarded in the

1995–96 academic year). There has been a general

decline in students seeking bachelor degrees in

business-related fields. See AICPA Supply Demand/

Study 1997, supra note 199, which indicates that

from 1992 to 1997, the number of students

obtaining bachelor degrees in accounting declined

by 14%, those obtaining finance degrees declined

by 17%, those obtaining general business degrees

declined by 8%, and those obtaining marketing

degrees declined by 27%.

the importance of auditing.’’193 This is

a trend that we and the accounting

profession alike must guard against

because, as one commenter remarked,

‘‘the value of [a CPA] license and the

public’s perception of that license is

going to be diminished when it becomes

another one of the alphabet soup titles

that people in the various professions

now use.’’194

b. Many Factors Affect Firms’

Recruiting Efforts. We take concerns

about recruiting and retention very

seriously. Nonetheless, we are skeptical

about the claim that the capacity to offer

non-audit services to audit clients is

critical to the auditing profession’s

ability to recruit and retain talented

professionals.

Today’s prosperity, with record lows

in unemployment, has intensified the

recruiting pressures on all sectors of the

economy, not just the accounting

profession.195 Enabling auditors to

provide all types of non-audit services

to audit clients is not likely to solve the

auditor recruiting issues for the

accounting firms. From 1993 to 1999,

the average annual growth rate for

revenues from management advisory

and similar services was twenty-six

percent.196 Over approximately the

same time frame, according to data from

the U.S. Census Bureau, the number of

candidates sitting for the first time for

the CPA exam dropped from 53,763

(1991) to 38,573 (1998),197 and the

percentage of students majoring in

accounting dropped from four percent

of all graduates in 1990 to two percent

in 2000.198 In other words, while

accounting firms have been dramatically

expanding their consulting practices,

there has been a steady decline in

certain indicators of interest in the

accountancy profession as a career

choice, and the firms have been hiring

fewer accounting graduates.199

According to some commenters,

potential recruits have negative

perceptions about the accounting

profession, including that accounting

work is unsatisfying and that

accountants have no interaction with

clients, and these perceptions must be

overcome in order for the profession to

attract the best and brightest

students.200 By ‘‘selling’’ the non-audit

practice to recruits, the commenters

suggest that they will be able to dispel

negative perceptions of the auditing

profession.

If a bar to successful recruiting is the

perception that auditing is not

especially rewarding, the profession

must take some responsibility for

creating it.201 As noted above, some

firms increasingly regard the audit as a

‘‘commodity,’’ downplay its importance,

and present themselves to the public as

business advisors first and only

incidentally as independent, objective

auditors. If large multidisciplinary firms

downplay to the general public the

importance of auditing, they do little to

dispel negative impressions of the

auditing profession to the public or to

potential recruits.202

Moreover, the salaries of accountants,

particularly in comparison to the

salaries of consultants, may exacerbate

recruiting problems. Dennis Spackman,

Chairman of the National Association of

State Boards of Accountancy, testified,

‘‘[T]here is a disparity in what [the

accounting firms] [a]re willing to pay

somebody to come on to their

consulting staff with what they’re

willing to pay for somebody to come on

the audit staff.’’203 In Mr. Spackman’s

view, the ‘‘big salary differential’’ gives

incentives to recruits who are looking

for a promising career path to work at

a public accounting firm in the

nonattest area, rather than the attest

area.204 Publicly available statistical

data support the conclusion that firms

pay accounting recruits less than

consulting recruits and that salaries for

accounting recruits have increased at a

significantly slower pace than starting

salaries for consultants.205

Undoubtedly, there are many factors

contributing to the decline in interest in

careers in the accounting profession.206

The O’Malley Panel noted a similar

concern about the decline in the

attractiveness of auditing as a career,

identifying increased educational

requirements, issues of compensation,

heavy workloads and issues of family or

lifestyle as contributing factors. In

addition, the Panel noted that the

decline

also has been influenced by the perception

that alternative career opportunities are more

exciting, challenging and rewarding than

auditing.* * * The profession will need to

restore the historic attractiveness of auditing

as a profession and convince the ‘‘best’’

people that it offers excellent long-term

career opportunities. To do so it will have to

Federal Register / Vol. 65, No. 234 / Tuesday, December 5, 2000 / Rules and Regulations 76027

207O’Malley Panel Report, supra note 20, ¶¶ 8.9,

8.10.

208See Written Testimony of Testimony of Jack

Ciesielski, accounting analyst (July 26, 2000);

‘‘Where Have All the Accountants Gone?’’ Bus. Wk.,

at 203 (Mar. 27, 2000) (noting that in addition to

competition from corporations and startups and

increasing college requirements, ‘‘also to blame,

many are beginning to argue, are regulations that

govern auditors’ ability to invest in stocks,’’ and

that the firms ‘‘are having a much harder time

addressing the biggest retention problem they face

today: regulatory restrictions on stock ownership.’’).

209See generally Deloitte & Touche Letter.

210See supra Section III.B.

211Testimony of Stephen G. Butler, Chief

Executive Officer, KPMG LLP (Sept. 21, 2000).

212Because we believed that it would have been

useful to have additional data concerning the

revenue mix of accounting firms, as well as the

extent to which fees to audit clients for non-audit

services exceed fees for audits, we solicited

comment on revenue data. In addition, SEC

Commissioner Isaac C. Hunt, Jr. informed the Big

Five firms that these data would help the

Commission in its deliberations. See Transcript of

July 26 hearing for questions of Commissioner Isaac

C. Hunt, Jr. posed to Joseph F. Berardino, Managing

Partner, Assurance and Business Advisory Services,

Arthur Andersen LLP, Robert R. Garland, National

Managing Partner, Assurance & Advisory Services,

Deloitte & Touche, and J. Terry Strange, Global

Managing Partner, Audit, KPMG LLP (July 26,

2000); see also Letters from Commissioner Isaac C.

Hunt, Jr. to Joseph F. Berardino, Robert R. Garland,

and J. Terry Strange (Aug. 18, 2000) and Letters

from Commissioner Isaac C. Hunt, Jr. to Kenton J.

Sicchitano, Global Managing Partner—

Independence and Regulatory Affairs,

PricewaterhouseCoopers LLP, and Mr. Robert

Herdman, Vice Chair—AABS Professional Practice,

Ernst & Young (Sept. 14, 2000). Counsel to Arthur

Andersen LLP, Deloitte & Touche LLP and KPMG

LLP indicated that some of these data might be

provided by mid-September (Letter from John F.

Olson, Gibson, Dunn & Crutcher LLP to

Commissioner Isaac C. Hunt, Jr. (Sept. 1, 2000).

However, no data were submitted by any of the five

firms.

213See Albert B. Crenshaw, ‘‘Breakup of

Andersen Firm Approved,’’ Wash. Post, at E3 (Aug.

8, 2000) (quoting former Arthur Andersen Chief

Executive James Wadia).

214See Proposing Release, Table 4 in Appendix

B.

215See, e.g., Letter of Joseph F. Simontacci, CPA

(Aug. 14, 2000); Letter of Leland D. O’Neal, CPA

(Aug. 15, 2000); Letter of Danny M. Riddle, CPA

(Aug. 16, 2000); Letter of Frank Chovanetz, CPA

(Aug. 16, 2000).

216Letter of National Conference of CPA

Practitioners (Sept. 25, 2000).

217Testimony of Larry Gelfond, CPA, CVA, CFE,

former President of the Colorado State Board of

Accountancy (Sept. 13, 2000); see also Letter of

John Mitchell, CPA (Aug. 14, 2000).

218See Testimony of Harold L. Monk, Jr.,

Chairman of the PCPS Executive Committee, AICPA

(Sept. 21, 2000); Letter of Peter J. Hackett, Clark,

Schaefer, Hackett & Co. (July 25, 2000); Letter of

Frank P. Orlando (July 28, 2000); Letter of Michael

L. Toms, York, Neel and Co. (Aug. 16, 2000).

219See, e.g., Testimony of Thomas J. Sadler, Past

Chair, Washington State Board of Accountancy

(Sept. 20, 2000); Letter of Mark A. Maurice, Chief

Financial Officer, Avenir Group, Inc. (Aug. 15,

2000); Letter of Allan W. Nietzke, CPA (Sept. 23,

2000); Letter of Steven F. Farrel, CPA, ABV Gaither

Rutherford & Co. LLP (Sept. 22, 2000); Letter of

Honkamp Krueger and Co., P.C. (Sept. 22, 2000).

lift the public perception of the profession to

a higher plane and convincingly demonstrate

the worth of the profession. This is an effort

that will require a partnership among audit

firms, professional societies and the

academic community.207

Finally, our revised rules on

investments may assist the accounting

profession in addressing their

difficulties in recruiting and retaining

professionals. In particular, by, among

other things, significantly shrinking the

circle of accounting firm employees to

whom restrictions on investments in

audit clients apply, the final rules will

allow more accountants to take greater

advantage of investment opportunities,

and therefore, may make the accounting

profession more attractive.208

c.The Rules Need Not Lead to

Restructurings. Some commenters said

that our proposals, if adopted, would

require accounting firms to restructure

their business by, for example, spinning

off their consulting practices.209 It was

not, and is not, our intention to cause

any firms to restructure. In any event,

we remain skeptical of the claim that

our rules will be the cause of wholesale

restructuring of the accounting

profession. Before we proposed these

amendments, three of the Big Five firms

had either consummated or announced

their intention to enter into transactions

that would separate their auditing and

consulting practices,210 and other firms

undertook restructurings while the

proposals were pending. That suggests

that reasons, apart from this rulemaking,

prompted those business decisions.

Indeed, one industry leader commented

that his firm was splitting off its

consulting business and ‘‘it wasn’t done

for cultural reasons, it was done for

different business reasons than that, and

it certainly wasn’t done for

independence issues.’’211

Moreover, while a few commenters

asserted that accounting firms will sell

their consulting practices if we adopt a

final rule, they did not provide us with

any basis beyond assertion for

evaluating their comments. While it

would have been preferable to have

information describing the economic

impact of the proposed rules upon

them, these commenters have not

elaborated on the claim.212

Without information supporting it,

the argument that firms will sell off

their consulting practices solely because

they cannot provide certain consulting

services to audit clients seems similarly

questionable. As noted in the Proposing

Release, while firms will be prevented

from providing some consulting services

to their audit clients, they will gain

potential clients from other firms who

are similarly situated.213 Even assuming

some accounting firms will lose the

ability to market their consulting

services based on asserted synergies

with their audit services, no other firm

will be better situated. Every consulting

firm, including non-accounting firms,

will have to compete for consulting

business on the same footing.

8. The Final Rules Will Apply to Small

Accounting Firms Only if They Have

SEC Audit Clients

The final rule applies only to public

companies and other entities registered

with the Commission or otherwise

required to file audited financial

statements with the Commission. It does

not apply to audits of financial

statements not required to be filed with

us. Big Five firms audit the vast majority

of the financial statements of public

companies. Data from the SECPS public

files indicate that, in 1999, non-Big Five

firms earned less than one percent of

their annual revenues from consulting

services provided to public company

audit clients.214 Consequently, we

believe there will be only an incidental

impact on accounting firms that provide

audit and non-audit services principally

to audit clients that are private

companies not registered with the SEC.

We received many letters from small

accounting firms expressing strong

support for our proposal,215 and the

National Conference of CPA

Practitioners, a national organization

comprised of 1,200 member firms that

represent 5,000 CPAs and service

between 400,000 and 500,000 small and

medium sized business clients,

similarly wrote to express support for

the proposal.216 Indeed, some

commenters pointed out that rather than

harming the interests of the small

practitioners, the rules could provide

smaller firms with new business

opportunities to provide non-audit

services to companies that previously

used their auditors to provide those

services.217

Some commenters expressed concern

about a possible derivative effect of our

rule amendments on smaller or regional

accounting firms that provide audit and

non-audit services solely or principally

to private companies.218 The concern is

that state boards of accountancy, which

regulate and license certified public

accountants, may adopt rules analogous

to our own for all accountants in their

jurisdiction without regard to whether

the companies to which they provide

non-audit services are public or private

companies.219 This certainly is not our

intention. Our concern throughout this

rulemaking has been with investors in

public companies and the public

securities markets.

76028 Federal Register / Vol. 65, No. 234 / Tuesday, December 5, 2000 / Rules and Regulations

220See, e.g., Letter of Baxter Rice, President,

California Board of Accountancy (Sept. 25, 2000);

Letter of James E. Houle, CPA, Chair, Oregon Board

of Accountancy (Sept. 24, 2000).

221See, e.g., Testimony of K. Michael Conaway,

Presiding Officer, Texas State Board of Public

Accountancy (Sept. 20, 2000); Letter of William D.

Baker, President, Arizona Board of Accountancy

(Sept. 20, 2000).

222See Letter from Arthur Siegel, Executive

Director, ISB (Aug. 31, 2000); Testimony of William

T. Allen, John C. Bogle, Manuel H. Johnson, and

Robert E. Denham (July 26, 2000).

223 In this regard, we note that in FRR No. 50, we

stated that we were not abdicating our

responsibilities in this area and that our existing

authority regarding auditor independence was not

affected. ISB standards and interpretations do not

take precedence over our regulations or

interpretations. See FRR No. 50 (Feb. 18, 1998). In

FRR No. 50, we also stated that ‘‘[i]n view of the

significance of auditor independence to investor

confidence in the securities markets, the

Commission also will review the operations of the

ISB as necessary or appropriate and, within five

years from the date the ISB was established, will

evaluate whether this new independence

framework serves the public interest and protects

investors.’’ Id. Some witnesses acknowledged that

changes to the ISB structure, such as having a

majority of public members, may benefit the

process and enhance the public’s perception of the

Board as a body focused on the public interest and

protecting investors. See, e.g., Testimony of William

T. Allen, Chairman of the ISB (July 26, 2000)

(‘‘[I]informally we have discussed whether or not it

would be desirable to increase the public

membership of the board to a majority. I don’t think

it would [change] the outcome of our deliberations,

but I recommended that we consider doing that on

the notion that it might help the perception of the

world, thinking that perhaps we were

compromising to get standards done.’’); Testimony

of Clarence Lockett, Vice President and Corporate

Controller, Johnson & Johnson (Sept. 20, 2000) (‘‘I

believe that [having a majority of public members]

would certainly go a long way in establishing that

body in giving the appearance of greater

independence from the profession of that body and

its role in establishing independence.’’); Testimony

of Philip A. Laskawy, Chairman, Ernst & Young

(Sept. 20, 2000); Written Testimony of James J.

Schiro, Chairman and Chief Executive Officer,

PricewaterhouseCoopers (Sept. 20, 2000);

Testimony of John J. Costello, Senior Director of

Litigation, Gursey, Schneider & Co., LLP (Sept. 20,

2000); see also the Memorandum by Shaun

O’Malley, Chair of the O’Malley Panel, to the

O’Malley Panel, dated Aug. 31, 2000, identifying

the expansion of the public representation on the

ISB as a ‘‘major recommendation’’ of the Panel.

224See, e.g., KPMG Letter; AICPA Letter; Written

Testimony of Philip D. Ameen, Philip B.

Livingston, Roger W. Trupin, Financial Executives

Institute (Sept. 20, 2000); Written Testimony of the

New York State Society of Certified Public

Accountants (Sept. 13, 2000).

225See, e.g., Letter of Kayla J. Gillan, General

Counsel, CalPERS (Sept. 25, 2000) (‘‘While CalPERS

supports the work of the [ISB], only this

Commission has the legal authority and effective

ability to weigh the competing public interests that

are represented in this area and reach conclusions

about the best way to protect shareowners and the

integrity of the financial markets.’’).

226 ISB Standard No. 2, ‘‘Certain Independence

Implications of Audits of Mutual Funds and Related

Entities,’’ ¶ 5 (Dec. 1999).

227Testimony of William T. Allen, Chairman, ISB

(July 26, 2000).

228Testimony of Robert E. Denham, Member, ISB

(July 26, 2000).

229Written Testimony of Robert E. Denham (July

26, 2000).

230Testimony of Manuel H. Johnson, Member ISB

(July 26, 2000).

231 During 1999, approximately 120 foreign

companies from 26 countries entered our markets

for the first time. At year-end, there were over 1,200

foreign companies from 57 countries filing reports

with us, and public offerings by foreign companies

totaled over $244 billion. SEC, Annual Report, at 76

(1999).

232 IOSCO is an association of securities

regulatory organizations and has over 100 members.

See IOSCO Annual Report (1999), App. III.

As we noted in the Proposing Release,

the proposals were not intended to

‘‘alter the relationship between federal

and state authorities’’ or to ‘‘affect the

ability of the states to adopt different

regulations in those areas they currently

regulate.’’ Though several state boards

suggested that our rules would have a

high degree of influence over their state

regulations,220 other commenters

pointed out that state boards of

accountancy have a strong independent

tradition.221 We fully expect that the

state boards will continue their practice

of exercising independent judgment in

determining the extent to which our

rules should be imported into what may

be a different context.

9. The Rules Take Into Account the

Work of the ISB

During this rulemaking process,

members of the ISB provided thoughtful

and constructive comments and

testimony.222 We appreciate their

commitment and professionalism in

pursuing their mandate, and their work

laid the foundation for our rulemaking.

Several commenters requested that we

defer to the ISB223 with respect to

financial and employment rules and

scope of services rules,224 while others

stated their belief that the Commission

is the appropriate body to act, and that

we should act now.225

In crafting our rules, we were, and

continue to be, mindful of the work of

the ISB, and we give due regard to their

requests for our guidance. For example,

the ISB noted in ISB Standard No. 2 that

the standard would not take effect until

the SEC revises its rules on

independence.226 Importantly, public

members of the ISB have stated that the

Commission is the appropriate body to

take action with respect to the scope of

services issues, and have requested that

we do so. As William T. Allen,

Chairman of the ISB, stated at our

public hearings, the scope of services

issue is ‘‘not well-suited for a board of

our character. It’s really a public policy

choice that the government needs to

make, I think. And that’s, I think the

view of us all.’’227 Similarly, Robert

Denham, a public member of the ISB,

stated, ‘‘the Commission is uniquely

well-suited to making the difficult

public policy choices that are required

to protect independence in an

environment that has become

increasingly complex.’’228 Mr. Denham

also stated,

As a public member of the ISB I have

encouraged the Commission to exercise its

authority in this area, because the

Commission is the only entity able to balance

and evaluate the difficult policy issues that

are involved. I am comfortable that the rules

proposed regarding scope of services

represent a rational, coherent and thoughtful

set of policies that will substantially improve

protection for auditor independence.229

Manuel H. Johnson, another public

member of the ISB, stated, ‘‘I do feel it’s

important the SEC undertake a new

rulemaking not only to strengthen the

standards and guidance of the ISB but

also to directly address in a timely

fashion the difficult policy issues

surrounding the proper scope of

services appropriate for accounting

firms charged with the trust of

performing independent audits.’’230 We

believe that these considerations, and

our evaluation of the important public

policy goals addressed by our

rulemaking, require us to act.

10. The Final Rules Encourage

International Efforts in This Area

Foreign companies increasingly seek

to raise capital in the U.S. securities

markets,231 and holdings by U.S.

investors of foreign company securities

have risen. With the increasing

globalization of the markets, regulators

worldwide have been re-examining

current regulatory requirements

applicable to cross-border offerings. We,

and regulators around the world, have

an interest in promoting high quality

international accounting, auditing, and

independence standards, while at the

same time preserving or enhancing

existing investor protections.

We have been involved in and

support efforts to raise the level and

quality of information available to

investors in connection with crossborder flows of capital, consistent with

our mandate to protect investors. We

worked on a project in which the

International Accounting Standards

Committee (‘‘IASC’’) developed the

principal components of a core set of

international accounting standards.

Earlier this year, the International

Organization of Securities Commissions

(‘‘IOSCO’’) 232 announced that it

completed its assessment of the IASC

core set of standards, and recommended

that its members allow multinational

issuers to use the IASC standards, as

supplemented by reconciliations,

Federal Register / Vol. 65, No. 234 / Tuesday, December 5, 2000 / Rules and Regulations 76029

233 IOSCO, Press Release, IASC Standards (May

17, 2000), available at www.iosco.org/iosco.html.

234 ‘‘International Accounting Standards,’’

Securities Act Rel. No. 7801 (Feb. 16, 2000) [65 FR

8,896].

235 ‘‘International Disclosure Standards,’’

Exchange Act Rel. No. 41936 (Sept. 28, 1999) [64

FR 53,900].

236The Institute of Management Accountants, the

AICPA, and the National Association of State

Boards of Accountancy are members of IFAC.

237 IFAC Ethics Committee, Independence:

Proposed Changes to the Code of Ethics for

Professional Accountants (Exposure Draft: Sept. 15,

2000).

238See, e.g., Letter of Horst Kaminski, German

Institut der Wirtschaftsprufer (Institute of Certified

Public Accountants) (Sept. 18, 2000); Letter of Ernst

& Young (UK practice) (Sept. 7, 2000); Testimony

of Jack Maurice, Member of Ethics Working Party,

Federation des Experts Comptables Europeens

(Sept. 21, 2000).

239See, e.g., Letter of Mike Rake, Chairman,

KPMG Europe (Sept. 22, 2000); Letter of Ernst &

Young (UK practice) (Sept. 7, 2000).

240See Letter from Phillipe Danjou, COB, to Lynn

Turner, Chief Accountant, SEC (Oct. 10, 2000) (‘‘I

can assure you that many regulators in Europe

(mainly continental Europe) do not agree with

FEE’s [conceptual] approach and have made their

views known to the European commission when it

started its consultation on the proposed

Recommendations on statutory auditors’

independence. I wrote a letter to Karel Van Hulle,

Head of Unit, European Commission, to make clear

that COB is not ready to accept a purely conceptual

system without clear prohibitions.’’).

241 Id. (noting that France, Germany, Italy, Spain,

Belgium and others presently have a system based

primarily on specific prohibitions of non-audit

services, with exceptions for special

circumstances). See also Letter from Michel Prada,

President, COB, to Marilyn Pendergast, Chairman,

Ethics Committee, IFAC (Sept. 15, 2000)

(commenting on IFAC’s Exposure Draft and noting

that ‘‘we believe that the thrust of the exposure

draft should be reversed from an ‘allowed if * * *’

system to a ‘forbidden except when * * *’ system.

The proposed change from a prescriptive approach

to a framework approach is flawed by the absence

of a clear definition of an auditor’s unique role and

position’’). In Australia, securities regulators

recently settled a case with one of the Big Five firms

where the firm agreed to undertakings that restrict

its ability to provide certain non-audit services. For

example, one of the covenants is that the firm

agreed not to ‘‘accept an audit engagement where

[the firm] has valued an asset and the valuation is

material to the audit engagement. The valuation

constitutes a service which is a barrier to the firm’s

ability to provide an independent audit opinion on

the client’s financial statements.’’ Media Release,

Australia Securities and Investments Commission

(Nov. 2, 2000), available at www.asic.gov.au. See

also Staff Report, supra note 74, at Appendix II;

Michael Firth, ‘‘The Provision of Nonaudit Services

by Accounting Firms to their Audit Clients,’’

Contemporary Accounting Research Vol. 14, No. 2,

pp. 1–21 (Summer 1997). With respect to a

recognized need by foreign regulators to take some

type of regulatory action in this area, see Testimony

of David A. Brown, Q.C., Chair, Ontario Securities

Commission (Sept. 13, 2000) (noting that for over

a year, the Ontario Securities Commission has

publicly raised concerns about the issue of auditor

independence, and that ‘‘[a]lthough we’ve not

begun to frame a regulatory solution, it has become

increasingly evident in Canada that some form of

regulatory involvement in a solution will be

essential.’’).

disclosure and interpretation where

necessary.233 In order to determine

whether and under what conditions we

should accept financial statements of

foreign issuers using the IASC

standards, earlier this year we issued a

Concept Release on International

Accounting Standards, seeking

comment on the necessary elements of

a high quality global financial reporting

framework that also upholds the high

quality of financial reporting

domestically.234 In addition, last year,

we amended our non-financial

statement disclosure requirements for

offerings by foreign issuers to conform

to the international disclosure standards

adopted by IOSCO in 1998.235

The International Federation of

Accountants (‘‘IFAC’’), in which the

accounting profession participates

actively, has several recent initiatives to

establish global auditing standards.236

Most recently, the IFAC Ethics

Committee issued for comment an

Exposure Draft proposing a framework

for independence.237 In the Exposure

Draft, IFAC presents a conceptual or

principle-based approach to addressing

auditor independence. Some

commenters on our proposal,

particularly foreign-based firms and

organizations such as the Federation

Des Experts Comptables Europeens

(‘‘FEE’’), suggested that we too adopt a

conceptual approach, as opposed to a

rules-based approach.238 Several of

these commenters argued that while a

rules-based approach has certain

advantages and is consistent with the

historical U.S. approach, a conceptual

approach, particularly in the area of

non-audit services, is more efficient and

flexible.239

We understand that many regulators

do not agree with the conceptual

approach,240 and several foreign

countries prohibit certain non-audit

services though standards vary from

country to country.241 Standards vary

for a number of reasons, including that

in some countries, audits are conducted

by statutory auditors who are directly

responsible to shareholders, and in

some cases audits may be conducted for

other than financial reporting purposes.

We believe that our final rules

combine important and useful elements

of both approaches. As noted, Rule 2–

01(c) does not set forth all

circumstances that may impair an

auditor’s independence from its audit

client. For other services, and in

particular future services, the

Preliminary Note makes clear that in

applying the general standard in Rule 2–

01(b), we will look in the first instance

to the four factors. The four factors

provide guiding principles for the

Commission, similar to what a

‘‘conceptual approach’’ would provide.

We recognize that our system of

regulation is not universal. We have

worked, and will continue to work

closely, both directly and through

IOSCO, with our foreign counterparts on

the important issue of auditor

independence.

D. It Is Appropriate To Ease Restrictions

on Financial and Employment

Relationships

In our approach to financial and

employment relationship restrictions,

we have attempted to draw lines that

promote investor confidence but

recognize the problems confronting dual

career families and employees of huge

accounting firms. Specifically, in the

investment and employment area, we

have adopted investment and

employment rules that allow auditors to

maximize the opportunities available to

them, while promoting the public

interest and protecting investor

confidence.

As noted in the Proposing Release and

above, there have been significant

demographic changes, changes in the

accounting profession, and changes in

the business environment that have

affected accounting firms. Among other

things, there has been an increase in

dual-career families and an everincreasing mobility among

professionals. Accounting firms have

expanded internationally. Most SEC

registrants now have their financial

statements audited by firms that have

offices and professionals stationed in

hundreds of cities around the globe, and

many of those offices and professionals

have no connection to, or influence

over, a company’s audit.

The current rules on financial and

employment relationships of auditors

were developed largely when the

accounting firms were smaller and less

diversified. The trends discussed above,

and others, have highlighted the need

for us to effect a modernization in these

areas. In particular, the current rules

describing the financial and

employment relationships that an audit

partner’s spouse could have with a

firm’s audit client called for

modernization. For example, under the

current rules, the spouse of a partner at

an accounting firm could not hold

certain positions at an audit client or

stock in an audit client, even through an

employee stock compensation or 401(k)

plan, even if the partner had no

connection to the audit. In light of the

trends noted above, including the

growth in dual-career families, we

sought to address this and similar

situations.

76030 Federal Register / Vol. 65, No. 234 / Tuesday, December 5, 2000 / Rules and Regulations

242See, e.g., Codification §§ 601.01 and 601.04.

243See, e.g., Codification § 602.02.c.i.

244See Rule 2–01(b), 17 CFR 210.2–01(b)

(accountant cannot act as ‘‘director, officer or

employee’’ of audit client and remain independent

for purposes of Regulation S–X); Codification

§602.02.d.

245See, e.g., Arthur Young, 465 U.S. at 819 n.15;

Codification §§ 602.02.e.i and ii.

246See supra note 15.

247See supra note 16; see also Written Testimony

of Dan L. Goldwasser, Vedder, Price, Kaufman &

Kammholz (July 26, 2000) (while acknowledging

that ‘‘these concepts are not novel and can be found

throughout the audit literature,’’ stating that they

‘‘should not be adopted as guiding principles to be

invoked each time a novel situation is

encountered.’’).

248See, e.g., Testimony of K. Michael Conaway,

Presiding Officer, Texas State Board of

Accountancy (Sept. 20, 2000) (‘‘[W]e would ask that

[the four principles] be better placed in a preamble

or a guidance document.’’); Testimony of Clarence

E. Lockett, Vice President and Corporate Controller,

Johnson & Johnson (Sept. 20, 2000) (‘‘[W]e do not

believe the four governing principles should be

stated as firm rules [but rather] be part of the

framework and serve [as] guiding principles.’’).

249Thomas D. Morgan and Ronald D. Rotunda,

eds., The Model Code of Professional Responsibility

(1995).

250 Id. at Preliminary Statement (citing

‘‘Professional Reponsibility: Report of the Joint

Conference,’’ 44 A.B.A.J., at 1159 (1958)).

251Federal Trade Commission, Rules and

Regulations Under the Securities Act of 1933, art.

14 (July 6, 1933).

252Cf. Staff Report, supra note 74, at 12–16. See

also SEC, Tenth Annual Report of the Securities

and Exchange Commission, at 205–207 (1944),

which states:

[T]he Commission has found an accountant to be

lacking in independence with respect to a particular

registrant if the relationships which exist between

the accountant and the client are such as to create

a reasonable doubt as to whether the accountant

will or can have an impartial and objective

judgment on the questions confronting him.

Accordingly, we are adopting final

rules that, among other things, reduce

the pool of people within audit firms

whose independence is required for an

independent audit of a company and

shrink the circle of family members

whose employment by an audit client

impairs an accountant’s independence.

As noted above, we are adopting these

changes not because doing so will itself

enhance independence, but because the

current rules are broader than necessary

to protect investors and our securities

markets.

IV. Discussion of Final Rules

A. The Preliminary Note

We have included a Preliminary Note

to Rule 2–01 that explains the

Commission’s approach to

independence issues. Rule 2–01 does

not purport to, and the Commission

could not, consider all circumstances

that raise independence concerns. The

Preliminary Note makes clear that, in

applying the standard in Rule 2–01(b),

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; 242

(b) places the accountant in the

position of auditing his or her own

work; 243

(c) results in the accountant acting as

management or an employee of the

audit client; or 244

(d) places the accountant in a position

of being an advocate for the audit

client.245

These factors are general guidance

and their application may depend on

particular facts and circumstances.

Nonetheless, we believe that these four

factors provide an appropriate

framework for analyzing auditor

independence issues. We had proposed

to include these four factors in the

general standard of Rule 2–01(b). While

some commenters agreed with including

the four principles in the rule,246 others

did not. Some commenters believed that

the principles were too general and

difficult to apply to particular

situations.247 Others suggested that the

principles should more appropriately be

used as ‘‘guide posts’’ and included in

a preamble instead of in the rule text.248

While the principles were derived

from current independence

requirements, because of these

concerns, we are including them in the

Preliminary Note. In the context of this

Preliminary Note, the four factors play

a role comparable to that of the Ethical

Considerations in the American Bar

Association’s Model Code of

Professional Responsibility. The Model

Code contains three separate but

interrelated parts.249 Ethical

Considerations ‘‘represent the objectives

toward which every member of the

profession should strive. They

constitute a body of principles upon

which the lawyer can rely for guidance

in many specific situations.’’250 Like

those Ethical Considerations, the four

principles constitute a body of

principles to which accountants and

audit committees can look for guidance

when an independence issue is raised

that is not explicitly addressed by the

final rule.

The Preliminary Note states that

‘‘these factors are general guidance only

and their application may depend on

particular facts and circumstances.’’ The

Preliminary Note also reflects the notion

that the influences on auditors may vary

with the circumstances and, as a result,

Rule 2–01 provides that the Commission

will consider all relevant facts and

circumstances in determining whether

an accountant is independent.

B. Qualifications of Accountants

Rule 2–01(a) remains unchanged and

requires that in order to practice before

the Commission an auditor must be in

good standing and entitled to practice in

the state of the auditor’s residence or

principal office. This requirement has

existed since the Federal Trade

Commission first adopted rules under

the Securities Act.251 It acknowledges

our deference to the states for the

licensing of public and certified public

accountants.

C. The General Standard for Auditor

Independence

Our rule provides a general standard

of auditor independence as well as

specifying circumstances in which an

auditor’s independence is impaired. As

to circumstances specifically set forth in

our rule, we have set forth a bright-line

test: an auditor is not independent if he

or she maintains the relationships,

acquires the interests, or engages in the

transactions specified in the rule. In

identifying particular circumstances in

which an auditor’s independence is

impaired, we have taken into account

the policy goals of promoting both

auditor objectivity and public

confidence that auditors are unbiased

when addressing all issues

encompassed within the audit

engagement. We have also taken into

account the value of specificity, and we

have tried to give registrants and

accountants substantial guidance and

predictability. The particular

circumstances that are set forth in our

rule as impairing independence are

those in which, in our judgment, it is

sufficiently likely that an auditor’s

capacity for objective judgment will be

impaired or that the investing public

will believe that there has been an

impairment of independence.

Circumstances that are not

specifically set forth in our rule are

measured by the general standard set

forth in final Rule 2–01(b). Under that

standard, we will not recognize an

accountant as independent with respect

to an audit client if the accountant is

not, or if a reasonable investor knowing

all relevant facts and circumstances

would conclude that the accountant is

not, capable of exercising objective and

impartial judgment on all issues

encompassed within the accountant’s

engagement.252

The general standard in paragraph (b)

recognizes that an auditor must be

independent in fact and appearance.

Some commenters suggested that the

Federal Register / Vol. 65, No. 234 / Tuesday, December 5, 2000 / Rules and Regulations 76031

253See, e.g., KPMG Letter.

254See, supra note 38–40; Proposing Release,

Section II.B.

255See, supra note 39.

256See, United States v. Gamache, 156 F.3d 1, 8

(1st Cir. 1998) (‘‘Now, undoubtedly, establishing

intent, short of a situation in which it is admitted,

is difficult and usually depends on the use of

circumstantial evidence.’’).

257See TSC Industries, Inc. v. Northway, Inc., 426

U.S. 438, 449 (1976) (information is material if it

would be ‘‘viewed by the reasonable investor as

having significantly altered the ‘total mix’ of

information made available’’); Basic, Inc. v.

Levinson, 485 U.S. 234–236 (1988).

258See also AICPA Code of Professional Conduct,

ET § 101.02 (revised Feb. 28, 1998).

259Rule 2–01(f)(5) states that the engagement

period ends when the registrant or accountant

notifies the Commission that the registrant is no

longer the accountant’s audit client. This notice

typically would occur when the registrant files with

the Commission a Form 8–K with disclosures under

Item 4 ‘‘Changes in Registrant’s Certifying

Accountant.’’ In some cases, however, a Form 8–K

is not required, such as when the registrant is a

foreign private issuer or when the audited financial

statements of a non-reporting company are filed

upon its acquisition by a public company.

Notification to the Commission in these cases

would occur by the filing of the next audited

financial statements of the foreign private issuer or

the successor corporation. Registrants or auditors in

these situations, however, may provide earlier

notice to the Commission on Form 6–K or by other

appropriate means.

260See AICPA SAS No. 1, Au § 220.03; AICPA

Code of Professional Conduct, ET § 101. Of course,

accountants also have to comply with applicable

state law on independence. Id.

261AICPA SAS No. 1, AU § 220.03.

262Cf. AUSA Life Ins. Co. v. Ernst & Young, 206

F.3d 202, 205 (2d Cir. 2000) (noting ‘‘E&Y’s failure

lay in the seeming spinelessness’’ of the audit

engagement partner and that ‘‘[p]art of the problem

was undoubtedly the close personal relationship

between’’ that partner and the company’s chief

executive officer, a former co-partner in the firm)

(quoting 991 F. Supp. 234, 248 (S.D.N.Y. 1997)

(district court opinion)).

use of an appearance-related standard

departs from current rules.253 As

discussed above and in the Proposing

Release, the Commission, courts, and

the profession have long recognized the

importance of the appearance of

independence.254

Moreover, the general standard we are

adopting merely reflects the different

means of demonstrating a lack of

objectivity. Objectivity is a state of

mind,255 and except in unusual

circumstances, a state of mind is not

subject to direct proof.256 Usually, it is

demonstrated by reference to

circumstantial evidence. Accordingly,

the final rule is formulated to indicate

that an auditor’s independence is

impaired either when there is direct

evidence of subjective bias, such as

through a confession or some way of

recording the auditor’s thoughts, or

when, as in the ordinary case, the facts

and circumstances as externally

observed demonstrate, under an

objective standard, that an auditor

would not be capable of acting without

bias.

The appearance standard

incorporated in the general standard is

an objective one. Appearance is

measured by reference to a reasonable

investor. The ‘‘reasonable person’’

standard is embedded in the law

generally. In particular, the ‘‘reasonable

investor’’ standard is reflected in the

concept of materiality under the federal

securities laws.257

Commenters expressed concern that a

general standard based on the

conclusion of a ‘‘reasonable investor’’

may have some imprecision. They urged

that the general standard require only

independence ‘‘in fact.’’ We believe,

however, that we have reduced

imprecision substantially by describing

in some detail particular circumstances

that give rise to an impairment of

independence. Moreover, reliance solely

on independence ‘‘in fact’’ would

increase the imprecision beyond a

‘‘reasonable investor’’ test, because

independence ‘‘in fact’’ is essentially an

inquiry into the subjective workings of

the accountant’s mind, whereas a

‘‘reasonable investor’’ test relies on

observable circumstances and is thus

better suited to uniform and consistent

application.

We recognize that there is an

irreducible degree of imprecision in the

notion of independence. We will be

mindful of this imprecision, and the

range of reasonable views that it

engenders, in applying the auditor

independence rules. We do not, for

example, seek to discourage the

development of non-audit services that

do not raise independence issues. In

considering our response to services not

explicitly covered by these rules, we

will take into account the nature of the

service, prior contacts with the staff,

relevant public statements by the

Commission or staff, and any related

professional literature.

Paragraphs (c)(1) through (5) require

the accountant to be independent

during the ‘‘audit and professional

engagement period.’’258 This term is

defined in Rule 2–01(f)(5) to mean the

period covered by any financial

statements being audited or reviewed,

and the period during which the auditor

is engaged either to review or audit

financial statements or to prepare a

report filed with us, including at the

date of the audit report.259 The use of

the word ‘‘during’’ in paragraphs (c)(1)

through (5) is intended to make clear

that an accountant will lack

independence if, for example, he or she

is independent at the outset of the

engagement but acquires a financial

interest in the audit client during the

engagement.

We have further confined the legal

standard by including the explicit

reference to ‘‘all relevant facts and

circumstances.’’ To make this explicit,

we have included the language in the

rule text. We have also modified the

language to refer to whether a

reasonable investor would ‘‘conclude’’

as opposed to ‘‘perceive’’ that the

accountant was not capable of

exercising objective and impartial

judgment. While this is not a

substantive change, it makes clear that

independence is an objective standard

measured from the perspective of the

reasonable investor.

Current Rule 2–01(c) provides that we

will look to all relevant circumstances,

including all relationships between the

accountant and the audit client and not

just those relating to reports filed with

the Commission. We proposed to

include this language in Rule 2–01(e).

Under the adopted rule, however, the

language appears in Rule 2–01(b) in

order to highlight that in applying the

general standard in Rule 2–01(b), we

will consider ‘‘all relevant

circumstances.’’

We remind registrants and

accountants that auditor independence

is not just a legal requirement. It is also

a professional and ethical duty. That

duty requires auditors to remain

independent of audit clients,260 and

includes an obligation to ‘‘avoid

situations that may lead outsiders to

doubt [the auditor’s] independence.’’261

In certain situations, whether or not

legally required, the best course may be

for the accountant to recuse himself or

herself from an audit engagement. On

occasion, there may be a relationship,

apart from those contemplated by any

standard or rule, that has an important

meaning to an individual accountant

and could create, or be viewed by a

reasonable investor with knowledge of

all relevant facts and circumstances as

creating, a conflict with the accountant’s

duty to investors.262 In this and any

similar situation, we encourage

accountants to seek to recuse

themselves from any review, audit, or

attest engagement, whether or not

specifically required by the

Commission’s, the ISB’s, or the

profession’s rules.

D. Specific Applications of the

Independence Standard

Rule 2–01(c) ties the general standard

of paragraph (b) to specific applications.

Paragraphs (c)(1) through (c)(5) address

separately situations in which an

accountant is not independent of an

76032 Federal Register / Vol. 65, No. 234 / Tuesday, December 5, 2000 / Rules and Regulations

263A number of the specified situations are based

on examples in the Codification and the AICPA and

SECPS membership rules.

264See infra Sections IV.H.3 and IV.H.5, for

detailed discussions of the definitions of ‘‘audit

client’’ and ‘‘affiliate of the audit client.’’ As

explained below, the affiliates of the audit client

that are deemed to included in the term ‘‘audit

client’’ for purposes of the financial relationship

provisions in paragraph (c)(1)(i) are more limited

than the group included in other parts of the rule.

265See, e.g., Written Testimony of Thomas M.

Rowland, Senior Vice President, Fund Business

Management Group, Capital Research and

Management Company (Sept. 20, 2000) (restrictions

should extend to persons in the firm beyond the

scope of ‘‘covered persons’’); Letter of John

Spadafora (June 28, 2000) (Narrowing the scope of

persons whose investments are restricted ‘‘is

another step backwards creating temptations to pass

inside information to those whose investments are

not restricted.’’).

266See, generally, Written Testimony of J.

Michael Cook, former Chairman and Chief

Executive Officer, Deloitte & Touche (July 26, 2000);

Testimony of Ray J. Groves, former Chairman and

Chief Executive Officer of Ernst & Young (July 26,

2000).

267See, e.g., Ernst & Young Letter.

268See, e.g., Written Testimony of William R.

Kinney, Jr., Professor, University of Texas at Austin

(Sept. 20, 2000) (proposed changes will ‘‘reduce

aggregate regulatory compliance without affecting

audit quality or increasing independence

impairment risk for investors’’); Testimony of

Robert L. Ryan, Chief Financial Officer, Medtronic,

Inc. (Sept. 20, 2000) (proposed financial

relationship rules are ‘‘logical, less bureaucratic,

and we’re completely in agreement’’).

269See infra Section IV.H.9 for a detailed

discussion of the definition of ‘‘covered persons in

the firm.’’

270Proposing Release, Section III.C.1(a) citing

Codification § 602.02.b.ii (Example 1).

audit client because of certain: (1)

financial relationships, (2) employment

relationships, (3) business relationships,

(4) transactions or situations involving

the provision of non-audit services, or

(5) transactions or situations involving

the receipt of contingent fees.263

The proposed rule included a

provision under which an accountant’s

independence would have been

impaired if the accountant had any of

the relationships or provided any of the

services described by proposed Rule 2–

01(c), or ‘‘otherwise [did] not comply

with the standard’’ of paragraph (b). We

have eliminated from the text of the rule

the language regarding the accountant’s

failure ‘‘otherwise’’ to comply with the

standard. Instead, we have modified the

structure of paragraph (c) to make clear

that the paragraph sets forth a ‘‘nonexclusive specification of

circumstances’’ that are inconsistent

with the standard of paragraph (b).

1. Financial Relationships

Rule 2–01(c)(1) sets forth the general

rule regarding financial relationships

that impair independence. It addresses,

among other things, direct or material

indirect investments, trustee positions

involving investment decision-making

authority, investments in common with

audit clients, debtor-creditor

relationships, deposit accounts,

brokerage accounts, commodity

accounts, and insurance policies.

Rule 2–01(c)(1) contains the general

standard that ‘‘[a]n accountant is not

independent if, at any point during the

audit and professional engagement

period, the accountant has a direct

financial interest or a material indirect

financial interest in the accountant’s

audit client.’’ The rule then specifies

certain financial interests that constitute

a direct or material indirect financial

interest in an audit client. As the rule

indicates, the list of specified interests

is not intended to be exclusive. The

specified interests represent common

types of financial interests that impair

independence, but the effect of other

types of financial interests on auditor

independence will be determined under

the general standards of paragraphs (b)

and (c)(1).

In applying the financial relationship

provisions of the rule, it is important to

bear in mind the definition of ‘‘audit

client.’’ ‘‘Audit client,’’ when used in

the rule, includes some ‘‘affiliate[s] of

the audit client,’’ as that term is defined

in the rule.264 Accordingly, financial

relationships with certain affiliates of

audit clients are subject to the

provisions of Rule 2–01(c)(1). In this

discussion, as well as in the rule,

references to ‘‘audit client’’ should be

understood to include the appropriate

affiliates of the audit client.

For the most part, the specified

financial interests described in this

section of the rule impair independence

only if they are financial interests of the

accounting firm, covered persons in the

firm, or immediate family members of

covered persons. (The exception

concerns situations involving beneficial

ownership of more than five percent of

an entity, or control of an entity.) This

represents a liberalization from prior

restrictions that generally reached all

partners in the firm regardless of

whether they had any relationship to

the audit of the particular client.

While the comments we received

reflected widespread (although not

universal) agreement with our goal of

modernizing the financial relationships

restrictions, some commenters urged us

not to liberalize these restrictions to the

extent we proposed. Generally, these

commenters argued in favor of the

prophylactic value of a rule precluding

a broader scope of persons from having

a financial interest in an audit client of

the firm.265 Several of these commenters

also spoke of the importance of a firm

culture that treats all clients as clients

of the firm, and in which the firm can

call on any partner to assist with the

audit of any client on short notice

without having to consider whether the

partner’s personal financial interests

preclude it.266

On the other hand, some commenters,

while agreeing generally with our

proposal to scale back the scope of

persons whose financial interests are

restricted, advocated that we further

narrow the group of persons who are

included in the restrictions. These

commenters generally expressed a

preference for a ‘‘tiered’’ approach that

would restrict even fewer people with

respect to some types of financial

interests.267

The balance we struck between these

two sets of concerns was viewed

favorably by many commenters.268 We

believe that fair, meaningful, and

relevant independence rules concerning

financial relationships should reflect a

calibrated approach to determining

what specific relationships realistically

give rise to independence concerns.

After considering the comments we

received, we have drawn the lines

essentially where we proposed—

‘‘covered persons in the firm’’ and their

immediate family members—though we

have modified slightly the definition of

‘‘covered persons’’ in the firm.269 The

final rule, like the proposed rule, would

attribute all investments by a covered

person’s ‘‘immediate family members,’’

that is, the covered person’s spouse,

spousal equivalent, and dependents, to

the covered person.

a. Investments in Audit Clients. Rule

2–01(c)(1)(i) describes investments that

impair an accountant’s independence as

to a particular audit client. Paragraph

(A) provides that an accountant is not

independent of an audit client if the

accounting firm, any covered person in

the firm, or any immediate family

member of any covered person has a

‘‘direct investment’’—such as stocks,

bonds, notes, options, or other

securities—in the audit client. As the

language of the rule makes clear, this is

not an exclusive list of all ownership

interests subject to the rule. Other than

with respect to the scope of persons

encompassed by the rule, paragraph (A)

does not represent any substantive

change to our rules on direct

investments.

We noted in the Proposing Release

that ‘‘as under current law, the rule

cannot be avoided through indirect

means.’’270 We stated, as an example,

that an accountant precluded from

having a direct investment in an audit

client could not evade that restriction by

Federal Register / Vol. 65, No. 234 / Tuesday, December 5, 2000 / Rules and Regulations 76033

271Proposing Release, Section III.C.1(a).

272See Ernst & Young Letter;

PricewaterhouseCoopers Letter.

273 17 CFR 240.13d–101, 13d–102.

274Cf. Ernst & Young Letter;

PricewaterhouseCoopers Letter (suggesting a similar

provision for immediate family members of all

partners in the firm).

275See Codification § 602.02.h (Examples 1 and

5).

276See former Rule 2–01(b).

277The analysis is different with respect to

situations where the entity has a material

investment in the audit client, or the audit client

has a material investment in the entity. We address

those situations in Rule 2–01(c)(1)(i)(E), discussed

below.

278The term ‘‘diversified management investment

company’’ refers to those entities meeting the

definitions of ‘‘management company’’ and

‘‘diversified company’’ in Sections 4(3) and 5(b)(1)

of the Investment Company Act, 15 U.S.C. §§ 80a–

4(3) and 80a–5(b)(1).

279Under the Investment Company Act, a

‘‘diversified’’ management company must meet the

following requirements: at least 75% of the value

of its total assets is in cash, cash items, Government

securities, securities of other investment

companies, and other securities limited in respect

Continued

investing in the client through a

corporation or as a member of an

investment club.271 Some commenters

proposed that we address that issue

with specific rule text, and they

proposed language.272 While not

adopting the language proposed by

commenters, we have, in the interest of

increased clarity, included in the final

rule language addressing that issue.

Specifically, we have added the

proviso that an investment through an

intermediary shall constitute a ‘‘direct

investment’’ in the audit client if either

of two conditions is satisfied: ‘‘(1) The

accounting firm, covered person, or

immediate family member, alone or

together with other persons, supervises

or participates in the intermediary’s

investment decisions or has control over

the intermediary; or (2) The

intermediary is not a diversified

management investment company . . .

and has an investment in the audit

client that amounts to 20% or more of

the value of the intermediary’s total

investments.’’ If either of these criteria

is satisfied, the investment is treated as

a direct investment in the audit client

and, therefore, impairs independence. If

an investment through an intermediary

does not satisfy either of these two

criteria, however, the investment is

considered ‘‘indirect,’’ and it impairs

independence only if it crosses one of

the thresholds set out in Rule 2–

01(c)(1)(i)(D) or (E).

Rule 2–01(c)(1)(i)(B) provides that an

accountant is not independent when

‘‘[a]ny partner, principal, shareholder,

or professional employee of the

accounting firm, any of his or her

immediate family members, any close

family member of a covered person in

the firm, or any group of the above

persons has filed a Schedule 13D or

13G 273 [] with the Commission

indicating beneficial ownership of more

than five percent of an audit client’s

equity securities, or controls an audit

client, or a close family member of a

partner, principal, or shareholder of the

accounting firm controls an audit

client.’’ Paragraph (B) is the only one of

the financial relationship provisions

that specifically encompasses a range of

persons beyond covered persons and

their immediate family members. The

broader scope of coverage under

paragraph (B) is based on the view that

when a financial interest in an audit

client of the firm becomes particularly

large, the fact that the person holding

that interest is distanced from the audit

engagement no longer sufficiently

mitigates the potential for a conflict.

We have made one substantive

addition to the proposed paragraph (B).

We have added at the end of the

paragraph the clause ‘‘or a close family

member of a partner, principal, or

shareholder of the accounting firm

controls an audit client.’’ This provision

identifies additional circumstances that

impair independence, beyond the

circumstances in our proposed rule.274

For instance, this provision would

provide that independence is impaired

when the sister or parent of a partner in

the firm who is not a covered person

controls an audit client. We agree that

the circumstances described by this

provision would result in an

impairment of independence. In

addition, we note that this provision is

consistent with existing rules.275

Rule 2–01(c)(1)(i)(C) provides that an

accountant is not independent when

‘‘[t]he accounting firm, any covered

person in the firm, or any of his or her

immediate family members, serves as

voting trustee of a trust or executor of

an estate containing the securities of an

audit client, unless the accounting firm,

covered person in the firm or immediate

family member has no authority to make

investment decisions for the trust or

estate.’’ Because a trustee or executor

typically has a fiduciary duty to

preserve or maximize the value of the

trust’s or estate’s assets, we believe it is

appropriate to treat the trustee’s or

executor’s interest as a direct financial

interest in the audit client and to deem

the auditor’s independence impaired.

We understand, however, that a person

might serve as a trustee or executor

without having any authority to make

investment decisions for the trust or

estate. Because we see no reason to

consider an auditor’s independence

impaired in those circumstances, we

have added the proviso at the end of

paragraph (C) to include an exception

for those circumstances.

Rule 2–01(c)(1)(i)(D) covers material

indirect investments in an audit client.

The basic rule provides that an

accountant is not independent when

‘‘[t]he accounting firm, any covered

person in the firm, any of his or her

immediate family members, or any

group of the above persons has any

material indirect investment in an audit

client.’’ This provision carries over the

existing proscription on material

indirect investments in audit clients.276

At the proposing stage, paragraph (D)

included two examples of what would

constitute a material indirect

investment: (1) Ownership of more than

five percent of an entity that has an

ownership interest in the audit client,

and (2) ownership of more than five

percent of an entity in which the audit

client has an ownership interest. A

number of commenters, however,

proposed eliminating those examples as

unnecessarily restrictive and

burdensome. We agree that the

examples would have consequences

beyond what we intended. Accounting

firms may, through their pension plans

or otherwise, acquire more than five

percent stakes in other entities. In these

situations, it may well be impracticable

for an accounting firm regularly to

monitor whether that entity has any

financial interest in an audit client or

whether an audit client has any

financial interest in the entity.277

Accordingly, we have omitted those

examples in the final rule.

Because the material indirect

investment rule is a general standard,

we have also decided to include one

additional provision to clarify the

meaning of ‘‘material indirect

investment’’ in the context of mutual

fund investments. Specifically, the rule

makes explicit that the term ‘‘material

indirect investment’’ does not include

ownership by any covered person in the

firm, any of his or her immediate family

members, or any group of the above

persons, of five percent or less of the

outstanding shares of a diversified

management investment company that

invests in an audit client.278

Consequently, the material indirect

investment rules, as adopted, allow

auditors to invest in management

investment companies, provided that

the company is diversified as defined

under the Investment Company Act of

1940.279 If an investment company is

76034 Federal Register / Vol. 65, No. 234 / Tuesday, December 5, 2000 / Rules and Regulations

of any one issuer to an amount not greater in value

than five percent of the value of the total assets of

such management company and not more than ten

percent of the outstanding voting securities of such

issuer. 15 U.S.C. § 80a–5(b)(1).

280One commenter recommended that

diversification be measured under Subchapter M of

the Internal Revenue Code rather than the

Investment Company Act of 1940. See Letter of

Investment Company Institute (Sept. 25, 2000) (‘‘ICI

Letter’’). Under Subchapter M, at the end of each

calendar quarter of the taxable year, at least 50%

of the value of the fund’s total assets must be

represented by cash, cash items, U.S. Government

securities, securities of other investment

companies, and investments in other securities,

which, with respect to any one issuer, do not

represent more than five percent of the value of

total assets of the fund or more than ten percent of

the voting securities of the issuer. In addition, no

more than 25% of the value of the fund’s total

assets may be invested in securities of any one

issuer. The Commission determined not to adopt

the tax code diversification test because an

investment company could concentrate its

investments in a smaller number of issues and

requires diversification only at the close of each

quarter.

281See Written Testimony of Thomas C. Rowland,

Senior Vice President, Fund Business Management

Group, Capital Research and Management Company

(Sept. 20, 2000) (suggesting a similar rule).

282See Ernst & Young Letter;

PricewaterhouseCoopers Letter.

283See AICPA Code of Professional Conduct, ET

section 101–8.

284Here, as elsewhere in the rule, we use the term

‘‘significant influence’’ as it is used in Accounting

Principles Board Opinion No. 18, ‘‘The Equity

Method of Accounting for Investments in Common

Stock’’ (Mar. 1971) (‘‘APB No. 18’’). See infra

Section IV.H.3. Because we have included a specific

rule on investments in non-clients, as well as the

material indirect investment rule of paragraph (D),

we have decided that a more limited definition of

‘‘affiliate of an audit client’’ is warranted for

purposes of the investment rules in paragraph

(c)(1)(i). The definition of ‘‘audit client’’ provides

that, for purposes of paragraph (c)(1)(i), audit client

does not include ‘‘entities that are affiliates of the

audit client only by virtue of paragraph (f)(4)(ii) or

(f)(4)(iii) of the section.’’ In other words, the only

‘‘affiliates of the audit client’’ that are included in

the term ‘‘audit client’’ in section (c)(1)(i) are those

that are in a control relationship with the audit

client or that are part of the same investment

company complex as the audit client. The rules on

investments specifically state that an investment in

certain entities that significantly influence, or are

significantly influenced by, the audit client, impair

the auditor’s independence. Accordingly, there is

no need to include those entities within the more

general definition of an ‘‘affiliate of the audit

client.’’

285See Rule 2–01(c)(1)(i)(E)(1)(ii).

286Rule 2–01(c)(1)(i)(E)(3). The operation of

paragraphs (E)(1)(ii) and (E)(3) is illustrated in the

chart attached as Appendix A.

287Rule 2–01(c)(1)(i)(E)(1)(i).

288Rule 2–01(c)(1)(i)(E)(2). The operation of

paragraphs (E)(1)(i) and (E)(2) is illustrated in the

chart attached as Appendix B.

non-diversified under the Investment

Company Act of 1940,280 the company

must disclose that fact in its prospectus.

As a result, an accountant can easily

determine by reviewing the prospectus

whether the company is diversified for

purposes of the rule. In addition, this

provision does not constitute any

substantive change from the proposed

rule, because the general categories of

examples in the proposed rule would

have covered this situation. This

provision is intended to ensure that all

firm personnel and their family

members can freely invest (up to the

five percent cap) in diversified mutual

funds that are not audit clients and are

not part of an investment company

complex that includes an audit client,

without bearing the burden of

constantly monitoring whether, and to

what degree, those funds invest in an

audit client’s securities.281

We have not included accounting

firms within this provision for two

reasons. First, in contrast to most

individual investors, accounting firms

through their pension funds may invest

large sums and, therefore, better access

diversified investment vehicles, such as

managed accounts that do not invest in

their audit clients. At the same time, the

large amounts that may be invested by

an accounting firm, through its pension

plan or otherwise, increase the chances

that the indirect investment may be

material to the audit client. This should

not be understood, however, to prevent

accounting firms from investing in

diversified mutual funds. Rather, when

they invest in such funds, they must

comply with the general ‘‘material

indirect investment’’ standard.

Second, at the suggestion of

commenters,282 we have included a new

paragraph (E) that governs (1)

investments in entities that invest in

audit clients (‘‘intermediary investors’’)

and (2) investment in entities in which

audit clients invest (‘‘common

investees’’). We have decided to codify

in our rule the substance of the existing

AICPA restrictions applicable to those

situations.283 We have codified those

restrictions in paragraph (c)(1)(i)(E).

Paragraph (E), like the AICPA rule, is

framed in terms of material investments

and the ability to exercise significant

influence over an entity.284 In the case

of an intermediary investor, paragraph

(E) provides that an accountant is not

independent if the firm, a covered

person, or an immediate family member

of a covered person has either (1) a

direct or material indirect investment in

an entity that has both an investment in

an audit client that is material to that

entity and the ability to exercise

significant influence over the audit

client,285 or (2) the ability to exercise

significant influence over an entity that

has the ability to exercise significant

influence over an audit client.286

In the case of a common investee,

paragraph (E) provides that an

accountant is not independent if the

firm, a covered person, or an immediate

family member of a covered person has

either (1) a direct or material indirect

investment in an entity in which an

audit client has a material (to the audit

client) investment and over which the

audit client has the ability to exercise

significant influence,287 or (2) any

material investment in an entity over

which an audit client has the ability to

exercise significant influence.288

With respect to paragraph

(c)(1)(i)(E)(2), which turns in part on

whether a covered person’s or

immediate family member’s investment

in an entity is material to that person,

we do not anticipate that compliance

requires a firm constantly to monitor the

net worth of all covered persons and

their immediate family members in

order to know at all times whether any

particular investment is material to

them. We anticipate that monitoring for

compliance with this paragraph will

involve routine monitoring of the

investments of all covered persons and

their immediate family members,

combined with monitoring of the

identity of entities over which the firm’s

audit clients have the ability to exercise

significant influence. When overlap

between those categories appears, the

firm can take additional steps to

determine whether the relevant

investment is material to the covered

persons or immediate family members

holding the investment.

If an ‘‘intermediary investor’’ or a

‘‘common investee’’ becomes an affiliate

of the audit client under paragraph

(f)(4)(i) or (iv), then paragraph (E) no

longer governs the question of

independence. Rather, paragraph (A)’s

provision concerning direct investments

in audit clients will apply to that

intermediary investor or common

investee, and any investment in that

entity by the firm, a covered person, or

an immediate family member of a

covered person would impair

independence.

b. Other Financial Interests. Rule 2–

01(c)(1)(ii) describes other financial

interests of an auditor that would impair

an auditor’s independence with respect

to an audit client because they create a

debtor-creditor relationship or other

commingling of the financial interests of

the auditor and the audit client. In some

situations, the continued viability of the

audit client may be necessary for

protection of the auditor’s own assets

(e.g., bank deposits or insurance) or for

the auditor to receive a benefit (e.g.,

insurance claim). These situations

reasonably may be viewed as creating a

self-interest that competes with the

Federal Register / Vol. 65, No. 234 / Tuesday, December 5, 2000 / Rules and Regulations 76035

289Consistent with the Proposing Release, we

have treated credit card debt as a separate category.

See discussion of paragraph (c)(1)(ii)(E) below.

290Regulation S–X, Rule 1–02(r), 17 CFR 210.1–

02(r).

291Regulation S–X, Rule 1–02(s)(2), 17 CFR

210.1–02(s)(2).

292See, e.g., Section 16 of the Securities Exchange

Act of 1934, 15 U.S.C. § 78p.

293See Ernst & Young Letter;

PricewaterhouseCoopers Letter. 294See generally, Deloitte & Touche Letter.

auditor’s obligation to serve only

investors’ interests. We have adopted

Rule 2–01(c)(1)(ii) largely as proposed,

though we have made some

modifications, described below.

(i) Loans/Debtor-Creditor

Relationships. Rule 2–01(c)(1)(ii)(A)

provides that an accountant will not be

independent when the accounting firm,

any covered person in the accounting

firm, or any of the covered person’s

immediate family members has any loan

(including any margin loan) to or from

an audit client, or an audit client’s

officers, directors, or record or

beneficial owners of more than ten

percent of the audit client’s equity

securities. As proposed, we have also

adopted exceptions for four types of

loans: 289 (1) automobile loans and

leases collateralized by the automobile;

(2) loans fully collateralized by the cash

surrender value of an insurance policy;

(3) loans fully collateralized by cash

deposits at the same financial

institution; and (4) a mortgage loan

collateralized by the borrower’s primary

residence provided the loan was not

obtained while the covered person in

the firm was a covered person.

As adopted, paragraph (A) varies from

the proposed rule in two respects, one

representing a substantive change and

one a clarifying change. The substantive

change involves increasing to ten

percent (up from the proposed five

percent) the percentage of an audit

client’s securities that a lender may own

without posing an independence

impairment for an accountant who

borrows from that lender. We have

made this change because we believe

that doing so will not make the rule

significantly less effective, and may

significantly increase the ease with

which one can obtain the information

necessary to assure compliance with

this rule. The ten percent threshold

corresponds to the definitions in the

Commission’s Regulation S–X of a

‘‘principal holder of equity

securities,’’290 as well as a

‘‘promoter.’’291 In addition, other

aspects of the securities laws attach

significance to an equity interest in

excess of ten percent.292 These

definitions and substantive legal

provisions clearly classify ten percent

shareholders as having a special and

influential role with the issuer.

Accordingly, a lender owning more than

ten percent of an audit client’s securities

would be considered to be in a position

to influence the policies and

management of that client.

The clarifying change involves the

wording of paragraph (A)(4), which

describes the mortgage loan exception.

The proposed rule referred to a

mortgage loan ‘‘collateralized by the

accountant’s primary residence.’’ In the

final rule, we have changed

‘‘accountant’’ to ‘‘borrower,’’ because we

intend for the exception to apply also to

mortgage loans obtained by an

immediate family member of a covered

person. The proposed rule also specified

that this exception was limited to loans

‘‘not obtained while the borrower was a

covered person in the firm or an

immediate family member of a covered

person in the firm.’’ In the final rule, we

have changed this language to ‘‘not

obtained while the covered person in

the firm was a covered person.’’ This

change is intended only as a way of

clarifying that the test focuses on the

status of the relevant covered person at

the time of the mortgage loan.

(ii) Savings and Checking Accounts.

Rule 201(c)(1)(ii)(B) concerns savings

and checking accounts. It provides that

an accountant is not independent when

the firm, a covered person, or an

immediate family member of a covered

person ‘‘has any savings, checking, or

similar account at a bank, savings and

loan, or similar institution that is an

audit client, if the account has a balance

that exceeds the amount insured by the

Federal Deposit Insurance Corporation

or any similar insurer, except that an

accounting firm account may have an

uninsured account balance provided

that the likelihood of the bank, savings

and loan, or similar institution

experiencing financial difficulties is

remote.’’

At the suggestion of commenters, we

have modified this provision from the

proposed rule by adding the exception

for accounting firm accounts with

institutions that have no more than a

remote likelihood of experiencing

financial difficulties.293 Large firms

often maintain account balances well in

excess of FDIC limits, and the heavy

daily volume of large transactions

imposes such demands on a financial

institution that there is, as a practical

matter, a very limited universe of banks

capable of servicing those accounts.

Under the circumstances, we are

persuaded that it is necessary to provide

an exception that would allow

accounting firms (but not individuals

who are covered persons) to maintain

balances above insured limits even if

the financial institution is an audit

client. We emphasize that this is a

narrow exception mandated by practical

necessity, and that, even so, the

exception only applies as long as there

is no more than a remote likelihood of

the institution experiencing financial

difficulties. If there is more than a

remote likelihood of the institution

experiencing financial difficulties, then

an uninsured balance will impair

independence because the auditor

would be placed in the situation of

having to decide whether to express an

opinion about the institution as a going

concern when the auditor’s own assets

may be at risk.

(iii) Broker-Dealer Accounts. Rule 2–

01(c)(1)(ii)(C) provides that an

accountant will not be independent

when the accounting firm, any covered

person in the firm, or any of the covered

person’s immediate family members,

has any brokerage or similar accounts

maintained with a broker-dealer that is

an audit client if any such accounts

include any asset other than cash or

securities (within the meaning of

‘‘security’’ provided in the Securities

Investor Protection Act (‘‘SIPA’’)), or

where the value of the assets in the

accounts exceeds the amount that is

subject to a Securities Investor

Protection Corporation (‘‘SIPC’’)

advance for those accounts, under

Section 9 of SIPA. Those final

provisions are as we proposed.

In addition, we have added to

paragraph (C) a provision intended to

ensure that brokerage accounts

maintained outside of the U.S. not

covered by SIPA will nonetheless not

impair independence so long as the

value of the assets in those accounts is

insured or protected pursuant to a

program similar to SIPA. Some

commenters noted that SIPC insurance

is not available in jurisdictions outside

the U.S. and suggested that we add this

provision.294 We believe that this

addition represents a logical extension

of our purpose in originally proposing

the SIPA exception. Again, however, the

insurance must be similar to SIPA for

the exception to apply.

(iv) Futures Commission Merchant

Accounts. Rule 201(c)(1)(ii)(D) provides

that the accountant will not be

independent when the accounting firm,

any covered person in the firm, or any

covered person’s immediate family

member has any futures, commodity, or

similar account maintained with a

futures commission merchant that is an

audit client. Few commenters

76036 Federal Register / Vol. 65, No. 234 / Tuesday, December 5, 2000 / Rules and Regulations

295See Deloitte & Touche Letter (agreeing that

such accounts ‘‘might, in certain circumstances,

create a perception that an accounting firm’s

independence has been impaired’’).

296See, e.g., AICPA Letter.

297Letter of XL Capital Limited (Sept. 25, 2000);

AICPA Letter; Letter of Swiss Re (Sept. 22, 2000).

298See AICPA Letter (suggesting this approach).

299See Rule 2–01(f)(4)(iv).

300 ISB Standard No. 2, ‘‘Certain Independence

Implications of Audits of Mutual Funds and Related

Entities,’’ at ¶3 (Dec. 1999).

301See infra Section IV.H.11.

commented on this provision, 295 and

we have adopted it exactly as proposed.

(v) Credit Cards. Rule 201(c)(1)(ii)(E)

provides that an accountant is not

independent when the accounting firm,

any covered person in the firm, or any

covered person’s immediate family

member has ‘‘[a]ny aggregate

outstanding credit card balance owed to

a lender that is an audit client that is not

reduced to $10,000 or less on a current

basis taking into consideration the

payment due date and any available

grace period.’’ This represents a slight

modification from the rule as proposed.

Under the proposed rule, independence

would have been impaired the moment

that a relevant credit card balance

exceeded $10,000. Commenters, noting

the occasional use of credit cards for

large consumer purchases, college

tuition, and tax payments, asked that we

modify the rule so that the $10,000 limit

applies only as of the due date.296 We

agree that the issue we seek to address

in this paragraph (E) is equally well

addressed with a more flexible

approach, taking account of the realities

of day-to-day life, that allows a credit

card balance to exceed $10,000 so long

as the balance is brought back down

below $10,000 within the immediate

credit card payment cycle.

(vi) Insurance Products. Rule

201(c)(1)(ii)(F) provides that an

auditor’s independence is impaired

whenever any covered person in the

firm or any immediate family member of

a covered person holds any individual

insurance policy issued by an insurer

that is an audit client unless: (1) The

policy was obtained at a time when the

person in the firm was not a covered

person; or (2) the likelihood of the

insurer becoming insolvent is remote.

The final rule reflects two modifications

from the proposed rule.

First, the rule that we proposed would

have provided that an accounting firm’s

independence was impaired by having a

professional liability policy originally

issued by an audit client. We have

reconsidered this issue in light of

comments pointing out that professional

liability insurance for accountants is

provided by relatively few insurers and,

moreover, complex syndication

relationships among those insurers

make it unreasonable to expect that any

given professional liability insurer will

ever be completely absent from the

coverage scheme that insures its

auditor.297 The final rule, therefore,

does not provide that a professional

liability policy gives rise to an

independence impairment. In addition,

by leaving the word ‘‘individual’’ in our

final rule, we intend to make clear that

the rule does not apply to professional

liability or any other type of insurance

policy held by an accounting firm.

Second, the rule that we proposed

would have provided that independence

was impaired by a covered person or

immediate family member having any

individual policy originally issued by

an insurer that is an audit client.

Commenters pointed out how this

provision could work a hardship where,

for example, an accountant obtains a life

insurance policy from an audit client of

the firm, but obtains the policy when he

or she is not a covered person with

respect to the client. If that accountant

later becomes a covered person with

respect to that insurer, our proposed

rule effectively would have required

that accountant to obtain that insurance

from another carrier. Changing life

insurers, however, could prove to be

very difficult and expensive depending

on many other factors that could have

changed since the accountant first

obtained the insurance.

We believe that the goal of this

paragraph (F) can be served equally well

by a provision that largely averts that

potential hardship. The final rule,

therefore, provides that, so long as the

likelihood of the insurer becoming

insolvent is remote, independence is not

impaired if a covered person or

immediate family member obtains a

policy from an audit client when the

covered person is not a covered person

with respect to that audit client.298 If,

however, the likelihood of the insurer

becoming insolvent is not remote, then

independence is impaired regardless of

the lack of ‘‘covered person’’ status at

the time the policy was obtained. In any

event, when the likelihood of

insolvency is remote, and the policy

was obtained when the covered person

was not a covered person, it is our

intention that the covered person be

able to renew the policy and increase

the coverage if done pursuant to the preexisting contractual terms of the policy.

Finally, as discussed in more detail

below, recusal remains an option in

some circumstances. If a person or a

member of that person’s immediate

family wished to obtain insurance from

an audit client, the person may be able

to recuse himself or herself from being

a covered person for that audit client.

For instance, depending on a firm’s

organization, persons that are covered

persons only because they are within

the definition of the ‘‘chain of

command’’ may be able to re-structure

their supervisory role with respect to a

particular audit client so as to fall

outside that definition with respect to

the audit client.

(vii) Investment Companies. Rule 2–

01(c)(1)(ii)(G) addresses investments in

an entity that is part of an investment

company complex. The rule provides

that, when an audit client is part of an

investment company complex, an

accountant is not independent if the

accounting firm, a covered person, or an

immediate family member of a covered

person has any financial interest in an

entity in the investment company

complex. Technically, this provision

represents an explicit statement of a

concept that otherwise necessarily

follows from other aspects of the rule.

Specifically, because the definition of

‘‘affiliate of the audit client’’ includes

any entity that is part of an investment

company complex (as defined in Rule

2–01(f)(14)) that includes an audit

client,299 the restrictions included in

paragraphs (c)(1)(i) and (c)(1)(ii)

necessarily apply to any such entity. We

have singled out these entities in

paragraph (G) to minimize the

possibility that a reader focused on the

financial relationship provisions might

overlook those entities’ inclusion as ‘‘an

affiliate of the audit client.’’ We

solicited comment on whether we

should follow ISB Standard No. 2,300

and our intent, as stated in the

Proposing Release, was to codify the

substance of ISB Standard No. 2.

Commenters generally did not object to

this concept, although several expressed

concerns about the definition of

‘‘investment company complex’’ as

discussed below.301 We have reworded

paragraph (G) from the Proposing

Release solely for the purpose of clarity.

No substantive change is intended.

c. Exceptions. We are adopting Rule

2–01(c)(1)(iii) regarding limited

exceptions to the financial relationship

rules substantially as proposed, with

slight modifications, and we are adding

one additional exception. These

exceptions recognize that there are

situations in which an accountant, by

virtue of being given a gift or receiving

an inheritance, or because the

accounting firm has taken on a new

audit client, may lack independence

Federal Register / Vol. 65, No. 234 / Tuesday, December 5, 2000 / Rules and Regulations 76037

302See Letter of KPMG Europe (Sept. 22, 2000);

Written Testimony of Institute of the Chartered

Accountants in England & Wales (‘‘ICAEW’’) (Sept.

13, 2000).

303See, e.g., ICI Letter; Deloitte & Touche Letter;

see also Letter of the Association of Private Pension

and Welfare Plans (Aug. 7, 2000).

solely because of events beyond the

accountant’s control. In these

circumstances, independence is not

deemed to be impaired if the financial

interest is promptly disposed of or the

financial relationship is promptly

terminated. These exceptions operate to

avert an independence impairment only

with respect to the financial interests

referenced in the exceptions. These

exceptions do not have the effect of

averting an independence impairment

caused by any other factors, such as

employment relationships or non-audit

services.

(i) Inheritance and Gift.

Rule 2–01(c)(1)(iii)(A) provides that an

accountant’s independence will not be

impaired by virtue of an unsolicited

financial interest, such as a gift or

inheritance, so long as the recipient

disposes of the interest as soon as

practicable, but in no event later than

thirty days after the recipient has

knowledge of, and the right to dispose

of, that interest. Our proposed version of

this provision required that the interest

be disposed of no later than thirty days

after the recipient has a right to dispose

of it. We have added the phrase ‘‘has

knowledge of’’ to avoid the unfairness

that could result in a case where the

recipient of a financial interest does not

learn of that interest immediately upon

acquiring it. In addition, several

commenters from foreign jurisdictions

noted that there are situations abroad in

which an accounting firm may be

appointed executor of an estate without

its advance knowledge.302 We have

modified the rule to address these

situations. Specifically, we have

expanded it to cover ‘‘unsolicited

financial interests’’ even if not acquired

through inheritance or gift.

(ii) New Audit Engagement. We are

adopting Rule 2–01(c)(1)(iii)(B)

substantially as proposed. It is designed

to allow accounting firms to bid for and

accept new audit engagements, even if

a person has a financial interest that

would cause the accountant to be not

independent under the financial

relationship rules. This exception is

available to an accountant so long as the

accountant did not audit the client’s

financial statements for the immediately

preceding fiscal year, and the

accountant was independent before the

earlier of (1) signing an initial

engagement letter or other agreement to

provide audit, review, or attest services

to the audit client, or (2) commencing

any audit, review, or attest procedures

(including planning the audit of the

client’s financial statements).

The new audit engagement exception

of Rule 2–01(c)(1)(iii)(B) is necessary

because an auditor must be

independent, not only during the period

of the auditor’s engagement, but also

during the period covered by any

financial statements being audited or

reviewed. Because of an existing

financial relationship between an

accounting firm or one of its employees

and a company (that is not an audit

client), an accounting firm may not be

able to bid for or accept an audit

engagement from the company without

this exception. This exception allows

firms to bid for and accept engagements

in these circumstances, provided they

are otherwise independent of the audit

client and they become independent of

the audit client under the financial

relationship rules before the earlier of

the two events specified in paragraphs

(B)(2)(i) and (ii).

We have modified the audit

engagement exception slightly from the

proposed rule. As proposed, the

exception would have applied only if

the firm was independent under the

financial relationship rules before the

earlier of beginning work on the audit

or accepting the engagement to provide

audit, review, or attest services.

Commenters have pointed out that it

would be reasonable to allow for some

grace period to divest of financial

interests after the audit client and the

accountant first agree to an audit

relationship. Otherwise, an accountant

would have little choice but to come

into compliance with the financial

interest rules before even bidding to

become the auditor for a particular

client.

Accordingly, we have revised

paragraph (B)(2)(i) to focus on the

‘‘signing of an initial engagement letter

or other agreement,’’ rather than

‘‘accepting the engagement.’’ By this

change, we mean to afford accountants

a divestiture window between the time

they first understand that a new client

has selected them to perform audit,

review, or attest services—or there has

been an oral agreement to that effect—

and the time that an initial engagement

letter or other written agreement is

actually signed, or audit procedures

commence. If an accountant is in

compliance with the financial

relationship rules before the earlier of

that signing or the commencement of

audit, review, or attest services, the

accountant’s independence is not

impaired by the operation of the

financial relationship rules of

paragraphs (c)(1)(i) and (c)(1)(ii).

(iii) Employee Compensation and

Benefit Plans. We are adopting an

additional exception to the financial

interest rules in response to concerns

expressed by several commenters. These

commenters encouraged us as part of

this modernization to allow for broader

participation by immediate family

members of auditors in employee

compensation and benefit plans.303 This

additional exception is consistent with

our goal of updating the independence

rules in ways that recognize the realities

of the modern economy (and dual

income households) and continue to

protect the public interest.

The exception is necessary because

our employment rules will allow an

immediate family member of a covered

person (most typically a spouse) to be

employed by an audit client in a

position other than an ‘‘accounting role

or financial reporting oversight role’’

without impairing the auditor’s

independence. In these situations, the

immediate family member would

remain subject to our financial interest

rules and therefore could not have a

direct financial interest in the audit

client. Accordingly, an employee in this

situation could be prevented from

participating in a stock-based

compensation program.

We are adopting an additional

exception to the financial interest rules

to provide some relief in these

situations. The exception will apply to

investments in audit clients by

immediate family members of covered

persons who are covered persons only

by virtue of being a partner in the same

office as the lead audit engagement

partner of, or a partner or manager

performing ten or more hours of nonaudit services for, an audit client. This

exception will allow the immediate

family members of these covered

persons to acquire an interest in an

audit client, if the immediate family

member works for the audit client and

acquires the interest as an ‘‘unavoidable

consequence’’ of participating in an

employee compensation program in

which employees are granted, for

example, stock options in the employer

as part of their total compensation

package, without impairing the audit

firm’s independence. The phrase

‘‘unavoidable consequence’’ in this

paragraph means that, to the extent the

employee has the ability to participate

in the program but has the option to

select investments in entities that would

not make him or her an investor in an

audit client, the employee must choose

76038 Federal Register / Vol. 65, No. 234 / Tuesday, December 5, 2000 / Rules and Regulations

304 ICI Letter.

305See Letter from POB to ISB (Jan. 12, 2000)

(‘‘Public ownership in an auidt firm or in its parent

or in an entity that effectively has control of the

audit firm would add another form of allegiance

and accountability to those identified by the

Supreme Court—a form of allegiance that in our

opinion will be viewed as detracting from, if not

conflicting with, the auditor’s ‘public

responsibility’ ’’).

306See AICPA Letter.

307See infra Section IV.H.2.

308See Written Testimony of William Travis,

McGladrey & Pullen LLP (Sept. 20, 2000).

other investments to avoid an

impairment of independence.

Immediate family members of this

subset of covered persons must dispose

of the financial interest as soon as

practicable once they have the right to

do so, however, and they may not

otherwise invest in the audit client

without impairing the firm’s

independence. Where there are legal or

other similar restrictions on a person’s

right to dispose of a financial interest at

a particular time, the person need not

dispose of the interest until the

restrictions have lapsed. For example, a

person will not have to dispose of an

investment in an audit client if doing so

would violate an employer’s policies on

insider trading. On the other hand,

waiting for more advantageous market

conditions to dispose of the interest

would not fall within the exception.

This exception is similarly available

to immediate family members of the

same subset of covered persons who

must invest in one or more audit clients

in order to participate in their

employer’s 401(k) or similar retirement

plan. Accordingly, under the exception,

the spouse or another immediate family

member of this subset of covered

persons can participate in a 401(k) plan,

even if his or her only investment

option within the plan is, for example,

a mutual fund that is in the same

investment company complex as a

mutual fund that is an audit client. If,

however, the immediate family member

has an alternative in the 401(k) plan that

does not involve investing in a fund

complex for which the person’s relative

is a covered person, then the family

member may not invest in the audit

client without impairing the auditor’s

independence. We highlight that the

exception in paragraph (c)(1)(iii)(C) is

available only to immediate family

members of covered persons who are

covered persons by virtue of being in

the same office as the lead audit

engagement partner of an audit client

(paragraph (f)(11)(iv)) or because they

perform ten or more hours of non-audit

services for an audit client (paragraph

(f)(11)(iii)).

The Investment Company Institute

proposed that the exception apply to the

immediate family members of all

covered persons in the firm.304 We

believe, however, that the exception we

are adopting is sufficiently broad. As

discussed elsewhere in this release,

even absent this exception, the rules we

are adopting significantly shrink the

circle of firm personnel to whom the

financial interest rules apply.

d. Audit Clients’ Financial

Relationships. Rule 2–01(c)(1)(iv)

specifies two sets of circumstances in

which an audit client’s financial

interests in the accounting firm cause an

accountant to be not independent of that

audit client. We have modified the

proposed rule as discussed below.

(i) Investments by the Audit Client in

the Auditor. As discussed in the

Proposing Release, when an audit client

invests in its auditor, the auditor may be

placed in the position of auditing the

value of any of its securities that are

reflected as an asset in the financial

statements of the audit client. In

addition, the accountant may reasonably

be presumed to have a mutuality of

financial interest with the owners of the

firm, including an audit clientshareholder.304

Under Rule 2–01(c)(1)(iv)(A), an

accountant is not independent with

respect to an audit client when the audit

client has, or has agreed to acquire, any

direct investment in the accounting

firm, such as stocks, bonds, notes,

options, or other securities, or the audit

client’s officers or directors are record or

beneficial owners of more than five

percent of the equity securities of the

accounting firm. In applying this

provision, it is important to remember

that the definition of accounting firm

includes ‘‘associated entities’’ of the

accounting firm, including any that are

public companies. Paragraph (A) seeks

to prevent a situation in which an

accountant, in order to audit asset

valuations of a client that holds

securities of the accounting firm, must

value the accounting firm’s own

securities. Paragraph (A) also seeks to

prevent a situation in which the audit

client, or in some circumstances its

officers and directors, can exercise any

degree of influence over the accounting

firm, whether by virtue of the

accounting firm’s fiduciary obligation to

its investors or by nominating and

voting for directors.

The AICPA noted in its comment

letter that its current rules also do not

permit an audit client to hold any

investment in its auditor.306 The AICPA

was critical of the application of our

proposed provision, at least without a

materiality threshold, to subsidiaries

and other entities related to the

accounting firm. Consistent with our

general approach, we have decided to

apply this rule to not only the corporate

entity performing the audit, but also its

subsidiaries and associated entities. We

note that we have eliminated the

definition of ‘‘affiliate of the accounting

firm,’’ which many commenters argued

captured more entities with some

relation to the accounting firm than

necessary.307

The proposed rule did not include

any provision restricting audit client

officers and directors from owning the

accounting firm’s securities. In that

respect, our proposed approach was

more liberal than existing law, which

deems independence impaired if an

audit client’s officers or directors own

any equity securities of the accounting

firm. We sought comment, however, on

whether the rule’s prohibitions should

also apply to other situations in which

the audit client has a financial interest,

such as when the audit client’s CEO

invests in the accounting firm. Although

some commenters opposed the addition

of this notion,308 we have determined

that the final rule should liberalize

existing law, simply not to the extent we

proposed. Accordingly, the final rule

provides that independence is impaired

if an officer or director of the audit

client owns more than five percent of

the equity securities of the accounting

firm. We believe that investments in the

accounting firm by audit client officers

and directors do not routinely give rise

to independence concerns, but that

concerns arise when an officer or

director of the audit client accumulates

a significant stake in the accounting

firm. Because record or beneficial

ownership interests exceeding five

percent will be reflected in Schedule

13D filings relating to the accounting

firm, the firm will be able to monitor for

compliance with this provision, without

having to rely solely on an intrusive

investigation or audit client monitoring

of its officers’ and directors’

investments.

(ii) Underwriting.

Rule 2–01(c)(1)(iv)(B) provides that an

accountant is not independent of an

audit client when the accounting firm

‘‘engages an audit client to act as an

underwriter, broker-dealer, market

maker, promoter, or analyst with respect

to securities issued by the accounting

firm.’’ Few transactions are as

significant to the financial health of a

company, including an accounting firm,

as the sale of its securities, whether in

private or public offerings. In an

Federal Register / Vol. 65, No. 234 / Tuesday, December 5, 2000 / Rules and Regulations 76039

309See PricewaterhouseCoopers Letter (‘‘We

endorse and applaud the SEC’s initiatives to

modernize the archaic financial interest and

employment rules in order to reflect today’s social

and business realities. We support, for the most

part, the treatment of these topics in the Release.’’).

310See, e.g., Deloitte & Touche Letter; Letter of

Steven Ryan, Chair, Financial Accounting

Standards Committee, American Accounting

Association (Oct. 12, 2000); Written Testimony of

John C. Bogle, Public Member, ISB (July 26, 2000).

311See, e.g., AICPA Letter; Written Testimony of

William T. Allen, Chair, ISB (July 26, 2000).

312See, e.g., Letter from Lynn E. Turner, Chief

Accountant, SEC, to Charles A. Bowsher, Chairman,

Public Oversight Board (Dec. 9, 1999); Letters from

Lynn E. Turner, Chief Accountant, SEC, to Michael

A. Conway, Chair, SECPS (Nov. 30, 1998; Dec. 9,

1999). These letters are available on our website.

313Nevertheless, we encourage, and we expect,

firms to follow the steps described in ISB Standard

No. 3, including the steps to be taken in the period

after the firm’s professional reports an intention to

join an audit client and the steps to be taken after

the professional actually joins the audit client. We

also anticipate that peer reviews conducted by the

POB will cover firms’ compliance with these steps.

314These examples are illustrative only and

should not be relied upon as a complete list of

employment relationships that impair an

accountant’s independence under paragraphs (b)

and (c)(2).

offering, an underwriter either buys and

then resells a company’s securities or

receives a commission for selling the

securities. In either circumstance, were

an audit client to act as underwriter of

an accounting firm’s or its associated

entity’s securities, the audit client

would assume the role of advocate or

seller of the accounting firm’s securities.

Moreover, depending on the terms of

the underwriting, the underwriter could

for a time become a significant

shareholder of the accounting firm.

There also may be indemnification

agreements that place the underwriter

and auditor in adversarial positions.

In addition, the accounting firm

would have a direct interest in ensuring

the underwriter’s viability and

credibility, either of which could be

damaged as the result of an audit.

Moreover, the auditor would have a

clear incentive not to displease an audit

client to which it had entrusted a

critical financial transaction. Similar

conflicts of interest may arise if an audit

client or an affiliate of an audit client is

engaged to perform other financial

services for an accounting firm, such as

making a market in the accounting

firm’s securities or issuing an analyst

report concerning the securities of the

accounting firm.

We have reworded paragraph (B) from

the proposed wording to avert an

unintended consequence. The proposed

rule provided that independence would

be impaired if an audit client ‘‘performs

any service for the accounting firm

related to underwriting, offering,

making a market in, marketing,

promoting, or selling securities issued

by the accounting firm, or issues an

analyst report concerning the securities

of the accounting firm.’’ Worded that

way, the provision could be read to

impair independence any time, for

example, a broker-dealer issues an

analyst’s report making a favorable

recommendation concerning the

securities of any associated entity of an

accounting firm, because, in a broad

sense, that report could benefit the

accounting firm and could be seen as a

‘‘service for’’ the accounting firm. To

avoid any possibility of that

construction, we have reworded

paragraph (B) to make clear that

independence is impaired only if the

accounting firm actually ‘‘engages’’ the

audit client for the purpose of obtaining

those services.

2. Employment Relationships

We are adopting, substantially as

proposed, Rule 2–01(c)(2), which sets

forth the employment relationships that

impair an auditor’s independence. As

discussed in the Proposing Release,

independence requirements related to

employment relationships between

accountants or their family members

and audit clients are based on the

premise that when an accountant is

employed by an audit client, or has a

close relative or former colleague

employed in certain positions at an

audit client, there is a significant risk

that the accountant would not be

capable of exercising the objective and

impartial judgment that is the hallmark

of independence.

We are modernizing the employment

relationship rules in a manner

consistent with the public interest and

investor protection. We are keenly

aware of the changes in traditional

family structures, the increased mobility

of professional employees, the recent

globalization of accounting firms, and

similar changes in society at large. We

have determined that, in this

environment, existing restrictions on

employment relationships between

accountants or their family members

and audit clients are more restrictive

than necessary to protect investors.

Accordingly, we are narrowing those

restrictions.

We received a number of comments

on our proposals to modernize the

employment relationship rules. The vast

majority of commenters who spoke to

this issue supported modernization in

general, even if they did not support all

aspects of our proposals.309 For

example, some commenters who agreed

with the objectives of our proposals

questioned if the ISB rather than the

Commission should prescribe

requirements in this area.310 Some

commenters expressed a preference for

the language used in ISB proposals and

ISB Standard No. 3.311 ISB Standard No.

3, ‘‘Employment with Audit Clients,’’

states, ‘‘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.’’ The

standard also describes the types of

safeguards that the ISB believes would

effectively eliminate the risk of an

impairment of independence.

We appreciate the concepts

underlying ISB Standard No. 3 and

strongly support firms’ use of quality

controls and ‘‘safeguards’’ to encourage

their partners and employees to be

aware of and adhere to auditor

independence standards. We are

concerned, however, that a ‘‘safeguards’’

approach, which is dependent on a

firm’s self-analysis and self-reviews,

will not provide a definitive standard.

In our view, independence is better

assured by consistent and uniform rules,

rather than by rules that rely on the

auditor’s assessment of the extent of its

own self-interest. Furthermore, it has

been our experience that the existence

of safeguards or quality controls alone

does not ensure compliance with even

the most basic independence

regulations.312 Accordingly, we have

chosen a more objective standard for

employment relationships, which is

described in paragraph (c)(2).313

Like the financial interest rules we are

adopting, the employment relationship

rules greatly reduce the pool of people

within audit firms whose families are

affected by the independence

requirements. Paragraph (c)(2) sets forth

the general rule that an auditor is not

independent of an audit client if the

accountant or a family member has an

employment relationship with an audit

client. The provision includes a nonexclusive list of employment

relationships that are inconsistent with

the general standard of paragraphs (b)

and (c)(2). Employment relationships

not specifically described in paragraphs

(c)(2)(i) through (c)(2)(iv) are subject to

the general test of paragraphs (b) and

(c)(2).

The following are examples of

employment relationships that impair

an auditor’s independence under the

final rule.314

• A current partner of an accounting

firm serves as a member of the board of

directors of the audit client;

76040 Federal Register / Vol. 65, No. 234 / Tuesday, December 5, 2000 / Rules and Regulations

315Compare Letter of Paula Morris, MPA, CPA,

Assistant Professor, Kennesaw State University

(Sept. 25, 2000) (expressing her concerns about

loosening the rules regarding spouses’ and

dependents’ employment relationships) with

Deloitte & Touche Letter (suggesting that an audit

client’s employment of a close family member of a

covered person who is not on the audit engagement

team or in the chain of command, should not be

deemed to impair the auditor’s independence, even

if the person holds an accounting or financial

reporting oversight role because there is only a

‘‘remote likelihood’’ that such a person could

influence the audit).

316 ISB, ‘‘Invitation to Comment 99–1: Family

Relationships Between the Auditor and the Audit

Client’’ (July 1999).

317AICPA Code of Professional Conduct, ET

§ 101.11.

318AICPA Letter (‘‘For the most part, the specific

positions listed in the definition . . . are

appropriate and provide helpful advice to

practitioners. . . . however . . . we do not believe

the vice president of marketing should be included

in this list.’’); Ernst & Young Letter.

319See, e.g., In the Matter of Jimmy L. Duckworth,

CPA, AAER No. 1205 (Nov. 10, 1999); In the Matter

of Pinnacle Micro, Inc., Scott A. Blum, and Lilia

Craig, AAER No. 975 (Oct. 3, 1997).

• A sibling of a covered person is

employed by an audit client as the

director of internal audit;

• A former professional employee of

an accounting firm who resigned from

the accounting firm two years ago is

employed by an audit client in an

accounting role and the former

employee receives a pension from the

firm tied to the firm’s revenues or

profits;

• A former partner of an accounting

firm accepts the position of chief

accounting officer at an audit client, and

the former partner continues to

maintain a capital balance with the

accounting firm; or,

• A former director of an audit client

becomes a partner of the accounting

firm, and that individual participates in

the audit of the financial statements of

the audit client for a period during

which he or she was a director of the

audit client.

We discuss each of the rules giving

rise to these examples in turn.

a. Employment at Audit Client of

Accountant. Rule 2–01(c)(2)(i)

continues the principle set forth in

current Rule 2–01(b) that to be

independent, neither the accountant nor

any member of his or her firm can be a

director, officer, or employee of an audit

client. Paragraph (2)(i) provides that an

accountant is not independent if any

current partner, principal, shareholder,

or professional employee of the

accounting firm is employed by the

audit client, or serves as a member of

the board of directors or similar

management or governing body of the

audit client. In the most basic sense, the

accountant cannot be employed by his

or her audit client and be independent.

b. Employment at Audit Client of

Certain Relatives of Accountant. Rule 2–

01(c)(2)(ii) provides that certain

employment relationships between

covered persons’ close family members

and an audit client will impair the

auditor’s independence. As discussed

below, close family members include

the covered person’s spouse, spousal

equivalent, dependents, parents,

nondependent children, and siblings.

The application of the rule to close

family members stands in contrast to the

financial interest rules, where only the

interests of the covered person’s

immediate family members (i.e., spouse,

spousal equivalent, and dependents) are

attributed to the covered person. As we

explained in the Proposing Release, we

believe this distinction is appropriate

because, while some close family

members’ investments may not be

known to a covered person, the place

and nature of such family members’

employment should be obvious.

Like the proposed rule, final Rule 2–

01(c)(2)(ii) limits the employment

relationships that impair auditor

independence when held by a close

family member of a covered person to

those involving an ‘‘accounting role or

financial reporting oversight role.’’ As a

result, an audit client’s employment of

even an immediate family member will

not necessarily impair an auditor’s

independence, unless that family

member is in an ‘‘accounting role or

financial reporting oversight role.’’

Not all commenters agreed with the

scope of the rule, some arguing that our

proposal was too generous and others

arguing that the proposal was too

restrictive.315 In this regard, we note

that the ISB has taken a more restrictive

approach in suggesting that

independence is impaired if an

immediate family member of a person

on the audit engagement team is

employed by the audit client in any

position.316 We continue to believe,

however, that we need only apply our

restriction to family members in an

‘‘accounting role or financial reporting

oversight role’’ at an audit client. Some

commenters, on the other hand, argued

for a rule that did not impose

restrictions on close family members of

all covered persons. While we

acknowledge that individuals who are

covered persons because they provide

ten or more hours of non-audit services

to the audit client or work in the same

office as the lead audit engagement

partner are less likely to be able to

influence an audit than covered persons

who are on the audit engagement team

or in the ‘‘chain of command,’’ we do

not agree that the likelihood is so

remote as to warrant carving their close

family members out of the rule.

We define ‘‘accounting role or

financial reporting oversight role’’ in

Rule 2–01(f)(3). The definition includes

two categories of persons. One category

includes those with more than minimal

influence over the contents of the

accounting records or anyone who

prepares them. This typically would

include certain persons working in the

accounting department or who perform

accounting functions. We have not

chosen to reach as many persons in the

audit client’s accounting department as

are covered by the ‘‘audit sensitive’’

category in the AICPA’s employment

rules.317 The definition also may

include certain individuals, such as an

accounts receivable supervisor or

manager, who are relied upon by

management to calculate amounts that

are placed directly into the company’s

financial statements.

The second category includes those

who influence the preparers or the

contents of the financial statements of

the audit client. The definition lists

positions in which we believe a person

generally wields the type of influence

over the financial statements that causes

independence concerns, such as a

member of the audit client’s 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, vice president of

marketing, or any equivalent position.

Several commenters expressed

support for the concept of ‘‘accounting

role or financial reporting oversight

role,’’ but recommended that we modify

the definition in various ways, for

example, by eliminating vice president

of marketing from the scope of the rule

or making the list an exhaustive list of

covered positions.318 We believe that

the vice president of marketing makes

important determinations that affect the

company’s financial results.319 These

include, for example, supervising sales

that result in the revenues reported in

financial statements, shaping sales

policies and procedures, and

participating at a high level in the

formulation of the company’s budget.

For these reasons, we consider a vice

president of marketing to be involved in

a financial reporting oversight role. We

have declined to make the list of

positions exhaustive because titles alone

do not always accurately describe a

person’s duties and functions.

Other modifications to the definition

make explicit our concerns about

positions in which the employee would

Federal Register / Vol. 65, No. 234 / Tuesday, December 5, 2000 / Rules and Regulations 76041

320See AICPA, Auditing Standards Division,

‘‘Audit Risk Alert—1994, General Update on

Economic, Accounting, and Auditing Matters,’’ at

35 (1994).

A few litigation cases suggest auditors need to be

more cautious in dealing with former coworkers

employed by a client. None of these cases involved

collusion or an intentional lack of objectivity.

Nevertheless, if a close relationship previously

existed between the auditor and a former colleague

now employed by a client, the auditor must guard

against being too trusting in his or her acceptance

of representations about the entity’s financial

statements. Otherwise the auditor may rely too

heavily on the word of a former associate,

overlooking that a common interest no longer

exists.

321See Paul M. Clikeman, ‘‘Close revolving door

between auditors, clients,’’ Accounting Today, at 20

(July 8–28, 1996); Cf. In the Matter of Richard A.

Knight, AAER No. 764 (Feb. 27, 1996) (individual

allegedly learned of accounting misstatements

while he was engagement partner for firm

conducting audit and resigned to become

registrant’s executive vice president and chief

financial officer).

322See, e.g., AUSA Life Ins. Co. v. Ernst & Young,

206 F.3d 202 (2d Cir. 2000); AICPA Board of

Directors, Meeting the Financial Reporting Needs of

the Future: A Public Commitment From the Public

Accounting Profession, at 4 (June 1993) (‘‘AICPA

Board Report’’); see also Staff Report, supra note 74,

at 51–52; In addressing an example of this problem,

the court in Lincoln S&L v. Wall, 743 F. Supp. 901,

917 n.23 (D.D.C. 1990) wrote:

Atchison, who was in charge of the Arthur Young

audit of Lincoln, left Arthur Young to assume a

high paying position with Lincoln. This certainly

raises questions about Arthur Young’s

independence. Here a person in charge of the

Lincoln audit resigned from the accounting firm

and immediately became an employee of Lincoln.

This practice of ‘‘changing sides’’ should certainly

be examined by the accounting profession’s

standard setting authorities as to the impact such

a practice has on an accountant’s independence. It

would seem that some ‘‘cooling off period’’

perhaps, one to two years, would not be

unreasonable before a senior official on an audit can

be employed by the client.

323 In response to these and other concerns, the

AICPA Board of Directors suggested in 1993 that we

prohibit a public company from hiring the partner

responsible for the audits of that company’s

financial statements for a minimum of one year

after the partner ceases to serve that company. See

AICPA Board Report, supra note 322, at 4. Our staff

has indicated, however, that, if implemented, this

suggestion would take the form of the firm’s

independence being impaired for a period of time

from the date the individual left the audit

engagement, rather than as a prohibition on hiring

the former partner. Staff Report, supra note 74, at

52 n.146. See also Committee of Sponsoring

Organizations of the Treadway Commission

(‘‘COSO’’), ‘‘Fraudulent Financial Reporting: 1987–

1997: An Analysis of U.S. Public Companies,’’ at 21

(1999) (finding, with respect to companies where

there was fraudulent financial reporting, that among

44 companies for which there was information

available on their CFO’s background, 11% of the

companies’ CFOs had previous experience with the

companies’ audit firms just before joining the

company).

324As noted in the Proposing Release, to avoid

adverse tax consequences to the individual,

accounting firms often settle their retirement

obligations to former partners by fully funding a

‘‘rabbi trust’’ from which payments will be made to

the individual. Under Rule 2–01(f)(16), a ‘‘rabbi

trust’’ is an irrevocable trust whose assets are not

accessible to the firm until all benefit obligations

have been met but are subject to claims of the firm’s

creditors in bankruptcy or insolvency. We are

adopting the definition of ‘‘rabbi trust’’ as proposed.

325See, e.g., Written Testimony of ICAEW (Sept.

13, 2000).

exercise more than minimal influence

over the contents of the accounting

records or anyone who prepares them,

or would exercise influence over the

contents of the financial statements or

anyone who prepares them. As noted

above, the final rule also incorporates

the proposed list of examples of

positions in which we consider a person

to exercise influence over the contents

of the financial statements or people

who prepare the financial statements.

We have singled out these two

categories of positions because persons

in these positions can influence the

financial reporting of the company.

As noted in the Proposing Release, the

so-called ‘‘five hundred mile rule’’ has

been eliminated under Rule 2–

01(c)(2)(ii). Whether a covered person

lives near a close family member who is

employed by the audit client no longer

seems relevant in today’s world of

instantaneous international

communications and global securities

markets. Accordingly, we have

dispensed with this test of auditor

independence.

c. Employment at Audit Client of

Former Employee of Accounting Firm.

We are adopting Rule 2–01(c)(2)(iii)

substantially as proposed, with the

minor modifications discussed below.

Rule 2–01(c)(2)(iii) describes the

circumstances under which an auditor’s

independence will be impaired by an

audit client’s employment of a former

partner, principal, shareholder, or

professional employee of the accounting

firm in an accounting role or financial

reporting oversight role. As we noted in

the Proposing Release, when these

persons retire or resign from accounting

firms, it is not unusual for them to join

the management of former audit clients

or to become members of their boards of

directors. Registrants and their

shareholders may benefit from the

former partner’s accounting and

financial reporting expertise. Investors

and the public in general also may

benefit when individuals on the board

or in management can work effectively

with the auditors, members of the audit

committee, and management to provide

informative financial statements and

reports.

When these persons, however, assume

positions with the firm’s audit client

and also remain linked in some fashion

to the accounting firm, they may well be

in a position to influence the content of

the audit client’s accounting records

and financial statements on the one

hand, and the conduct of the audit, on

the other. This is particularly true when

the individual, while at the accounting

firm, was in some way associated with

the audit of the client. A close

association between a member of the

board of directors or of senior

management with his or her former firm

creates an impression of a mutuality of

interest and may well affect the

auditor’s judgment.320

In addition, even under the usual

circumstances, there is some possibility

that accounting firm partners may

compromise their independence in

order to secure management positions

with the audit clients.321 That risk is

heightened where there is a ‘‘revolving

door’’ between the auditor and the

client.322 Finally, there is the risk that

the former partner’s familiarity with the

firm’s audit process and the audit

partners and employees of the firm will

enable him or her to affect the audit as

it progresses.323 Accordingly, under the

final rule, as under current

requirements, an auditor’s

independence with respect to an audit

client is deemed to be impaired when

former partners, shareholders,

principals, or professional employees of

the firm are employed in an accounting

or financial reporting oversight role at

an audit client, unless certain

conditions are met.

Consistent with our proposal, the

final rule provides that independence

will not be impaired if certain steps are

taken to ensure the individual’s

separation from the accounting firm.

Under the final rule, the former partner,

principal, shareholder, or professional

employee must not: (i) Influence the

firm’s operations or financial policies,

(ii) have a capital balance in the firm, or

(iii) have a financial arrangement, other

than one providing for regular payment

of a fixed dollar amount, as described in

paragraphs 2–01(c)(2)(iii)(C)(1) and (2).

Any payment of a fixed dollar amount

must be made pursuant to a fully

funded retirement plan, rabbi trust or

similar vehicle. Or, in the case of a

former professional employee who was

not a partner, principal, or shareholder

of the firm and has been disassociated

from the accounting firm for more than

five years, the fixed payments made to

the former employee must be immaterial

to him or her.

As proposed, the rule contemplated

only fixed payments made pursuant to

a fully funded retirement plan or rabbi

trust.324 Several commenters expressed

concern about the rule’s application in

foreign jurisdictions in which rabbi

trusts are not recognized.325 In response

to these comments, we have modified

the rule to indicate that using a similar

payment vehicle will satisfy the rule. If

76042 Federal Register / Vol. 65, No. 234 / Tuesday, December 5, 2000 / Rules and Regulations

326We would not consider an individual’s 401(k)

account to constitute a financial arrangement with

the accounting firm to be fully funded for these

purposes because, although the investment remains

subject to market risk, the account balance is not

dependent on the accounting firm’s financial

performance even if the firm continues to

administer the account for the former firm

personnel.

327With regard to cooling off periods, see AICPA

Board Report, supra note 322, at 4 (June 1993)

(suggesting that the Commission prohibit a public

company from hiring the partner responsible for the

audits of that company’s financial statements for a

minimum of one year after the partner ceases to

serve that company) and Lincoln S&L v. Wall, 743

F. Supp. at 917 n.23 (‘‘It would seem that some

‘cooling off period,’ perhaps one to two years,

would not be unreasonable before a senior official

on an audit can be employed by the client.’’).

328See, e.g., Letter of Pamela Roush, Ph.D., CMA

(undated).

329See, e.g., Written Testimony of Mauricio

Kohn, CFA, CMA, CFM, AIMR (Sept. 20, 2000)

(‘‘We do not believe it is necessary to impose a

mandatory ‘cooling-off period,’ prohibit clients

from hiring audit firm professionals, or stipulate

that an audit firm’s independence is impaired when

its professionals accept key positions with current

clients.’’).

330Nonetheless, we encourage firms to maintain

adequate controls to ensure that former employees

are not unduly influencing the audit engagement

team.

331Of course, once an employee of an accounting

firm, the person would also be subject to all other

independence requirements applicable to other firm

members. For example, if the former audit client

employee becomes a covered person, he or she

could have no financial interest in the audit client.

See Rule 2–01(c)(1).

332The AICPA recommended that the rule apply

to all professional employees of the accounting

firm, not just to partners, shareholders, and

principals. See AICPA Letter. We agree and,

therefore, have modified the final rule to encompass

this situation.

333See, e.g., Deloitte & Touche Letter; Written

Testimony of Dennis Paul Spackman, Chairman,

National Association of State Boards of

Accountancy (Sept. 13, 2000) (‘‘I am in full

agreement with the provisions of the Commission’s

proposal [regarding] Business Relationships.’’).

334See Codification § 602.02.g.

335See Deloitte & Touche Letter (‘‘Although we

agree with the direction of [Rule 2–01(c)(3)], it

provides no basis for prohibiting business

relationships with beneficial owners of more than

five percent of the equity securities of the audit

client or any of its affiliates.’’).

a rabbi trust is available in the

jurisdiction, however, the accounting

firm and the former professional must

use a rabbi trust, rather than some other

vehicle.

As noted, to satisfy the conditions of

paragraph (C)(1), the retirement plan or

rabbi trust must be fully funded.326 We

believe that full funding is critical to

breaking the link between the firm and

the individual. Any situation that

requires the individual to be dependent

on the firm to fund his or her retirement

payments weds the financial interests of

the former employee and the firm, and

creates the potential for the firm to exert

influence over the individual, or vice

versa.

The proposed rule did not contain a

‘‘cooling off’’ period. We solicited

comment on whether we should require

a mandatory cooling off period for

former partners and professional staff of

an audit firm who join an audit

client.327 Several commenters supported

the notion of a cooling off period,328 but

others disagreed.329 We have

determined that a cooling off period

unnecessarily restricts the employment

opportunities of former professionals,

and we have decided not to adopt a

cooling off provision.330

We also solicited comment on

whether application of the rule should

depend on whether the professional

leaving the accounting firm was a

partner at the firm or non-managerial

audit staff. We considered whether to

provide a sunset provision so that

accounting firms need not track all

former professional employees

indefinitely to determine, for purposes

of this provision, whether they become

employed in an accounting role or

financial reporting oversight role at an

audit client. While we believe that it is

usual for accounting firms to know

whether their former partners,

principals, or shareholders are

employed in these roles at an audit

client, we understand the practical

difficulties firms might have tracking all

former professionals who left the firm

while at a managerial or staff level.

Accordingly, we are adopting a rule

under which the accountant’s

independence will not be impaired

when a former professional, who was

not a partner, joins an audit client in an

accounting role or financial reporting

oversight role position after five years,

provided the retirement benefits of the

former employee are immaterial to him

or her.

The materiality provision is necessary

because, to satisfy the conditions in

paragraph (C)(2), the retirement plan

does not have to be fully funded. In the

absence of such funding, we believe that

the receipt by the former employee of

more than an immaterial amount would

create the unification of financial

interests discussed above.

d. Employment at Accounting Firm of

Former Employee of Audit Client. We

are adopting Rule 2–01(c)(2)(iv)

substantially as proposed. The rule

specifies that individuals who were

formerly officers, directors, or

employees of an audit client and who

later become partners, principals, or

shareholders of the accounting firm will

impair the independence of the firm

with respect to that audit client, unless

they do not participate in, and are not

in a position to influence, the audit of

the financial statements of the audit

client covering a period during which

the individuals were employed by or

associated with the audit client. When

a former employee of an audit client

joins the accounting firm, the

independence rules ensure that the

employee is not in a position to

influence the audit of his or her former

employer.331 Because participating in

the audit of the former employer could

easily require former employees to audit

their own work, the rule provides that

independence is impaired unless the

former employees do not participate in

and are not in a position to influence

the audit of the financial statements of

the audit client for any period during

which they were employed by or

associated with that audit client.

The final rule applies to all former

employees of the audit client, not only

those who were in accounting or

financial reporting oversight roles. It

also applies to former audit client

employees whether they become

partners, principals, or shareholders of

the accounting firm or professional

employees of the firm.332

3. Business Relationships

We proposed Rule 2–01(c)(3) to

describe the business relationships that

impair an auditor’s independence from

an audit client. We are adopting the rule

substantially as proposed with two

minor modifications. The rule continues

the Codification’s current standard that

an auditor’s independence with respect

to an audit client is impaired when the

accounting firm, or a covered person in

the firm, has a direct or material indirect

business relationship with an audit

client, or any person associated with the

audit client in a decision-making

capacity, such as an audit client’s

officers, directors, or substantial

stockholders.

Commenters were generally

supportive of the approach we took in

the proposal, with the exception of one

provision.333 We proposed that

independence was also impaired if the

accounting firm or any covered person

had a direct or material indirect

business relationship with ‘‘record or

beneficial owners of more than five

percent of the [audit client’s] equity

securities.’’ This formulation was

intended to provide a more precise

definition of the subset of associated

persons who constitute ‘‘substantial

stockholders’’ in the existing restrictions

on business relationships in the

Codification.334 Commenters, however,

expressed concerns with this

threshold.335 Similarly, one large

accounting firm expressed concern with

Federal Register / Vol. 65, No. 234 / Tuesday, December 5, 2000 / Rules and Regulations 76043

336Ernst & Young Letter; see also AICPA Letter

(‘‘Such sweeping new restrictions would

dramatically constrict the parties with which

accounting firms could engage, even though many

such parties at most have only very attenuated ties

to audit clients. . . . We view independence risks

as extremely remote in such circumstances and,

therefore, consider the reach of such provisions

unnecessarily broad.’’).

337See Codification § 602.02.g; Letter from

Jonathan G. Katz, Secretary, SEC, to Duane R.

Kulberg, Arthur Andersen & Co. (Feb. 14, 1989).

338See, e.g., Deloitte & Touche Letter.

339See infra Section IX; Codification 602.02(g).

340See AICPA Letter.

341See Letter from Jonathan G. Katz, Secretary,

SEC, to Duane R. Kulberg, Arthur Anderson & Co.,

(Feb. 14, 1989).

342See, e.g., Proposing Release, Section

III.D.1.(b)(i)(iv) (regarding bookkeeping and

actuarial services, respectively). But see Proposing

Release, Section III.D.1.(b)(ii) (regarding financial

information systems).

343See, e.g., Testimony of Barry Melancon,

President and Chief Executive Officer, AICPA (Sept.

21, 2000).

344See Testimony of Joseph F. Bernardino,

Managing Partner, Assurance and Business

Advisory Services, Arthur Anderson LLP (Sept. 20,

2000) and Testimony of James E. Copeland, Chief

Executive Officer, Deloitte & Touche LLP (Sept. 20,

2000) (responsing to questions from Chairman

Artrhur Levitt, SEC, about whether they would be

comfortable if our final rules on non-audit services

paralleled the profession’s own rules); see also

testimony of K. Michael Conaway, President

Officer, Texas State Board of Accountancy (Sept.

20, 2000).

345See infra Section IV.D.4.b(x).

346AICPA Code of Professional Conduct, ET

§ 101.05; Codification § 602.02.c.i.

347Proposing Release, Section III.D.1(b)(i);

Codification § 602.02.c.

the proposed language, asserting that

our proposal would ‘‘greatly expand[]

the universe of venture capital firms

with which we could not have any

business relationships.’’336

In response to these comments, we are

adopting instead the language used in

the Codification, which refers to an

associated person ‘‘in a decision-making

capacity, such as an audit client’s

officers, directors or substantial

stockholders.’’ Because our rule, as

adopted, conforms more closely to the

Codification, we anticipate that it will

provide greater clarity to the profession

in interpreting Rule 2–01(c)(3) and

address the concerns about the proposal

that were articulated by several

commenters.

We are also clarifying the rule by

adding the words ‘‘to the audit client’’

after ‘‘provides professional services’’ in

the last sentence of the rule. As

discussed in the Proposing Release, the

exception for providing professional

services is meant only to make clear that

Rule 2–01(c)(3) does not address the

provision of professional services by the

auditor to the audit client. The addition

of these four words is intended to make

clear that joint business ventures or

prime/subcontractor arrangements in

which audit clients and auditors jointly

provide ‘‘professional services’’ would

continue to impair the auditor’s

independence.337

We also proposed defining the phrase

‘‘consumer in the ordinary course of

business’’ as part of the definitions

explicitly set forth in Rule 2–01(f).

Commenters, however, expressed

concern that, as defined, this phrase

could have unintended

consequences.338 Accordingly, we omit

the definition of ‘‘consumer in the

ordinary course of business’’ in the rules

we are adopting and will continue to

apply the term consistent with its use in

the Codification.

As we noted in the Proposing Release,

we are retaining a number of the

examples currently found in the

Codification to provide guidance on

permissible and impermissible business

relationships.339 We expect that the

interpretations and examples that have

evolved under the Codification with

respect to this rule will continue to

provide useful guidance to the

profession.

We also solicited comment as to

whether we should retain the ‘‘direct or

material indirect business relationship’’

formulation or if there was another

formulation that could provide

additional or more precise guidance.

The AICPA asserted that ‘‘not all

business relationships with audit clients

should be proscribed if they are

immaterial. . . . The inclusion of a

materiality standard in the context both

of [sic] all business relationships (direct

and indirect) sufficiently mitigates

whatever independence risk would be

posed.’’340 For the same reasons we

have explained before, we do not

believe that auditors should be allowed

to have any direct business

relationships with their audit clients

other than as a consumer in the ordinary

course of business.341 We have carefully

considered the comments we have

received and believe that the rule we are

adopting constitutes a fair and balanced

approach that protects independence

without unduly restricting business

opportunities for auditors or their

clients.

4. Non-Audit Services

a. General Rule. We are adopting a

rule that provides that an accountant is

not independent if the accountant

provides the non-audit services

identified in paragraph (c)(4). The rule

is derived from current Rule 2–01, our

releases that have been incorporated

into the Codification, and existing

AICPA rules.

The proposed rule identified certain

services that could not be provided by

the auditor without impairing the

auditor’s independence with respect to

the audit client ‘‘[e]ven if the audit

client accept[ed] ultimate responsibility

for the work that is performed or

decisions that are made . . . .’’ In the

final non-audit services rule, Rule 2–

01(c)(4), we have eliminated that

language. As described below, we have

added certain exceptions to the nonaudit services that impair an auditor’s

independence. These exceptions are

appropriate only where management

takes certain actions and accepts certain

responsibilities. For example, we have

set forth certain circumstances where an

auditor does not lose his or her

independence by providing certain

actuarial services to insurance company

audit clients. The exception, however, is

available only where management

accepts responsibility for significant

actuarial methods and assumptions.

The final amendments identify nine

non-audit services that, when provided

by the auditor to an audit client, impair

the auditor’s independence. In the

proposed rule, we identified ten such

services. For many of the non-audit

services that we proposed to include in

the rule, we aimed to codify existing

restrictions.342 Commenters expressed

concerns, however, that certain of our

proposed rules were written more

broadly than existing independence

rules.343 In addition, commenters

indicated that, to the extent our

proposals differed from current

standards, they believed current

standards more appropriately

circumscribed auditors’ non-audit

activities.344 In response to these

comments, we made several

modifications to the rules, including

eliminating altogether the provision on

expert services.345

b. Particular Non-Audit Services that

Impair Independence. (i) Bookkeeping

or Other Services Related to the Audit

Client’s Accounting Records or

Financial Statements. We proposed and

are adopting paragraph (c)(4)(i), which,

with limited exceptions, would deem an

auditor’s independence to be impaired

when the auditor performs bookkeeping

services for an audit client. Even prior

to our proposals, auditors were

restricted by AICPA Ethics Rules and

the Codification from providing certain

bookkeeping services.346 As explained

in the Codification and reiterated in the

Proposing Release,347 providing

bookkeeping services for an audit client

impairs the auditor’s independence

because the auditor will be placed in the

position of auditing the firm’s work

76044 Federal Register / Vol. 65, No. 234 / Tuesday, December 5, 2000 / Rules and Regulations

348See, e.g., Deloitte & Touche Letter; AICPA

Letter.

349See, Ernst & Young Letter.

350For example, as part of the audit process, the

auditor might process adjustments that eventually

are incorporated into the audit client’s financial

statements. See Deloitte & Touche Letter.

351AICPA Code of Professional Conduct, ET

§ 101.05.

352See, e.g., Deloitte & Touche Lettter.

353Codification § 601.02.c.ii, Example 6.

354Codification § 601.02.c.iii.

355Proposing Release, note 160.

356 Deloitte & Touche Lettter; Ernst & Young

Letter; PricewaterhouseCoopers Letter.

357There may be entities that are not large enough

to maintain the capability in-house, yet there may

not be reputable providers of these services where

domestic companies’ foreign affiliates are located or

a reputable firm may not want to provide the

Services because they will generate only minimal

fees. See Codification § 601.02.e.iii.

358Codification § 601.02.c.iii (requiring

compliance with this condition, ‘‘so that an

informed observer in the foreign location would

have no cause to question the fact or appearance of

independence’’).

359Codification § 601.02.c.iii.

360The Commission has determined to raise to

$10,000 from $1,000 the dollar threshold in the

Codification in light of the inflation since the

provisions in the Codification were adopted.

361See generally, Arthur Andersen Letter;

Deloitte & Touche Lettter.

when auditing the client’s financial

statements. It is hard to maintain the

requisite objectivity about one’s or one’s

firm’s own work. This is especially true

where finding an error would raise

questions about the adequacy of the

bookkeeping services provided by 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.

We have modified our final rule in

response to several comments.348 First,

commenters believed that the proposed

definition should not cover all financial

statements, including those not filed

with the Commission. For example,

auditors sometimes prepare statutory

financial statements for foreign

companies, and these are not filed with

us. At least one commenter requested

that we therefore exclude those

financial statements from the rule’s

coverage.349 Focusing solely on whether

the financial statements are filed with

us would not be appropriate in all

circumstances, since in some instances

statutory financial statements form the

basis of the U.S. GAAP financial

statements that are filed with us. Under

these circumstances, an auditor 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. GAAPconverted financial statements.

Accordingly, the final rule amendments

cover not only financial statements that

are filed with us, but also financial

statements that form the basis of

financial statements that are filed with

us. As proposed, the final amendments

also cover any service involving

maintaining or preparing the audit

client’s accounting records.

Second, although we proposed to

cover services that resulted in the

accountant generating financial

information that would be disclosed to

investors, commenters believed that this

language was too broad. As part of the

audit process, auditors may generate

data in connection with evaluating

financial information that eventually

may be disclosed to investors.350 We

believe that they should continue to be

able to do so. Accordingly, we narrowed

the definition to eliminate this language

and instead are incorporating wording

from the AICPA Ethics Rules to the

effect that an accountant cannot prepare

source documents or originate data

underlying the client’s financial

statements without impairing

independence.351

Third, several commenters requested

that we provide an exception to the rule

so that auditors could perform

bookkeeping services in emergency or

other unusual situations.352 The

Codification provides such an

exception. Example 6 of Section

602.02.c.ii of the Codification states that

when, due to the unexpected

resignation of a company’s comptroller

at the end of the year, the accountant

was called upon to provide assistance in

closing the books and the accountant

did not make decisions on a managerial

level, the accountant’s independence

was not impaired.353 We recognize that

there may be emergency or other

unusual situations, such as the one

described above, in which the auditor

will need to provide bookkeeping

services that are otherwise prohibited.

Accordingly, we are adopting an

exception from the bookkeeping

restriction for emergency or other

unusual situations, provided that the

accountant does not act as a manager or

make any managerial decisions. We

expect that such situations will be rare.

We encourage registrants and auditors

to contact the staff with any questions

about the application of this provision

to particular circumstances.

Finally, the final rule contains a

limited exception related to

bookkeeping for foreign subsidiaries or

divisions of audit clients. The

Codification provides this type of

exception.354 The Proposing Release

noted that the Commission recognized

the need for relief in this area, and that

therefore we had proposed to retain this

section of the Codification.355 In

response to commenters’ concerns,356

however, we are incorporating the

exception into the rule. Accountants

therefore may provide these services for

foreign divisions or subsidiaries of a

domestic audit client under certain

conditions. First, the services must be

limited, routine, or ministerial. Second,

it must be impractical for the entity

receiving the services to obtain them

from another provider.357 Third, under

the adopted rule as under the

Codification, the foreign entity for

which the accountant is performing

these services cannot be material to the

consolidated financial statements.

Fourth, as under the Codification, the

entity must not have employees capable

or competent to perform the services.

Fifth, the services performed must be

consistent with local professional ethics

rules.358 Last, as explained in the

Codification, ‘‘the Commission believes

that a comparison of the fees for the

bookkeeping services and the audit

should provide a fair test for

determining the significance of the work

to the registrant and the accountant, and

indirectly, the possible effect on the

firm’s independence,’’ and that

therefore a limit on the services can be

‘‘based on the relationship of the fee

charged for the service to the total audit

fee charged to the registrant.’’359

Accordingly, the final rule provides that

the total fees for the bookkeeping

services provided by the auditor to a

company’s foreign entities collectively

(for the entire group of companies)

cannot exceed the greater of one percent

of the consolidated audit fee or

$10,000.360

(ii) Financial Information Systems

Design and Implementation. Paragraph

(c)(4)(ii) identifies certain information

technology services that, if provided to

an audit client, impair the accountant’s

independence. Paragraph (c)(4)(ii) also

identifies other information technology

services that may be provided to an

audit client without impairing

independence so long as certain

conditions are satisfied.

The rule we adopt today on

information technology services

represents a change from the rule we

proposed. Some commenters objected to

our proposed rule. This provision lay at

the heart of some of the largest

accounting firms’ arguments that our

proposed rules would hinder their

access to technology, limit their

understanding of their clients’

operations, and hurt their recruiting

efforts.361 These arguments compete

Federal Register / Vol. 65, No. 234 / Tuesday, December 5, 2000 / Rules and Regulations 76045

362See AICPA Code of Professional Conduct, ET

§ 101.05.

363Although we anticipate that accountants and

their audit clients will usually seek to meet these

conditions, we note certain points about paragraph

(c)(4)(ii)(B) relevant to situations where these

conditions are not met. First, by ‘‘significant,’’ 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

final before financial statements are generated, an

accounting firm may need to evaluate the general

nature of the information rather than wait to

evaluate system output during the period of the

audit engagement. For example, without satisfying

the conditions of paragraphs (c)(4)(ii)(B)(1)–(5), an

accountant would not be independent of an audit

client for which it designed an integrated Enterprise

Resource Planning (‘‘ERP’’) system. (An ERP system

is designed to integrate all functions and

departments in a company into one computer

system that can serve the needs of each

department.) In addition, without satisfying the

conditions, a firm’s independence would be

impaired if it designed and implemented an

accounts receivable/order management system that

recorded and summarized sales that were material

to the financial statements of the audit client. A

firm’s independence would not be impaired,

however, if the accounting firm designed and

implemented a system for a foreign subsidiary

whose financial condition and results of operations

were not material to the financial statement of the

audit client.

364Ernst & Young Letter; PricewaterhouseCoopers

Letter.

with the widespread and persistent

perceptions that large, lucrative

information technology consulting

relationships with an audit client may

give rise to conflicts of interest, may

result in auditors functioning as

management, or may result in an auditor

auditing his or her own work.

The final rule reflects a pragmatic

approach to a difficult issue. The rule

singles out certain information

technology services as independence

impairments under any circumstances,

and identifies other categories of

information technology services that

will not impair independence if certain

conditions are fulfilled. Those

conditions are designed to minimize the

potential for an auditor to end up

making management decisions or

auditing his or her own work.

The rule also takes a pragmatic

approach to the potential independence

problem posed by the economic

incentives that accompany large

consulting contracts. Rather than

effectively ban those relationships, we

are amending the proxy disclosure rules

to require public companies to make

specific disclosure of fees paid to their

auditor for information technology

services. In addition, public companies

must disclose that their audit committee

(or, if there is no audit committee, the

board of directors) considered whether

the provision of the information

technology services, as well as all other

non-audit services, is compatible with

maintaining the auditor’s independence.

As discussed in greater detail below,

we anticipate that audit committees will

consider the independence implications

of the engagements that are subject to

the disclosure requirements. Moreover,

the disclosure will provide information

to enable investors themselves to

evaluate auditor independence, and will

enable future study of whether large

information technology consulting

relationships have an effect on audit

quality and auditors’ independence.

Paragraph (c)(4)(ii)(A) provides that

an accountant is not independent of an

audit client if the accountant is

‘‘[d]irectly or indirectly operating, or

supervising the operation of, the audit

client’s information system or managing

the audit client’s local area network.’’

These services impair an accountant’s

independence under existing AICPA

rules, 362 and, under the rules we adopt

today, will impair independence under

any circumstances.

Under paragraph (c)(4)(ii)(B),

‘‘[d]esigning 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, taken

as a whole,’’ will impair an accountant’s

independence unless certain conditions

are met.363 This section of the final rule

differs from the proposed rule in that we

have modified the description of the

hardware and software systems that the

rule reaches by adding the phrase ‘‘that

aggregates source data underlying the

financial statements.’’ This change was

suggested by commenters. 364We have

adopted this change because, to the

extent that the design and

implementation activities concern

hardware and software systems that

aggregate source data, they are likely to

be the types of systems that raise

independence concerns.

The conditions that the rule imposes

are intended to reduce the likelihood

that the auditor will be placed in a

position of making, and then auditing,

managerial decisions. They are also

intended to ensure that management

will make all significant decisions

during the process and, at its

conclusion, will be fully responsible for

the results of the project including the

proper functioning of the company’s

internal accounting controls.

The first condition, set out in

paragraph (c)(4)(ii)(B)(1), is that ‘‘the

audit client’s management has

acknowledged in writing to the

accounting firm and the audit client’s

audit committee, or if there is no such

committee then the board of directors,

the audit client’s responsibility to

establish and maintain a system of

internal accounting controls in

compliance with Section 13(b)(2) of the

Securities Exchange Act of 1934, 15

U.S.C. § 78m(b)(2).’’ This condition

makes clear that this statutory

responsibility cannot be shifted to the

accounting firm.

Paragraphs (c)(4)(ii)(B)(2) and

(c)(4)(ii)(B)(3), setting out the second

and third conditions, complement each

other. Paragraph (B)(2) articulates the

condition that ‘‘the audit client’s

management designates a competent

employee or employees, preferably

within senior management, with the

responsibility to make all management

decisions with respect to the design and

implementation of the hardware or

software system.’’ Paragraph (B)(3)

articulates the condition that ‘‘the audit

client’s management makes all

management decisions with respect to

the design and implementation of the

hardware or software system including,

but not limited to, decisions concerning

the systems to be evaluated and

selected, the controls and system

procedures to be implemented, the

scope and timetable of system

implementation, and the testing,

training and conversion plans.’’ These

conditions are intended to ensure that

an audit client that receives information

technology services from its auditor

does not delegate to its auditor

responsibility for ‘‘management

decisions’’ relating to the design and

implementation of the system.

The fourth condition, set out in

paragraph (c)(4)(ii)(B)(4), is that ‘‘the

audit client’s management evaluates the

adequacy and results of the design and

implementation of the hardware or

software system.’’ Paragraph

(c)(4)(ii)(B)(5) sets out the fifth

condition, that ‘‘the audit client’s

management does not rely on the

accountant’s work as the primary basis

for determining the adequacy of its

internal controls and financial reporting

systems.’’ These conditions reiterate the

principles that management is to make

all substantive decisions, that the

auditor should not have a mutual

interest in the successful operation of

the systems, and that the auditor should

not be placed in the position of auditing

his or her firm’s decisions about the

system.

The rule expressly does not limit

services in connection with the

assessment, design, and implementation

of internal accounting and risk

management controls, provided the

auditor does not act as an employee or

perform management functions. During

the audit, accountants generally obtain

76046 Federal Register / Vol. 65, No. 234 / Tuesday, December 5, 2000 / Rules and Regulations

365The ISB has identified threats to the

independence of firms that perform appraisal and

valuation services for audit clients. See ISB,

Discussion Memorandum 99–3 ‘‘Appraisal and

Valuation Services,’’ at 7–9.

366See generally Codification § 602.02.c.

367See e.g., Arthur Anderson Letter; Deloitte &

Touche Letter; PricewaterhouseCoopers Letter.

368Of course, reference to financial statements

includes results of operations, financial conditions

and cash flows.

369AICPA Code of Professional Conduct, ET

§101.05 states that an auditor’s independence

would not be impaired in connection with appraisal

and valuation services ‘‘when all significant matters

of judgment are determined or approved by the

client and the client is in a position to have an

informed judgment on the results of the valuation.’’

370See, e.g., Arthur Andersen Letter.

371 Deloitte & Touche Letter.

372We note in this regard, that if an acquisition

individually, and when aggregated with other

acquisitions reflected in the financial statements, is

immaterial to the audit client’s financial statements,

then assisting in the allocation of the purchase price

would not fall within the conditions of the rule and

therefore would not be deemed to impair the

auditor’s independence.

373See, e.g., Deloitte & Touche Letter; Ernst &

Young Letter; Letter of KPMG Europe (Sept. 22,

2000).

374Ernst & Young Letter.

375See e.g., Deloitte & Touche Letter; Letter of

KPMG Europe (Sept. 22, 2000).

376See Letter from Lynn Turner, Chief

Accountant, SEC, to Antonio Rosati, CONSOB (Aug.

24, 2000). In that letter, our Chief Accountant did

not deem the auditor’s independence to be

impaired where there were certain agreed-upon

procedures for the contribution-in-kind report and

an understanding of their audit clients’

systems of internal accounting controls

and may recommend ways in which

those controls can be improved or

strengthened. This service can be

valuable to companies and their audit

committees, and may also enhance audit

quality, without raising independence

concerns. In addition, we do not see any

significant reason for concern about an

audit firm’s work on hardware or

software systems that are unrelated to

the audit client’s financial statements or

accounting records.

(iii) Appraisal or Valuation Services

and Fairness Opinions. We are adopting

a rule that, with some exceptions,

provides that an accountant is not

independent if the accountant provides

appraisal or valuation services or any

service involving a fairness opinion.365

Appraisal and valuation services

include any process of valuing assets,

both tangible and intangible, or

liabilities. Fairness opinions are

opinions that an accounting firm

provides on the adequacy of

consideration in a transaction. As

explained more thoroughly in the

Proposing Release, if an audit firm

provides these services to an audit

client, when it is time to audit the

financial statements the accountant

could well end up reviewing his or her

own work, including key assumptions

or variables suggested by his or her firm

that underlie an entry in the financial

statements.366 Where the service

involves the preparation of projections

of future results or future cash flows, the

accountant may develop a mutuality of

interest with the audit client in attaining

the forecasted results.

We solicited comment on whether we

should provide an exception from the

rule when the amounts involved are

likely to be immaterial to the financial

statements that later would be reviewed

by the auditor. Several commenters

stated that such an exception is

warranted.367 In response, we are

limiting application of the rule to the

provision of appraisals, valuations, or

services involving a fairness opinion

where it is reasonably likely that the

results, individually or in the aggregate,

would be material to the audit client’s

financial statements 368 or where the

results would be audited by the auditor.

As a general matter, auditors would be

auditing the results when they perform

a GAAS audit.

The rule also contains an exception

for appraisal or valuation services where

the accounting firm reviews and reports

on work done by the audit client itself

or an independent, third-party specialist

employed by the audit client, and the

audit client or specialist provides the

primary support for the balance

recorded in the client’s 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.

Another exception allows accountants

to continue to value an audit client’s

pension, other post-employment benefit,

or similar liabilities, so long as the audit

client has determined and taken

responsibility for all significant

assumptions and data underlying the

valuation.369 Accountants historically

have provided pension assistance to

their audit clients, and if appropriate

persons at the audit client determine the

underlying assumptions and data, we

believe that independence is not

impaired.

Commenters also stated that an

accountant’s independence should not

be deemed impaired when the

accountant performs appraisal or

valuation services as a necessary part of

permitted tax services. As the rule text

and this Release make clear,

accountants will continue to be able to

provide tax services to audit clients. A

few commenters pointed out, however,

that unless accountants can perform

appraisal and valuation services that are

part of a tax planning strategy or for tax

compliance purposes, the client would

not hire the accountant to provide tax

services.370 The final rule makes clear

that accountants can perform appraisal

and valuation services for those

purposes without impairing

independence.

Commenters requested an exception

for appraisal and valuation services

where the services are for non-financial

purposes. Because our principal

concern about appraisal and valuation

services is that they lead auditors to

audit their own work, so long as the

results do not affect the financial

statements, appraisal or valuation

services performed for non-financial

purposes do not impair an auditor’s

independence.

At least one commenter suggested that

we include an exception for purchase

price allocations.371 An exception is not

appropriate here because these

allocation decisions, particularly those

regarding the valuation of intangible

assets, can have a direct, significant, and

immediate impact on companies’

financial statements. For example,

where a company acquires another

company with large, on-going in-process

research and development projects, the

acquiring company will need to decide

how much of the purchase price to

allocate to those projects. This may

affect in turn the amount charged

against earnings in the current year as

in-process research and development

expense, and the amount to be classified

as goodwill and amortized against

future years’ earnings. Any such

allocations later will be reviewed in the

course of the audit, leading the firm to

audit its own work.372

Finally, commenters raised concerns

about the restriction on the provision of

contribution-in-kind reports.373 We

have removed the language in the rule

referring to contribution-in-kind reports

because we view such reports to be akin

to fairness opinions, which are

restricted under the final rules. We

understand from commenters that

certain foreign jurisdictions require

auditors to issue contribution-in-kind

reports for their audit clients 374 and

that, in some European jurisdictions,

auditors may be appointed or approved

by an administrative or judicial

authority to act as an independent

expert and issue a contribution-in-kind

report for the audit client.375 The

Commission is sensitive to those issues

and in the past has worked with foreign

regulators and companies to reach an

acceptable resolution.376 We will

Federal Register / Vol. 65, No. 234 / Tuesday, December 5, 2000 / Rules and Regulations 76047

the accountant represented in the report that the

report did not express an opinion on the fairness

of the transaction, the value of the security, or the

adequacy of consideration to shareholders. This

letter is available on our website.

377SECPS Reference Manual (‘‘SECPS Manual’’)

§1000.35.

378PricewaterhouseCooopers Letter; Ernst &

Young Letter; see also Deloitte & Touche Letter.

379SECPS Manual §1000.35, at ¶ 5.

380Although it addresses a different topic,

accountants and registrants may refer to ISB,

‘‘Interpretation No. 99:1: Impact on Auditor

Independence of Assisting Clients in the

Implementation of FAS 133 (Derivatives)’’ for

general guidance on what constitutes ‘‘assistance’’

as opposed to ‘‘performing’’ certain functions or

services.

381See SECPS Manual §1000.35.

382See Committee of Sponsoring Organizations of

the Treadway Commission, Internal Control—

Integrated Framework, at 7 (1992) (the ‘‘COSO

Report’’).

383Testimony of Robert E. Denham (July 26,

2000); see also Testimony of John Whitehead,

retired Chairman, Goldman Sachs & Co. (Sept. 13,

2000) (‘‘internal auditing is the function of

management’’).

384Testimony of Manuel H. Johnson, Public

Member, ISB (July 26, 2000).

385See AICPA Code of Professional Conduct, ET

§101.15 (Interpretation 101–13).

386Testimony of John D. Hawke, Jr. (July 26,

2000). He also reported a trend among banks in

favor of outsourcing internal audit work to the

external auditor. He testified that ‘‘[o]f [the] 50

largest banks’’ within the jurisdiction of the OCC,

‘‘8 out-source their internal audit, and 7 of those 8

out-source to the same firm that does their external

audit. That’s a pretty good chunk of the largest

banks.’’ Id. In addition, Mr. Hawke reported that in

a survey of the OCC banks in the Northeast region,

one-third outsource their internal audit work and

half of those banks outsource to their external

auditor. Id.

387 In this study, companies with small, ‘‘meansized,’’ and large internal audit departments were

asked to indicate their level of agreement (on a scale

of zero to five, with five being the strongest) with

the following statement: ‘‘There is an independence

Continued

continue our practice of determining

whether to accept a contribution-in-kind

report on a case-by-case basis. In this

regard, we encourage registrants and

their auditors to contact the staff to

discuss particular situations where a

foreign jurisdiction requires a

contribution-in-kind report to enable the

staff to work with the registrant and the

foreign jurisdiction in reaching an

appropriate resolution.

(iv) Actuarial Services. SECPS rules

currently prohibit member accounting

firms from providing certain actuarially

oriented advisory services to insurance

companies.377 Accountants providing

these services assume a key

management task. In addition, because

actuarially oriented advisory services

may affect amounts reflected in an

insurance company’s financial

statements, providing these services

may cause an accountant later to audit

his or her own work. Rule 2–01(c)(4)(iv)

addresses these issues.

Commenters expressed concern that

the proposal was broader than a similar

SECPS rule, in that the restrictions in

the proposal applied to services

provided to all public companies, not

just insurance companies, and the

proposal did not include the four

examples of appropriate services that

are included in the SECPS rule.378 We

have modified our final rule with

respect to actuarial services to parallel

closely the SECPS rule, including the

four exceptions. The final rule limits

only actuarially oriented advisory

services involving the determination of

insurance company policy reserves and

related accounts. We are narrowing the

prohibition to services for insurance

companies because, as explained in the

SECPS rule, it is primarily in these

companies that the actuarial function is

‘‘basic to the operation and

management’’ of the company.379

The final rule states that an auditor’s

independence is impaired if the audit

firm provides certain actuarially

oriented advisory services involving the

determination of insurance company

policy reserves and related accounts,

unless three conditions are met. First,

the audit client must use its own

actuaries or third-party actuaries to

provide management with the primary

actuarial capabilities. Second,

management must accept responsibility

for any significant actuarial methods

and assumptions employed by the

accountant in performing or providing

the actuarial services. Third, the

accountant cannot render the actuarial

services to the audit client on a

continuous basis. All of these

conditions are designed to ensure that

the accountant does not assume a

management function for the audit

client.

Assuming these conditions are met,

the accountant can perform four types of

actuarial services for an insurance

company audit client without impairing

the accountant’s independence. The

four types of actuarial services are: (i)

Assisting management to develop

appropriate methods, assumptions, and

amounts for policy and loss reserves

and other actuarial items presented in

financial reports, based on the

company’s historical experience,

current practice, and future plans; 380

(ii) assisting management in the

conversion of financial statements from

a statutory basis to one conforming with

GAAP; (iii) analyzing actuarial

considerations and alternatives in

federal income tax planning; and (iv)

assisting management in the financial

analyses of various matters, such as

proposed new policies, new markets,

business acquisitions, and reinsurance

needs. Allowing accountants to provide

these four types of actuarially oriented

advisory services under the three

conditions is consistent with the SECPS

rule.381 We believe that if the conditions

are met, in the context of state-regulated

insurance companies, the four services

would not constitute an assumption of

the insurance company management’s

role or responsibilities, and would not

impair the auditor’s independence.

(v) Internal Audit Services. Although

companies are not required to do so,

they may, as part of their internal

controls, form internal audit

departments that are used to make sure

that control systems are adequate and

working. According to the Committee of

Sponsoring Organizations (‘‘COSO’’),

internal auditors play an important role

in evaluating and monitoring a

company’s internal control system.382

As explained by Robert Denham, a

member of the ISB, at our public

hearings, ‘‘Good internal auditing . . .

requires the internal auditor to be very

closely integrated with management.

The internal auditor is part of the

management team. He or she is

identifying problems and providing

reports that help management correct

those problems.’’383 In sum, ‘‘the

internal audit function is, basically, an

arm of management,’’384 and internal

auditors are, in effect, part of a

company’s internal accounting control

system.

Although a company may prefer to

outsource its internal audit function,

management must continue to be

responsible for the function.385 When a

company outsources the function to a

third-party provider, there may be a

concern that management has ceded this

responsibility. While this is a concern in

any internal audit outsourcing

arrangement, there are additional

concerns when a company outsources

the work to its external auditor. As

Comptroller of the Currency John D.

Hawke, Jr., testified, ‘‘When a bank outsources its internal audit function to the

same firm that performs the bank’s

external financial audit . . . the

possibility for inherent conflicts and

impairments of auditor independence

and auditor integrity is greatest.’’386

Although Mr. Hawke discussed the

conflicts in the bank context, his

comments are equally applicable to any

registrant.

Research commissioned by the

Institute of Internal Auditors indicates

that the internal auditors surveyed

perceive an independence problem

where internal audit work is outsourced

to the external auditor.387 In particular,

76048 Federal Register / Vol. 65, No. 234 / Tuesday, December 5, 2000 / Rules and Regulations

problem if the external audit firm performs

extended audit services (internal audit services) for

the same firm for which it performs the annual

financial statement audit.’’ The level of agreement

among respondents was between 3.7 and 4.0,

‘‘indicating a perception of an independence

problem.’’ Larry E. Rittenberg and Mark A.

Covaleski, The Outsourcing Dilemma: What’s Best

for Internal Auditing, at 68 and Exh. 4–4 (Institute

of Internal Auditors Research Foundation 1997).

388AICPA SAS No. 55, AU § 319 (effective for

audits on or after Jan. 1, 1990).

389See, e.g., Testimony of John D. Hawke, Jr.,

Comptroller of the Currency (July 26, 2000) (noting

concerns about the effect of the proposed rule on

small banks); Testimony of Wayne A. Kolins,

National Director of Assurance, BDO Seidman, LLP

(Sept. 20, 2000).

390These hardships could include, for example,

difficulty in obtaining suitable professional services

at a cost appropriate to the size of the business, or,

for a small accounting firm, the loss of a substantial

portion of its client base for either its audit or

internal audit services.

391Using the $200 million threshold reasonably

isolates companies that are relatively small

themselves—approximately 54% of the 9,414

public reporting companies in the Standard & Poors

Research Insight Compustat Database (‘‘Compustat

Database’’) ‘‘ and has the effect of almost completely

excepting smaller accounting firms. Approximately

85% of the public company audit clients (other

than bank holding companies) of non-Big Five

accounting firms have less than $200 million in

assets. Of public company audit clients with more

than $200 million in assets—the companies that

would not trigger the exception—no more than

6.1% (again, excluding bank holding companies)

are audited by non-Big Five firms. The source for

these data is the Compustat Database, October 31,

2000. For further analysis, see infra Section V.B.

(cost-benefit analysis).

392See, e.g., Testimony of Jacqueline Wagner

(Sept. 13, 2000) (testifying for the Institute of

Internal Auditors) (‘‘The IIA believes that the total

outsourcing of the internal auditing function to the

organization’s external auditing firm impairs that

firm’s independence.’’); Testimony of Dominick

Esposito, Chief Executive Officer, Grant Thornton

LLP (Sept. 13, 2000) (‘‘I think if there is the entire

internal audit department outsourced, it can present

a conflict.’’).

393Testimony of Ray J. Groves (July 26, 2000).

394See AICPA Code of Professional Conduct, ET

§101.15 (Interpretation 101–13).

395Testimony of Barry Melancon, President and

Chief Executive Officer (Sept. 13, 2000). Mr.

Melancon also noted that ‘‘[t]here still has to be

management responsibility for the overall internal

audit function . . . we certainly agree that the

ultimate responsibility for internal auditing, the

management decision making, must [lie] with

management, not with the auditor.’’

396When providing internal audit services to an

audit client with $200 million or more in assets, the

auditor must measure the internal audit services

provided to the audit client in full-time employee

hours. In order to remain independent, the auditor

must ensure that it provides 40% or less of the total

hours expended by the audit client, the auditor and

anyone else on internal audit matters related to

internal accounting controls, financial systems, and

financial statements, and matters that impact the

financial statements.

397 In addition, performing procedures that

generally are considered to be within the scope of

the engagement for the audit of the audit client’s

financial statements, such as confirming accounts

receivable and analyzing fluctuations in account

balances, would not impair the accountant’s

independence, even if the extent of testing exceeds

that required by GAAS. For example, if an

accountant in normal circumstances would plan to

observe ten percent of an audit client’s inventory,

but at the audit client’s request the accountant

observes 50% of inventory on hand, the

accountant’s independence would not be impaired.

398AICPA Code of Professional Conduct, ET

§101.15 (Interpretation 101–13).

in auditing the company’s financial

statements, the accountant will consider

the extent to which he or she may rely

on the internal control system in

designing its audit procedures.388 When

the auditor has performed the internal

audit work, the auditor will need to

consider or examine its own work.

Final Rule 2–01(c)(4)(v) seeks to curb

these conflicting interests without

precluding companies, particularly

small companies, from obtaining

internal audit services from their

auditors where the auditor’s

independence would not be

compromised. Under the final rule, an

auditor’s independence is impaired by

performing more than forty percent of

the audit client’s internal audit work

related to the internal accounting

controls, financial systems, or financial

statements, unless the audit client has

$200 million or less in assets.

The final rule provides an exception

for businesses with $200 million or less

in assets. Specifically, the rule provides

that audit clients who have less than

$200 million in total assets may receive

more than forty percent of their internal

audit functions from their auditor

without giving rise to an impairment of

independence. We provide this

exception after carefully considering the

potential impact of our rules on small

businesses. At the proposing stage, we

requested comment on whether we

should provide an exception for smaller

businesses. We adopt this exception in

response to comments that we

received,389 and in recognition of the

fact that smaller businesses, many of

which may be located away from major

business centers, could suffer particular

hardships if we do not provide some

exception.390

We chose a $200 million threshold for

various reasons. From the available

data, the $200 million threshold appears

to provide a line below which not only

are the companies themselves smaller,

but the accounting firms that audit them

also tend to be smaller.391

Commenters distinguished the

situation in which the auditor

supplements an audit client’s internal

audit function from the situation in

which the auditor supplants the client’s

internal audit function. They suggested

that an auditor should not be permitted

to provide all of the internal audit

services required by an audit client but

should be allowed to provide a limited

amount of internal audit services

without impairing the auditor’s

independence.392 For example, Ray J.

Groves, former Chairman and Chief

Executive Officer of Ernst & Young, said

that ‘‘limited amounts in specific areas

of internal out-sourcing make a lot of

sense, as opposed to complete outsourcing, as long as the audit client

maintains their own independent

internal audit function with capable

management and people within it.’’393

These comments in large part reflect the

current AICPA rule on internal audit

outsourcing,394 which, as explained by

a senior official of the AICPA,

‘‘prohibit[s] the complete

outsourcing.’’395 In response to these

comments and in recognition of the

AICPA rule, our final rule, with respect

to registrants with $200 million or more

in assets, allows auditors to perform up

to forty percent of an audit client’s

internal audit work.396

Several commenters expressed

concern about the effect of the proposed

rule on small businesses that have no

internal audit department or staff. They

noted that 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. According

to these commenters, we should

encourage this practice. Unless these

companies can turn to their external

auditors, they state, the work will not be

done at all. Because we agree that small

businesses should be encouraged to use

internal audit services, the final rule

allows auditors to provide an unlimited

amount of internal audit services to

clients with less than $200 million in

assets, provided certain conditions are

met.

In addition, the final rule does not

restrict internal audit services regarding

operational internal audits unrelated to

the internal accounting controls,

financial systems, or financial

statements. This is because our focus is

on services that affect the integrity of

financial statements and reported

financial information.397

Under all circumstances in which an

auditor performs any internal audit

services for an audit client, including

with respect to companies with assets

under $200 million, the auditor must

comply with the six conditions listed in

paragraph (B) to avoid an impairment of

independence. Four of the six

conditions are drawn from a ruling

published in 1996 by the Ethics

Committee of the AICPA.398 It states

that AICPA members may provide

certain internal audit outsourcing

services to audit clients without

Federal Register / Vol. 65, No. 234 / Tuesday, December 5, 2000 / Rules and Regulations 76049

399AICPA Code of Professional Conduct, ET

§191.206–207 (Interpretation 101–103).

400Former Rule 2–01(b), 17 C.F.R. 210.2–01(b);

AICPA Code of Professional Conduct, ET §101.02.

401See SECPS Manual §1000.35 App. A; see also

AICPA Code of Professional Conduct, ET §101.05

(Interpretation 101–3) (deeming an auditor’s

independence impaired when the auditor negotiates

employee compensation or benefits, or hires or

terminates client employees). 402SECPS Manual §1000.35 App. A. 403 Id. 404 Id. 405 Id.; AICPA Code of Professional Conduct, ET

§101.05. 406 Id. 407SECPS Manual §1000.35 App. A 408See, e.g., Deloitte & Touche Letter; KPMG

Letter; PricewaterhouseCoopers Letter; Ernst &

Young Letter. 409See, e.g., KPMG Letter; Ernst & Young Letter. 410See, e.g., Deloitte & Touche Letter; Ernst &

Young Letter.

411Former Rule 2–01(b), 17 CFR 210.2–01(b).

412Codification §602.02.e.iii.

413See AICPA Code of Professional Conduct ET

§101.05.

414See, e.g., Ernst & Young Letter;

PricewaterhouseCoopers Letter.

415See Arthur Andersen & Co., 1994 SEC No Act.

LEXIS 617 (July 8, 1994) (‘‘Andersen No-Action

Letter’’) in which the staff stated it would not

recommend enforcement action under the

Investment Advisers Act where an accounting firm

did not register as an investment adviser but an

Continued

impairing their independence, so long

as, among other things, (i) the client

designates a competent member of

management to be responsible for the

internal audit function, (ii) management

determines the scope, risk, and

frequency of internal audit activities,

including those to be performed by the

auditor, (iii) management evaluates the

findings and results arising from the

internal audit activities, including those

performed by the auditor, and (iv)

management evaluates the adequacy of

the audit procedures performed and the

findings resulting from performance of

those procedures. In addition,

consistent with a later ruling by the

AICPA, the final rule requires that (v)

the audit client acknowledges its

responsibility to establish and maintain

a system of internal accounting controls

in compliance with Section 13(b)(2) of

the Securities Exchange Act, and (vi)

that management not rely on the

auditor’s work as the primary basis for

determining the adequacy of its internal

controls.399

In the Proposing Release we noted

that we were inclined not to follow the

AICPA rule on internal audit

outsourcing because we believed that, in

providing such services, the auditor

assumed a management function and, in

the course of the audit, would have to

review his or her own work. As

discussed above, however, we have

been persuaded that the auditor can

perform a limited amount of an audit

client’s internal audit function without

supplanting management’s role or

auditing its own work. In addition, we

have been persuaded that encouraging

internal audit outsourcing at small

businesses is wise public policy. We

have, accordingly, determined to allow

the limited relationships described

above under the conditions

recommended and used at this time by

the AICPA.

(vi) Management Functions. Current

Rule 2–01 of Regulation S–X and the

AICPA’s rules preclude accountants

from acting as management.400 We are

adopting Rule 2–01(c)(4)(vi) as

proposed, which 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 or performs any decisionmaking, supervisory, or ongoing

monitoring functions.

(vii) Human Resources. Under current

SECPS rules, accountants cannot

perform certain executive recruiting and

human resource services for audit

clients.401 Specifically, under those

rules, an accountant’s independence

would be impaired if the accountant: (a)

Searches for or seeks out prospective

candidates for managerial, executive or

director positions with audit clients;402

(b) engages in psychological testing, or

other formal testing or evaluation

programs;403 (c) undertakes reference

checks of prospective candidates for

executive or director positions with

audit clients;404 (d) acts as a negotiator

on the audit client’s behalf, such as in

determining position, status or title,

compensation, fringe benefits, or other

conditions of employment;405 or (e)

recommends, or advises an audit client

to hire, a specific candidate for a

specific job.406 Those rules do not,

however, preclude an accountant from,

upon request of the audit client,

interviewing candidates and advising an

audit client on the candidate’s

competence for financial, accounting,

administrative or control positions.407

Excessive involvement 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, an

auditor may be reluctant to suggest that

those employees failed to perform their

jobs appropriately because doing so

would require the auditor to

acknowledge shortcomings in its human

resource service.

Commenters were concerned that our

proposed language expanded upon the

limitations in the AICPA and SECPS

rules.408 For example, commenters

expressed concern that the proposed

rule would prohibit an accountant from

advising an audit committee on the

competence of a prospective controller

or CFO.409 Commenters also were

concerned that the proposed rule

limited accountants from providing taxrelated services related to structuring

compensation packages.410 We agree

that an objective evaluation by the

accountant of a candidate’s competency

for an accounting or financial position

may be useful to some, particularly

smaller, companies and that the impact

of this evaluation is reduced by the

proscription that the accountant may

not recommend that the audit client hire

a particular candidate. We also believe

that an accountant should not negotiate

regarding the contents of a

compensation package the accountant

has designed. Accordingly, in light of

the comments received, we have

modified the final rule, and final Rule

2–01(c)(4)(vii) more closely parallels the

SECPS rules.

(viii) Broker-Dealer Services. Current

Rule 2–01 states that an accountant’s

independence is impaired if the

accountant is connected with the audit

client as an underwriter or promoter.411

The Codification further states that

concurrent engagement as a brokerdealer is incompatible with the practice

of public accounting.412 Rule 2–

01(c)(4)(viii) combines these provisions

with certain provisions from the AICPA

rules.413 As adopted, the amendments

state that an accountant’s independence

will be impaired if the accountant acts

as a broker-dealer, promoter, or

underwriter on behalf of an audit client,

makes investment decisions on behalf of

the audit client or otherwise has

discretionary authority over an audit

client’s investments, executes a

transaction to buy or sell an audit

client’s investment, or has custody of

assets of the audit client, such as taking

temporary possession of securities

purchased by the audit client. As noted

in our existing standards, activities such

as recommending securities, soliciting

customers, and executing orders create

a mutuality of interest and the potential

for self-review.

Although our intention was to codify

current restrictions, commenters

believed that our proposal went

further.414 In particular, commenters

were concerned that by including the

term ‘‘investment adviser’’ we were

precluding accountants from providing

certain investment advisory or personal

financial planning services that they

currently provide.415 In response to

76050 Federal Register / Vol. 65, No. 234 / Tuesday, December 5, 2000 / Rules and Regulations

affiliated registered investment adviser provided

investment advisory services. The staff permitted

the affiliate to publish a newsletter with financial

planning information, provided the newsletter does

not recommend any specific industry sectors or

securities, to identify categories of mutual funds

that satisfy an advisory client’s investment

objectives, and to recommend two or more mutual

funds in each category. When an advisory client

wants more specific advice, the investment

advisory affiliate accountant will provide a client

with a list of two or more investment advisers or

broker-dealers that meet certain predetermined

criteria, provided that the accountant does not

receive any fee or other economic benefit from the

mutual funds, investment advisers or broker-dealers

recommended. The advisory affiliate will disclose

to advisory clients that the recommended mutual

funds, investment advisers, or broker dealers may

include audit clients. See also Ernst & Young Letter

(citing Andersen No-Action Letter).

416AICPA Code of Professional Conduct, ET

§101.05 (Interpretation 101–3).

417 Id.

418Codification §602.02.e.iii.

419See Arthur Andersen Letter (acknowledging

that it is appropriate to prohibit accountants from

recommending any specific securities to audit

clients and from recommending audit clients’

securities to non-audit clients).

420See AICPA Code of Professional Conduct, ET

§101.05, Interpretation 101–3, which states that an

accountant’s independence would not be impaired

if that accountant assists in developing corporate

strategies, assists in identifying or introducing the

client to possible sources of capital that meet the

client’s specifications or criteria, assists in

analyzing the effects of proposed transactions,

assists in drafting an offering document or

memorandum, or participates in transaction

negotiations in an advisory capacity.

421Letter from Edmund Coulson, Chief

Accountant, SEC, to Edward McGowen, Pannell

Kerr Forster, at 2 (July 11, 1988) (discussing mergers

and acquisition services, among others).

422See Ernst & Young Letter;

PricewaterhouseCoopers Letter.

423See also ISB, ‘‘Discussion Memorandum 99–

4: Legal Services’’ (Dec. 1999).

424See Proposing Release, Section III.D.1(b)(ix).

425Codification §602.02.e.ii.

426Arthur Young, 465 U.S. at 819–20 n.15.

427American Bar Association Commission on

Multidisciplinary Practice, Report to the House of

Delegates, at 5 (July 2000) (‘‘ABA Report’’)

(available at www.ABAnet.org/cpr/

mdpfinalrep2000.html).

these concerns, we have removed the

term ‘‘investment adviser’’ from the rule

text.

Current AICPA rules specify

investment advisory services that

accountants may provide to audit

clients without impairing their

independence. Under these rules,

accountants can recommend the

allocation of funds that an audit client

should invest in various asset classes,

based on the client’s risk tolerance and

other factors; provide a comparative

analysis of the client’s investments to

third-party benchmarks; review the

manner in which the audit client’s

portfolio is being managed by

investment account managers; and

transmit a client’s investment selection

to a broker-dealer, provided that the

client has made the investment decision

and has authorized the broker-dealer to

execute the transaction.416 Accountants

may continue to provide those services

without impairing their independence.

Current AICPA rules also specify

investment advisory services

accountants may not provide to audit

clients without impairing their

independence. The final rule

incorporates these restrictions.

Accordingly, as under the AICPA’s

rules,417 auditors cannot make

investment decisions for audit clients or

exercise discretionary trading authority

over an audit client’s account, cannot

execute transactions for audit clients,

and cannot take custody of an audit

client’s assets. Providing such services

creates a mutuality of interest and may

result in the auditor having to audit the

value of investments that the auditor

made for the client.

The Codification states that ‘‘[t]he

functions customarily performed [by a

broker-dealer] include the

recommendation of securities, the

solicitation of customers and the

execution of orders, any one of which

could involve securities transactions of

clients either as issuer or investor and

provide third parties with sufficient

reason to question the accountant’s

ability to be impartial and objective.’’418

Because these activities continue to be

encompassed within the meaning of

‘‘broker-dealer’’ under the rule we are

adopting, and therefore, when

performed on behalf of an audit client,

impair an auditor’s independence, we

have eliminated the language ‘‘in any

capacity recommending the purchase or

sale of an audit client’s securities’ from

the rule text.

By restricting broker-dealer services to

those provided ‘‘on behalf of the audit

client,’’ we do not mean to suggest that

an auditor can recommend an audit

client’s securities to either another audit

client or a non-audit client.419 The

language ‘‘on behalf of’’ the audit client

encompasses all situations in which the

auditor is directly or indirectly

compensated for the recommendation.

The final rule, however, will not alter

current guidance as to the corporate

finance consulting services auditors

provide to audit and non-audit

clients.420 For example, accountants,

without impairing their independence,

may advise audit clients in need of

capital that one alternative is to do a

public offering of their securities. Also,

the staff has indicated that limited

activities on the part of the auditor by

way of general explanatory work and

limited fact finding (such as identifying

and introducing an audit client to

potential merger partners that meet

specified criteria) would not impair an

auditor’s independence. An auditor’s

independence would be impaired,

however, by entering into preliminary

or other negotiations on behalf of an

audit client, by promoting the client to

potential buyers, or ‘‘with respect to

subsequent audits of a client if the

accountant renders advice as to

whether, or at what price a transaction

should be entered into.’’421 These

interpretations of former Rule 2–01(b)

apply equally to the amended rule we

adopt today. To the extent an auditor is

otherwise permitted to provide services

to a non-audit client concerning

corporate financing transactions to

which an audit client is a party, the

permissibility of those services does not

turn on whether the advice involves

transactions in which the consideration

provided by an audit client to the nonaudit client is in the form of an audit

client’s securities, as opposed to cash or

other assets.

Commenters expressed concern that,

because the terms ‘‘securities

professional’’ and ‘‘analyst’’ are not

defined in the securities laws, they

would cause confusion.422 To avoid any

such confusion and to limit concerns

about overbroad application of those

terms, we have eliminated those terms

from the rule text. We note, however,

that broker-dealers provide an array of

services that may include analyst

activities.

Finally, we have not included in the

final rule the prohibition relating to

designing broker-dealer or investment

adviser compliance systems. We have

eliminated this provision to conform the

rule to current law.

(ix) Legal Services. For the reasons set

forth in the Proposing Release, we

believe that there is a fundamental

conflict between the role of an

independent auditor and that of an

attorney. The auditor’s charge is to

examine objectively and report,

regardless of the impact on the client,

while the attorney’s fundamental duty is

to advance the client’s interests.423 As

discussed in the Proposing Release at

greater length, 424 existing

regulations, 425 the U.S. Supreme

Court,426 and professional legal

organizations 427 have deemed it

inconsistent with the concept of auditor

independence for an accountant to

provide legal services to an audit client.

Accordingly, we are adopting the

proposed rule as to legal services with

a few modifications. Final Rule 2–

01(c)(4)(ix) provides that an accountant

is not independent of an audit client if

the accountant provides any service to

Federal Register / Vol. 65, No. 234 / Tuesday, December 5, 2000 / Rules and Regulations 76051

428See Ernst & Young Letter;

PricewaterhouseCoopers Letter; Arthur Andersen

Letter.

429See, e.g., Va. Sup. Ct. R. 1A:4 (2000).

430See, e.g., Arthur Andersen Letter.

431See ABA Report, supra note 427.

432 Id. at 5 (footnote omitted).

433See, e.g., PricewaterhouseCoopers Letter;

Deloitte & Touche Letter.

434AICPA Code of Professional Conduct, ET

§101.202–101.203.

435See, e.g., Arthur Andersen Letter.

436AICPA Code of Professional Conduct, ET

§102.07 (‘‘[I]n the performance of any professional

service, a member shall comply with rule 102 [ET

§102.01], which requires maintaining objectivity

and integrity and prohibits subordination of

judgment to others.* * * Moreover, there is a

possibility that some requested professional

services involving client advocacy may appear to

stretch the bounds of performance standards, may

go beyond sound and reasonable professional

practice, or may compromise credibility, and

thereby pose an unacceptable risk of impairing the

reputation of the member and his or her firm with

respect to independence, integrity, and objectivity.

In such circumstances, the member and the

member’s firm should consider whether it is

appropriate to perform the services.’’).

437AICPA SAS No. 22, AU § 311.04b; AU

§ 9311.03.

438See, e.g., PricewaterhouseCoopers Letter;

Deloitte & Touche Letter.

an audit client under circumstances in

which the person providing the service

must be admitted to practice before the

courts of a U. S. jurisdiction.

We understand that some firms,

largely through their foreign affiliates,

are providing legal services outside of

the United States. Moreover, we

understand 428 that lawyers affiliated

with foreign affiliates of U. S.

accounting firms on occasion provide

legal services in the United States where

they are not required to be admitted to

a bar in the United States. The final rule

does not address these practices, where

local law does not preclude such

services and the services relate to

matters that are not material to the

consolidated financial statements of an

SEC registrant or are routine and

ministerial. We note, however, that it is

clear to us that legal services provided

outside the United States raise serious

independence concerns under

circumstances other than those meeting

at least those minimum criteria.

We solicited comment on whether our

proposed rule on legal services created

uncertainty or complexity since the

prohibition focused on the jurisdiction

in which the legal services were

provided. Commenters stated that

indeed the rule should be revised

because U.S. attorneys can, under

various circumstances, render legal

services in jurisdictions where they are

not licensed to practice law. For

example, when an attorney is not

licensed to practice law in a particular

jurisdiction, he or she can apply to a

court pro hac vice to be able to appear

before the court for purposes of the

case.429 Accordingly, we modified the

rule so that an accountant’s ability to

render legal services no longer depends

on his or her being licensed in the

jurisdiction where the services are

rendered, but rather on whether, under

the circumstances, the provider of the

services must be admitted to practice

before the courts of a U.S. jurisdiction.

Some commenters suggested that

safeguards, such as firewalls, could

prevent or cure any independence

problem that might arise by virtue of an

accountant providing legal services to

an audit client.430 Recently, the

Commission on Multidisciplinary

Practice of the ABA considered whether

firewalls would address sufficiently

issues that might arise if a law firm were

to provide both legal and other

services.431 That Commission rejected

the firewall approach, stating ‘‘[We]

explicitly recognize[] the[]

incompatibility [of legal and audit

services]. [We] do not believe that a

single entity should be allowed to

provide legal and audit services to the

same client.’’432 In light of current

regulations and the ABA Report, we

have determined not to adopt a firewall

approach.

(x) Expert Services. We are not

adopting the proposal to restrict the

provision of expert services. The

proposed rule would have provided that

an accountant’s independence is

impaired as to an audit client if the

accountant renders or supports expert

opinions for the audit client or an

affiliate of the audit client in legal,

administrative, or regulatory filings or

proceedings (‘‘expert services’’).

Commenters said that our proposals

went beyond current rules.433 For

example, AICPA Ethics Standards

permit accountants to serve as expert

witnesses.434

Commenters argued that accountants

may need to act as experts in defending

work they have done for audit clients

before such bodies as the Internal

Revenue Service, and indeed, this

Commission.435 As stated in the

Proposing Release, we did not intend for

our proposals to prohibit an auditor

from testifying as a fact witness to its

audit work for a particular client. In

those instances, the auditor is merely

providing a factual account of what he

or she observed and the judgments he or

she made. Nevertheless, to avoid

confusion and any uncertainty that

might be created by permitting the

accountant to testify in one capacity but

not another, we have determined not to

adopt a restriction on expert services.

When an accountant performs such

services, however, he or she should be

particularly mindful of his or her duty

to maintain objectivity and integrity, as

discussed in the AICPA Ethics

Regulations.436

c. Alternative Approaches to Scope of

Services Restrictions. As discussed in

the Proposing Release, we considered a

number of alternatives concerning scope

of services. We solicited public

comment on each alternative. After

considering the comments received, we

have determined not to adopt any of the

alternatives proposed.

For the reasons discussed above, we

have not adopted a disclosure-only

approach or a complete ban on auditors’

provision to audit clients of non-audit

services. In addition, as discussed

above, we welcome and encourage

active oversight by audit committees

with respect to auditor independence,

but do not believe that such oversight

obviates the need for the rule we adopt

today. In this regard, it is our statutory

responsibility to protect the public

interest.

We are persuaded that relying on a

firewalls approach is also unworkable.

Under a firewalls approach, there would

be a strict separation between those

professionals in the accounting firm

who perform audit work for an audit

client and those who provide non-audit

services for the client. GAAS, however,

under certain circumstances requires

that auditors seek out a registrant’s

consultants in the course of an audit to

discuss work performed by the

consultant.437 Accordingly, a strict

firewalls approach would conflict with

GAAS requirements.

5. Contingent Fees

We proposed to restrict the receipt of

contingent fees from audit clients, and

we continue to believe that contingent

fee arrangements result in the auditor

having a mutual interest with the client.

For example, if an accounting firm

arranged to receive an audit fee of

$200,000, but half of that fee was

contingent on the audit client

successfully completing an initial

public offering within the following

year, the auditor would have a mutual

interest with the audit client in the

success of the planned IPO and in the

continuing viability of the audit client.

Consequently, we are adopting a

restriction on contingent fees. In

response to comments,438 however, we

76052 Federal Register / Vol. 65, No. 234 / Tuesday, December 5, 2000 / Rules and Regulations

439AICPA Code of Professional Conduct, ET

§ 302.01.

440As Ray J. Groves, former Chairman and CEO,

Ernst & Young testified, ‘‘It does not impair

independence to reward a professional who excels

in his or her performance, or who exceeds

reasonable expectations.’’ Written Testimony of Ray

J. Groves (July 26, 2000).

441See Letter from Lynn Turner, Chief

Accountant, SEC, to Charles Bowsher, Chairman,

POB (Dec. 9, 1999); see, e.g., In the Matter of

PricewaterhouseCoopers, LLP, AAER No. 1098 (Jan.

14, 1999).

442See Letters from Lynn Turner, Chief

Accountant, SEC, to Michael Conway, Chairman,

SECPS Executive Committee (Nov. 30, 1998; Dec. 8,

1999; May 1, 2000).

443AICPA Letter; Deloitte & Touche Letter; KPMG

Letter; Letter of Jodi L. McFall, CPA (Sept. 1, 2000);

Letter of Electronic Data Systems (Sept. 11, 2000);

Letter of William Tourville, CPA (Sept. 14, 2000);

Letter of Gary Whitsell (Sept. 19, 2000).

444Letter of Thomas Graves (July 18, 2000); Letter

of the FEE (Sept. 25, 2000).

445See Ernst & Young Letter.

446See, e.g., Ernst & Young Letter.

modified the rules to parallel more

closely the existing restrictions.439

Final Rule 2–01(c)(5) defines a

contingent fee as any fee established for

the performance of any service pursuant

to an arrangement in which no fee will

be charged unless a specified finding or

result is attained, or in which the

amount of the fee is otherwise

dependent upon the finding or result of

such service. Contingent fees include

commissions and similar payments.

Consistent with the AICPA rules, our

definition of ‘‘contingent fees’’ contains

an exception for fees fixed by courts or

other public authorities, or, in tax

matters, fees determined based on the

results of judicial proceedings or the

findings of governmental agencies. We

have added the AICPA’s exception for

fees, in tax matters, determined based

on the results of judicial proceedings or

the findings of governmental agencies.

This exception is based, in part, on the

position that when the fee is determined

not by the parties but by courts or

government agencies acting in the

public interest, it is less likely that such

fees will be used to create a mutual

financial interest between the auditor

and audit client. This exception also

acknowledges that, as explained above,

tax services generally do not create the

same independence risks as other nonaudit services.

In response to comments, we have

eliminated from the rule text the

language regarding ‘‘value added’’ fees.

Some commenters represented that

accounting firms sometimes receive fees

where the client determines at the end

of the engagement whether the services

rendered warrant an additional fee, but

there is no agreement (written or

otherwise) for the audit client to pay the

additional fee. In these situations, the

client, at its complete discretion,

determines at the end of the

performance period that the accountant

provided services that had greater value

than the amount due under the contract.

That type of ‘‘value added’’ fee is not

within the scope of the prohibition.440

On the other hand, the staff will look

closely to determine whether a fee

labeled a ‘‘value added’’ fee is in fact a

contingent fee, such as where there are

side letters or other evidence that ties

the fee to the success of the services

rendered. For example, as discussed in

the Proposing Release, an auditor might

undertake a study of certain types of a

client’s expenditures in order to identify

greater amounts of qualifying expenses

that would result in greater income tax

credits. Fees for such services might be

based on a percentage of the tax credits

generated, a base fee plus a percentage

of tax credits generated over a predetermined base amount, or a base fee

plus a ‘‘value added’’ amount to be

added to the base fee. In that case, the

accounting firm’s economic benefit will

be greater if the tax credits are

maximized. Because this interest (in the

economic benefit) is inconsistent with

acting independently in assessing the

accuracy of the impact on the income

tax accounts and financial statements of

the tax credits, those kinds of fee

arrangements are prohibited under the

final rule.

E. Quality Control Provisions

We recognize that situations may arise

where an accountant’s independence

becomes impaired inadvertently, such

as where a family member makes an

investment of which the covered person

is not aware. Paragraph (d) addresses

those situations. We are adopting a

limited exception pursuant to which

inadvertent violations of these rules by

covered persons will not make the

accounting firm not independent if the

accounting firm maintains certain

quality controls and satisfies other

conditions. The effect of this provision

is that an accounting firm that has

appropriate quality controls will not be

deemed to lack independence when an

accountant did not know of the

circumstances giving rise to the

impairment and, upon discovery, the

impairment is quickly resolved.

As we explained in the Proposing

Release, strong quality controls deter,

detect, and provide a means to address

impairments of an auditor’s

independence. Our staff has stated

repeatedly that it is concerned that

firms, particularly larger firms, may lack

appropriate worldwide quality

controls.441 The staff has urged certain

firms to review and modernize existing

procedures.442

Many firms have designed and

implemented quality controls or are

doing so now. In that regard, several

commenters wrote that because firms

already have quality control procedures

in place, there is no need for this

provision.443 Other commenters

supported the provision and asked us to

adopt it.444 We are adopting this limited

exception to the general principle that

attributes to an entire firm

independence impairments of

individual accountants. We proposed

such a limited exception in the belief

that adequate quality controls would

limit the occasions in which the

exception would come into play.

Without such a requirement, we fear

that the incidence of individual

violations would be much greater.

Paragraph (d) provides that an

accounting firm’s independence will not

be impaired solely because a covered

person in the firm is not independent,

as long as three conditions are met.

First, the covered person must not have

known of the circumstances giving rise

to the lack of independence. The

proposed rule provided that to take

advantage of the exception, the firm

must show that the covered person did

not know, and was ‘‘reasonable in not

knowing,’’ of the circumstances giving

rise to the impairment. One commenter

suggested eliminating this language

because, once a firm implements a

quality control system envisioned in the

rule (with automated tracking of

investments, ongoing training, and

inspections and monitoring programs), a

person may never be deemed to be

‘‘reasonable’’ in not knowing the

circumstances giving rise to an

impairment, and the exception would

never be available.445 Accordingly, we

have revised the first condition to apply

when the covered person did not know

of the circumstances giving rise to the

impairment.

The second condition is that the

covered person’s lack of independence

was corrected as promptly as possible

under the relevant circumstances after

the covered person, or the firm, became

aware of it. Several commenters

suggested adding the phrase ‘‘under the

relevant circumstances.’’446 We agree

that this change is appropriate because

whether an action is ‘‘prompt’’ depends,

at least in part, on the surrounding

circumstances. In light of this change,

however, we also have revised this

provision so that the lack of

independence must be corrected as

Federal Register / Vol. 65, No. 234 / Tuesday, December 5, 2000 / Rules and Regulations 76053

447Proposing Release, n. 192.

448See Ernst & Young Letter (acknowledging that

the requirement applies worldwide).

449See KPMG Letter; Letter of KPMG Europe

(Sept. 22, 20000).

450 GAAS already requires firms to have quality

controlls for their audit practices and refers auditors

to the ‘‘Statements on Quality Control Standards’’

(‘‘SQCS’’) for guidance regarding the elements of

those systems. AICPA SAS No. 25; AU section 161.

451We considered whether to use the number of

firm professionals, instead of the number of SEC

registrants, to determine which firms are required

to implement the quality controls in Rule 2–01(d)

to qualify for the limited exception. See SECPS

Manual § 1000.46. We use number of SEC

registrants because we are particularly concerned

with those firms that audit a large number of SEC

registants, regardless of the number of

professionals, and because we can more easily

verify the number of SEC registrants audited by a

firm.

452Letter from Lynn Turner, Chief Account, SEC,

to Michael Conway, Chairman, SECPS Executive

Committee (DEC. 9, 1999).

453See, e.g., Letter of KPMG Europe (Sept. 22,

2000).

454See Ernst & Young Letter;

PricewaterhouseCoopers Letter.

promptly as possible under the relevant

circumstances.

The third condition is that the

accounting firm must have a quality

control system in place that provides

‘‘reasonable assurance’’ that the firm

and its employees do not lack

independence. As we stated in the

Proposing Release, we believe that a

quality control system is the first line of

defense to guard against independence

impairments. We understand that

accounting firms vary greatly. The rule

we are adopting, as proposed, explicitly

states that the quality control provisions

may take into account the size and

nature of the firm’s practice.

In the Proposing Release, we stated

that a firm’s quality controls should

apply to the firm and its affiliates

worldwide,447 and we solicited

comment about whether a firm’s quality

controls should be this comprehensive.

We received useful comments about the

applicability of this provision to foreign

affiliates.448 Because we have

eliminated the definition of affiliate of

the accounting firm, however, we have

modified the third provision to state

that the quality controls must cover at

least all employees and associated

entities of the accounting firm

participating in the engagement,

including employees and associated

entities located abroad. While we do not

necessarily expect a firm making use of

the limited exception to demonstrate

that it has implemented appropriate

quality control systems in each of its

offices worldwide, the rule requires

that, to avail itself of the limited

exception, the firm must have quality

control systems that cover each

employee and associated entity

participating in the engagement for

which independence was impaired.

Several commenters stated that while

it is appropriate for the Commission to

examine whether a firm or a covered

person is independent, we should not

prescribe quality controls.449 The rule

does not require any firm to adopt

quality controls.450 Rather, for the

reasons stated above, it makes adequate

quality controls a prerequisite for a

limited exception where the firm

otherwise would be deemed not

independent.

Rule 2–01(d)(4) describes the

elements of a quality control system that

large accounting firms—those with more

than 500 SEC registrants as audit,

review, or attest clients—must have in

place to qualify for the limited

exception.451 Many of the elements are

set forth in a 1999 letter from the staff

to the SECPS.452 While the rule as

adopted requires only the larger firms to

implement these elements to qualify for

the limited exception, we note that

some of these elements may be suitable

for other firms as well. We discuss the

elements below.

1. Written Independence Policies and

Procedures

The largest firms’ independence

policies and procedures must be

reduced to writing. As we stated in the

Proposing Release, we expect the

policies and procedures to be

comprehensive, to cover all

professionals in the accounting firm,

and to address all aspects of

independence, including financial,

employment, and business

relationships, as well as fee

arrangements.

2. Automated Systems

Large firms must have automated

systems to identify investments that

may impair independence. In our

proposal, this provision applied to all

employees in the firm. Commenters

stated, however, that it may not be

necessary for the automated quality

control system to include the financial

investments of persons below the

managerial level. Commenters also

stated that it may be difficult to

establish a system to identify all

financial relationships that might impair

independence.453 These commenters

suggested revising the provision for an

automated tracking system to apply only

to partners and managerial employees,

while adding a provision providing for

timely dissemination of information

about its current list of audit clients to

all professionals.454 We agree with these

commenters that non-managerial

employees have less control over the

audit process and, therefore, need not be

included in the automated system.

However, to meet this limited

exception, a firm’s quality control

system must provide reasonable

assurance that nonpartners and

managerial employees are complying

with the applicable independence rules.

We also have clarified the scope of the

required automated system, by changing

the words ‘‘financial relationships’’ to

‘‘investments in securities.’’

Accordingly, an automated system

would not need to track covered

persons’ ‘‘other financial interests,’’

such as brokerage and credit card

accounts, to qualify for this limited

exception. We also note that, for

purposes of monitoring compliance

with our rule on ‘‘material’’ indirect

investments, an automated system need

not track covered persons’ net worth to

determine if an indirect investment is

material to that person. Nonetheless,

such a system must provide some means

of identifying indirect investments that

might impair independence under the

material indirect investment rule.

3. Timely Information

In light of the changes made to the

requirement for automated systems, we

added a provision that applies to all

professionals. The quality controls of a

large firm taking advantage of the

limited exception must include a system

that provides timely information about

the entities from which the accountant

must be independent. We expect that

this system, for example, would contain

current and accurate information about

audit, review, and attest clients of the

accounting firm and the affiliates of

those audit clients. All professionals

should be able quickly to determine

whether an investment they are about to

make may cause the independence of

the firm to be impaired.

4. Training

Large firm quality controls also must

include annual or ongoing firm-wide

training about auditor independence,

and we are adopting this provision as

proposed. Each professional in a large

accounting firm should be able to

demonstrate competence with respect to

professional standards, legal

requirements, and firm policies and

procedures.

76054 Federal Register / Vol. 65, No. 234 / Tuesday, December 5, 2000 / Rules and Regulations

455See Ernst & Young Letter;

PricewaterhouseCoopers Letter.

456Letter of KPMG Europe (Sept. 22, 2000).

457See Ernst & Young Letter; Letter of Ernst &

Young, U.K. (Sept. 7, 2000); Letter of KPMG Europe

(Sept. 22, 2000); Deloitte & Touche Letter.

458See Letter from Michael A. Conway,

Chairman, SECPS Executive Committee, to the

Managing Partners of the SECPS Member Firms

(April 2000).

5. Internal Inspection and Testing

For a large firm to qualify for the

limited exception, its quality controls

must include an internal inspection and

testing program to monitor adherence to

the independence requirements of the

profession, standard setters, and other

regulatory bodies. This would entail

procedures to audit, on a test basis,

information submitted by employees

and partners and information in a client

investment database. Firms also should

monitor the investments of the firms

themselves and their pension and

retirement plans, and any business

arrangements with their audit clients.

6. Notice of Names of Senior

Management Responsible for

Independence

We also proposed to require, with

respect to large firms, that all firm

members, officers, directors, and

employees be notified of the name and

title of the member of senior

management responsible for compliance

with the independence requirements.

We are adopting this provision as

proposed.

7. Prompt Reporting of Employment

Negotiations

The quality control system of a large

firm must contain written policies and

procedures to require firm professionals

to report promptly to the firm as soon

as they begin employment negotiations

with an audit client. The firm also

should have appropriate procedures to

remove immediately such a professional

from an audit client’s engagement and

review the professional’s work related to

that audit client. In addition, we believe

such engagements should be selected for

peer review. As proposed, this provision

would have applied to all firm

professionals. Commenters, however,

suggested that the provision should

apply only to partners and covered

persons.455 Because of the number of

professionals employed by the larger

firms, and because we are most

concerned with individuals who may

affect the audit, we have revised this

provision to apply only to partners and

covered persons.

8. Disciplinary Mechanism

As we proposed, the quality control

system of a large firm also must have a

disciplinary mechanism to ensure

compliance. One commenter stated that

a disciplinary mechanism may only

promote compliance, but cannot ensure

it.456 Although no system can guarantee

100% compliance in all circumstances,

a firm’s quality controls should be

designed and implemented to ensure

compliance, not merely to promote it.

We are, therefore, adopting this

language as proposed.

Several commenters noted that firms

operating overseas may be prohibited

from requesting certain information

based on local restrictions on

information gathering, or they may be

required to amend an employee’s

employment contract before doing so.457

We are sensitive to these concerns and

we have responded, in part, by

providing for a long transition period for

accountants operating abroad, as

discussed below. In any event, the

SECPS has required member firms to

implement quality controls, including

many of these provisions.458 If a firm is

unable to apply its quality controls to

offices outside the U.S., it may be

unable to take advantage of the limited

exception we are adopting.

F. Transition and Grandfathering

1. Transition

a. Appraisal or Valuation Services or

Fairness Opinions, and Internal Audit

Services. We proposed that, for the two

years following the effective date of

Rule 2–01, providing to an audit client

certain non-audit services identified in

the rule would not impair the

accountant’s independence if the

services were provided under an

existing contract and performing the

services would not impair the

accountant’s independence under

existing requirements. As discussed

above, we modified eight of the nonaudit service provisions proposed to

parallel or draw from current

independence requirements regarding

these services. Because the restrictions

embodied in these provisions now more

closely parallel current restrictions, we

assume that accountants currently

comply with them.

With respect to appraisal or valuation

services or fairness opinions and

internal audit services, however, we are

providing for a longer transition because

the new rule extends beyond current

restrictions. Final Rule 2–01(e)(1)(i)

provides that an accountant’s

independence will not be impaired if

the accountant continues for up to

eighteen months to provide to an audit

client these services, so long as the

services did not impair the accountant’s

independence under pre-existing

independence requirements.

We recognize that adoption of these

and other provisions might require a

registrant to decide between continuing

to engage its auditing firm to audit its

financial statements and continuing to

engage that firm to provide certain nonaudit services. It may not be feasible for

the registrant and the auditor to cease

all ongoing or scheduled non-audit

engagements immediately. The

company may need time to find a new

provider of those services, to complete

works in progress, and to provide for a

smooth transition from one provider of

services to another. Consequently, with

respect to the two identified non-audit

services, the final rule provides for an

eighteen-month transition.

Under the transition provision

proposed, accounting firms could not

have entered into any new non-audit

service contracts with their audit clients

without impairing their independence.

In response to commenters’ concerns

that the viability of these lines of

business could be called into question if

they were prohibited from entering into

new contracts, we modified the

provision to allow firms the flexibility

to make business decisions over the

next eighteen months that, in light of

the new rule, are appropriate for their

firms.

Final Rule 2–01(e)(1)(i), however,

requires performance on any contracts

inconsistent with the non-audit service

provisions to be completed within

eighteen months of the effective date of

the final rule. To the extent that work

on current contracts and contracts

entered into within eighteen months of

the effective date cannot be completed

before the non-audit service provisions

of the final rule take effect, accountants

must take whatever steps are necessary

to ensure that, at the end of the

eighteen-month transition period, they

are not providing any non-audit services

inconsistent with final Rule 2–01.

b. Other Financial Interests and

Employment Relationships. Rule 2–

01(e)(1)(ii) provides for a three-month

transition for certain of the financial

interest rules (paragraph (c)(1)(ii)) and

all of the employment provisions

(paragraph (c)(2)) in the final rule. We

are providing a transition period for

these provisions because Rule 2–01

modestly expands current restrictions

on certain accounting firm personnel in

these areas. Because accounting firms

may, therefore, need time to educate

their employees and provide guidance

on the new rule, we are providing a

transition period of three months after

the effective date of the rule.

Federal Register / Vol. 65, No. 234 / Tuesday, December 5, 2000 / Rules and Regulations 76055

459SECPS Manual § 1000.46 (April 2000).

460Ernst & Young Letter (suggesting a three-year

transition period); Letter of Ernst & Young U.K.

(Sept. 7, 2000).

461AICPA Ethical Standard ET § 101.07

(grandfathering certain loans that existed as of

January 1, 1992).

c. Quality Control Systems. As

discussed at length above, accounting

firms can take advantage of the limited

exception to the independence

requirements provided by paragraph (d)

of the rule, if they have in place a

quality control system that, based on

several factors, ‘‘provides reasonable

assurance’’ that the firm and its

employees do not lack independence.

Under Rule 2–01(d)(4), the quality

control systems of accounting firms that

provide audit, review or attest services

to more than 500 SEC registrants will

not be considered to provide reasonable

assurance of independence, unless the

systems have certain characteristics. We

are providing a transition provision that

applies to the implementation date for

the specific elements of a quality control

system as described in paragraph (d)(4)

of the rule.

Recently adopted SECPS provisions

require quality controls substantially

similar to those described in paragraph

(d)(4).459 Because these SECPS

requirements are effective December 31,

2000, which precedes the effective date

for the Commission’s final rule, no

transition date for paragraph (d)(4) is

necessary for domestic accounting

firms. By the date that this rule becomes

effective, SECPS member firms should

have appropriate quality control

systems in place.

In the Proposing Release, however, we

noted that foreign offices, or foreign

‘‘associated’’ or ‘‘sister’’ firms, of

domestic firms may require additional

time to develop and implement quality

control systems that satisfy the

requirements of paragraph (d)(4). We

solicited comment on whether foreign

offices, accordingly, should be afforded

a transition period to phase in the

quality control systems necessary to

take advantage of the limited exception

provided by the rule. Some commenters

suggested that because establishing and

implementing quality controls to apply

worldwide would be difficult, we

should provide for a long transition

period.460 In response to these

comments, we determined to give

accounting firms’ foreign offices until

December 31, 2002 to implement the

quality controls described by the final

rule.

We believe that investors in our

capital markets should have the right to

expect that the same quality controls

over a firm’s adherence to the

independence requirements apply

irrespective of where the audit, or where

parts of the audit, take place. The twoyear transition period strikes a

reasonable balance between the need for

improved quality control systems by all

offices participating in an audit and the

practical problems inherent in

implementing these controls abroad.

As a result of this transition

provision, before January 1, 2003, if a

domestic firm with more than 500 SEC

registrants as audit clients seeks to avail

itself of the limited exception in

paragraph (d), it must have a quality

control system that complies with

paragraph (d)(4) and any foreign office

of the firm (or foreign associated or

sister firm) participating in the audit of

that company must have a system that

provides reasonable assurance of

independence, as required by paragraph

(d)(3). After December 31, 2002, the

foreign office (or foreign associated or

sister firm) also must comply with the

requirements in paragraph (d)(4).

2. Grandfathering

The rule provisions related to loans,

insurance products, and employment

relationships take effect three months

after the effective date of the rule. Under

the new rule, absent a grandfathering

provision, a limited number of

accountants or their family members

might have been required, for example,

to refinance a mortgage loan with an

audit client or to leave their current

employment with an audit client, in

order for the auditor to remain

independent. Because we would expect

it to be more problematic in some cases

for auditors and their family members to

refinance a loan or to obtain a

replacement insurance policy than, for

example, for them to obtain a new credit

card (from a non-audit client), we have

grandfathered these relationships in

Rule 2–01(e)(2), provided that these

relationships do not impair

independence under existing

requirements. The AICPA similarly

grandfathered certain loans that auditors

and their family members had with

audit clients when it revised its

independence requirements related to

loans in November 1991.461

Accordingly, under the final rule,

auditors and their relatives should not

have to alter their loan agreements,

change insurance policy providers, or

require family members to find different

employment for the accountant to

maintain his or her independence.

Likewise, we have grandfathered

contracts for the provision of financial

information systems design and

implementation in existence on the

effective date of the rule. The

information technology rule we adopt

today imposes five conditions on these

services, but we believe it would be

unfair to require auditors providing

these services to their audit clients

under existing contracts to satisfy these

conditions. We do not, however, believe

that the conditions are so onerous as to

warrant a transition period for new

contracts. Accordingly, we are

grandfathering contracts that are in

place on the effective date of the rule,

but requiring all contracts entered after

the effective date of the rule to meet the

conditions imposed by Rule 2–

01(c)(4)(ii)(B).

3. Settling Financial Arrangements with

Former Professionals

As discussed above, under Rule 2–

01(c)(2)(iii), an accounting firm will not

be considered independent of an audit

client if a former employee of the firm

has an ‘‘accounting role or financial

reporting oversight role’’ at the audit

client and the firm and the former

employee have a financial arrangement

that does not satisfy the requirements

set forth by Rule 2–01(c)(2)(iii). Rule 2–

01(e)(3) provides that, notwithstanding

Rule 2–01(c)(2)(iii), an accounting firm

will not lose its independence with

respect to an audit client if the former

employee with whom it maintains a

financial arrangement inconsistent with

Rule 2–01(c)(2)(iii) assumed an

accounting or financial reporting

oversight role at the audit client prior to

the effective date of this rule. With

respect to former firm employees who

join an audit client in such a role after

the effective date of this rule, however,

the firm must ensure that the

requirements of paragraph (c)(2)(iii) are

met in order to maintain its

independence with respect to the audit

client. We are including this provision,

which essentially grandfathers existing

employment relationships between

former audit firm employees and audit

clients, because our intention was not to

require former firm employees who are

currently in accounting or financial

reporting oversight roles at audit clients

to leave their positions to preserve the

accounting firm’s independence.

G. Proxy Disclosure Requirement

We proposed to require disclosure of

certain information regarding, among

other things, non-audit services

provided by the registrant’s auditor to

the registrant. We solicited comment on

whether the proposed disclosures

would be useful to investors. As noted

above, most commenters addressing the

issue supported a disclosure

76056 Federal Register / Vol. 65, No. 234 / Tuesday, December 5, 2000 / Rules and Regulations

462See supra note 25.

463See Earnscliffe II, supra note 38, at 45, which

states, ‘‘Most people sensed that the relationship

between the auditor and auditee was appropriate,

typically neither too close nor tension-ridden. The

one area of greater concern had to do with the

provision of non-audit services to audit clients,

where participants felt unsettled and discomfited.

Avoidance of this practice seemed preferred, but

disclosure was seen as a helpful alternative step as

well.’’

464The disclosure requirement pertains to the

accounting firm that is the registrant’s principal

accountant. The principal accountant generally is

the accounting firm that takes responsibility for the

report on the financial statements of the registrant

for each year presented. See SEC Division of

Corporation Finance, ‘‘Accounting Disclosure Rules

and Practices: An Overview,’’ Topic Four, I.D. (Mar.

31, 2000).

465See proposed Rule 14a–101 Item 9(e)(4); Rule

10–01(d) of Regulation S–X and Item 310 of

Regulation S–B, 17 CFR 210.10–01, 228.310(b).

466Ernst & Young Letter.

467PricewaterhouseCoopers Letter; Ernst & Young

Letter; Testimony of J. Michael Cook, former

Chairman and Chief Executive Officer, Deloitte &

Touche (July 26, 2000); Testimony of Philip D.

Ameen, Chair, Committee on Corporate Reporting,

FEI–CRR (Sept. 20, 2000).

468See supra Section IV.D.4.b(ii). The services

described in Rule 2–01(c)(4)(ii)(B) relate to systems

that aggregate source data underlying, or generate

information significant to, the financial statements,

which may be a particular concern to investors. See

Earnscliffe I, supra note 65, at 24, which states,

‘‘Some felt that installing computer systems was not

a problem * * * others argued that if the computer

system had anything to do with the financial

reporting systems * * * then the auditor would be

in serious conflict.’’ The required disclosure will

permit investors to decide whether such services

create independence concerns.

469See Earnscliffe I, supra note 65, at 26, which

describes responses to a scenario when the annual

audit fee was $1 million and the auditor performed

computer system work for $10 million, which was

1% of the auditor’s annual revenues, and states,

‘‘First off, the sheer size of the contract was seen

as a potential perception challenge. Even though

$10 million might be good value for the client, and

only a tiny fraction of the audit firm’s business,

there was a sense of doubt that the firm would be

willing to walk away from such a relationship, if

that were necessary to protect the independence of

the audit.’’

470Companies Act 1985, Part XI, Chapter V,

Auditors, §390B, ‘‘Remuneration of Auditors and

Their Associates for Non-audit Work,’’ and

Regulations 1991, §5, ‘‘Disclosure of Remuneration

for Non-Audit Work.’’ See generally Written

Testimony of Graham Ward, Institute of Chartered

Accountants of England and Wales (‘‘ICAEW’’)

(Sept. 13, 2000).

471Michael Firth, ‘‘The Provision of Nonaudit

Services by Accounting Firms to their Audit

Clients,’’ Contemporary Accounting Research, at 6

(Summer 1997). Firth hypothesized that companies

with potentially high agency costs (i.e., companies

in which directors do not control management or

which have a large amount of debt) would limit the

non-audit services provided by their auditors

because the appearance of a lack of auditor

independence would increase their cost of capital.

Firth’s sample data came from the 500 largest

British industrial, listed companies. Firth’s findings

were consistent with his hypothesis.

requirement, though several raised

concerns with elements of the

proposal.462 We believe that with the

disclosures we are adopting, investors

will be better able to evaluate the

independence of the auditors of the

companies in which they invest.463

Accordingly, we are requiring

companies to provide certain

disclosures, but we have modified the

proposed disclosure requirement as

discussed below.464 Our disclosure

requirement has three components: (1)

Disclosure regarding fees billed for

services rendered by the principal

accountant; (2) disclosure regarding

whether the audit committee considered

the compatibility of the non-audit

services the company received from its

auditor and the independence of the

auditor; and (3) disclosure regarding the

employment of leased personnel in

connection with the audit.

1. Disclosure of Fees

The final proxy disclosure rule, like

the proposal, requires registrants to

aggregate and disclose the fee paid for

the annual audit and for the review of

the company’s financial statements

included in the company’s Forms 10-Q

or 10-QSB for the most recent fiscal

year.465 In light of the other

modifications described below, we are

requiring this fee disclosure under a

caption entitled ‘‘Audit Fees.’’

We proposed to require registrants to

describe each professional service, other

than audit services, provided by their

principal accountants during the most

recent fiscal year, and to disclose the fee

for each of these professional services;

however, under the proposed

disclosures, a registrant would not have

had to describe the service or disclose

the fee if the fee for the service was less

than the lesser of $50,000 or ten percent

of its audit fee. We solicited comment

on the scope of this proposed

disclosure. Several commenters

believed that this proposed disclosure

was too detailed. At least one

commenter worried that the detailed

disclosure requirement could place

registrants at a competitive disadvantage

when, for example, they disclose that

the audit firm was retained to conduct

due diligence in connection with a

possible acquisition.466 Other

commenters suggested that a simpler

disclosure, focused on the aggregate

amount of non-audit and audit services

provided to a company by its auditor,

would be more useful to investors.467

We were persuaded by these arguments

and, accordingly, we are adopting a

more limited disclosure requirement.

Under the final rule, we are not

requiring registrants to describe each

professional service or to disclose the

fee for each service. Instead, we are

requiring that registrants disclose under

the caption, ‘‘Financial Information

Systems Design and Implementation

Fees,’’ the aggregate fees billed for

services of the type described in final

Rule 2–01(c)(4)(ii)(B)(information

technology services) 468 rendered by the

registrant’s principal accountant during

the most recent year, and, under the

caption ‘‘All Other Fees,’’ the fees billed

for all other non-audit services,

including fees for tax-related services,

rendered by the principal accountant

during the most recent year.

Although some commenters suggested

that we require disclosure only of the

aggregate fees billed by the principal

accountant for audit and for non-audit

services, we are, in essence, requiring

registrants to break non-audit services

into two categories—one category

focused on information technology

services and one category encompassing

all other non-audit services. As

discussed above, our concern with

information technology services relates

both to the relative size of non-audit

fees to audit fees and the value of the

services themselves.469 Our twopronged approach responds to both of

these concerns.

We are also requiring disclosure of

fees billed for non-audit services, other

than information technology services,

rendered by the principal accountant in

the last fiscal year. While we proposed

to require disclosure of fees for each

service as discussed above, we have

determined to require only disclosure of

aggregate fees billed for non-audit

services, excluding information

technology services. As noted above,

commenters generally favored more

simple disclosure, believing it is more

useful to investors. In requiring

disclosure of aggregate fees, we are

adopting a disclosure requirement that

is similar to the disclosure that the

United Kingdom has required since

1989. As discussed in the Proposing

Release, since 1989, the British

government has required companies to

disclose their annual audit fee and fees

paid to their auditor for non-audit

services.470 ‘‘The [British] government

believes that the publication of the

existence of, and extent of, non-audit

consultancy services provided to audit

clients will enable shareholders,

investors, and other parties to judge for

themselves whether auditor

independence is likely to be

jeopardized.’’471

Some have argued that disclosure

should be our sole response to auditor

independence issues and that we should

adopt no additional rules, noting that

this is the regulatory scheme in the

Federal Register / Vol. 65, No. 234 / Tuesday, December 5, 2000 / Rules and Regulations 76057

472See Arthur Andersen Letter.

473See Department of Trade and Industry, ‘‘A

Framework of Independent Regulation for the

Accounting Profession,’’ ¶¶ 29, 35, 39, 44, and 46

(Nov. 1998).

474Testimony of Graham Ward, ICAEW (Sept. 13,

2000).

475 ICI Letter.

476We note that audit committees currently

receive information about the auditor’s provision of

non-audit services under ISB Standard No. 1 and

SECPS Manual § 1000.08. See ISB Standard No. 1,

supra note 167; SECPS Manual § 1000.08 (requiring

the auditor to report annually to the audit

committee or board of directors (or its equivalent

in a partnership) of SEC registered audit clients on

the ‘‘total fees received from the client for

management advisory services during the year

under audit and a description of the types of such

services rendered’’).

477The O’Malley Panel has recommended that

audit committees pre-approve non-audit services

that exceed a threshold determined by the

committee. This recommendation is consistent with

the recommendations of the Blue Ribbon

Committee regarding auditors’ services. The Panel

set forth factors for audit committees to consider in

determining the appropriateness of a service. See

O’Malley Panel Report, supra note 20, at ¶ 5.30.

478The ISB cites threats to independence arising

from these structures and identifies quality controls

to ensure the independence of the auditors in these

situations. See ISB, ‘‘Discussion Memorandum 99–

Continued

U.K.472 As we discussed above, we have

determined to adopt a two-pronged

approach—disclosure plus restrictions

on the provision of certain non-audit

services. The U.K. disclosure rules are

just one piece of a larger regime in the

U.K. to address auditor independence

issues. The self-regulatory authority in

the U.K. has a majority of public

members and generally exercises broad

examination authority.473 An

‘‘independent practice inspection unit’’

sends inspectors to the 20 largest

accounting firms (who audit ninety

percent of the companies listed on the

London FTSE) every year to examine

the accounting firms for independence

issues.474 The differences in the U.K.

and U.S. regulatory schemes and selfregulatory approaches highlight the

need for our two-pronged approach—

disclosure plus restrictions on the

provision of certain non-audit services.

We requested comment on whether,

in the case of investment companies, the

rule should extend beyond the registrant

to require the disclosures as to all

entities in the investment company

complex. One commenter suggested that

applying the proxy disclosure

requirements to the investment

company complex would be of limited

utility to investors, particularly where

the adviser’s parent company is an

entity, such as a bank, broker-dealer or

insurance company whose operations

are completely separate from the

investment adviser and the registrant.

The commenter suggested requiring

disclosure only of the aggregate fees

billed for information technology

services and other non-audit services

provided to certain other service

providers in the investment company

complex.475

We recognize that it could be

confusing to provide investors with

disclosure concerning audit and nonaudit services for all entities (including

all the funds) within the investment

company complex. We believe,

however, that the ability to compare the

registrant’s audit fee with the aggregate

fees billed for non-audit services

provided to all the entities that operate

an investment company would be useful

for investors in evaluating the

independence of the investment

company’s auditor. Because the adviser

plays an integral role in managing and

overseeing the investment company, we

believe the fees billed for non-audit

services provided to a fund’s adviser are

relevant and should be disclosed. In

addition, various service providers to

the investment company are in a control

relationship with the adviser. We

believe that investors should be

informed of the aggregate amount of the

registrant’s audit fee and the fees billed

for information technology services and

other non-audit services provided by the

independent principal accountant to

these service providers.

As a result, the proxy rules require

investment companies to disclose a

fund’s audit fee and the aggregate fees

billed for information technology and

other non-audit services provided by the

registrant’s auditors to the registrant, its

adviser, and entities in a control

relationship with the adviser that

provide services to the registrant. This

approach will provide investors with

pertinent information about the

relationship between the fund’s auditor

and other entities in the investment

company complex.

2. Audit Committee Disclosure

As discussed above, audit committees

play an important role in overseeing the

financial reporting process and the

auditor’s independence. We proposed to

require that companies disclose in their

proxy statements whether, before each

disclosed non-audit service was

rendered, the company’s audit

committee approved, and considered

the effect on independence of, such

service provided by the company’s

principal accountant. Several

commenters encouraged us to wait until

the full effects of recently enacted audit

committee reforms are known, in

particular the effects of ISB Standard

No. 1, the new exchange listing rules,

and our recent audit committee

disclosure rules. However, we think that

the disclosure requirements that we are

adopting will complement those

initiatives by encouraging audit

committees to focus particular attention

on scope of services issues.

We have modified the proposed

disclosure to require disclosure only of

whether the audit committee considered

whether the principal accountant’s

provision of the information technology

services and other non-audit services to

the registrant is compatible with

maintaining the principal accountant’s

independence.476 In light of the

recommendations adopted by the

O’Malley Panel and the other audit

committee reforms,477 we believe that

companies will be providing useful

information to investors under the

modified requirement. Investors will be

aided by knowing whether the

company’s audit committee considered

whether the provision of non-audit

services by the company’s principal

accountant is compatible with

maintaining the accountant’s

independence. We are requiring issuers

to disclose only whether the audit

committee considered whether the

principal accountant’s provision of nonaudit services is compatible with

maintaining the principal accountant’s

independence. We are not requiring

issuers to disclose the conclusions of

the audit committee deliberations.

Accordingly, we see little possibility of

private liability arising from these

disclosures.

3. Leased Employees

Under the final amendments, a

company will have to disclose, if greater

than fifty percent of the hours expended

on the audit engagement, the percentage

of hours expended by personnel the

principal auditor leased or otherwise

acquired from another entity. This

disclosure requirement responds to a

recent trend by some accounting firms

to sell their non-audit practices to

financial services companies. Often in

these transactions, the partners and

employees become employees of the

financial services firm. The accounting

firm then leases assets, namely

professional auditors, back from those

companies to complete audit

engagements. In such an arrangement,

audit professionals become full- or parttime employees of the financial services

company, but work on audit

engagements for their former accounting

firm. They receive compensation from

the financial services firm and, in some

situations, from the accounting firm, as

well.478 We believe that investors

76058 Federal Register / Vol. 65, No. 234 / Tuesday, December 5, 2000 / Rules and Regulations

2: Evolving Forms of Firm Structure and

Organization,’’ at 20 (Oct. 1999).

479AICPA SAS No. 1, AU § 543 also sets forth

guidance on when a principal auditor discloses and

makes reference to another auditor who performs an

audit of a component of the entity.

480See, e.g., Testimony of Robert E. Denham,

Member, ISB (July 26, 2000) (recommending that

disclosure be put in footnotes to the financial

statements or in the Form 10–K).

481See, e.g., Letter of Peter C. Clapman, Senior

Vice President and Chief Counsel, Investments,

TIAA-CREF (Sept. 21, 2000).

482See Item 9 of Schedule 14A. 17 CFR 240.14a–

101.

483 15 U.S.C. 78(d).

484 ‘‘Foreign private issuer’’ is defined in

Securities Act Rule 405 (17 CFR 230.405) and

Exchange Act Rule 3b–4 (17 CFR 240.3b–4).

should be informed of arrangements

whereby most of the auditors who work

on an audit are employed elsewhere.479

4. Proxy Statement

Finally, under the final rules,

companies must provide the disclosures

we are requiring in their proxy and

information statements. We solicited

comment on whether the disclosure

should instead be required in the Form

10–K. Some commenters said that the

disclosure should be made in the Form

10–K,480 with some commenters

expressing concern that the proxy

statement will become overloaded with

information. Other commenters

expressed a preference for the

disclosure to be in proxy

statements.481We have determined that

the proxy statement is the appropriate

place for the disclosure since

shareholders often vote on whether to

select or ratify the selection of the

auditors.482 Companies must provide

the disclosure only in the proxy

statement relating to an annual meeting

of shareholders at which directors are to

be elected (or special meeting or written

consents in lieu of such meeting). This

disclosure is not required for companies

reporting solely under Section 15(d) of

the Exchange Act 483 since they are not

subject to our proxy rules. Similarly,

this disclosure will not be required to be

provided by foreign private issuers 484

since they have different corporate

governance regimes and are not subject

to our proxy rules.

Companies must comply with the

new proxy and information statement

disclosure requirements for all proxy

and information statements filed with

us after the effective date.

H. Definitions

As we proposed, we are including

definitions of some of the key terms

used in Rule 2–01 in paragraph (f) of the

Rule. In this section of the release, we

provide a more detailed explanation of

those defined terms not discussed in the

preceding sections. We have made clear

in the rule we adopt that paragraph (f)

provides definitions only for the

purposes of Rule 2–01 and not for other

sections of Regulation S–X.

1. ‘‘Accountant’’

We are adopting, as proposed, Rule 2–

01(f)(1) that defines the term

‘‘accountant.’’ The rules are written in

terms of an accountant’s independence

from the audit client. The definition of

‘‘accountant’’ includes the accounting

firm in which the auditor practices. The

definition makes clear that an

individual accountant’s lack of

independence may be attributed to the

firm.

2. ‘‘Accounting Firm’’

We are adopting the definition of

‘‘accounting firm’’ in Rule 2–01(f)(2)

with two modifications from the version

proposed. As adopted, ‘‘accounting

firm’’ means ‘‘an organization (whether

it is a sole proprietorship, incorporated

association, partnership, corporation,

limited liability company, limited

liability partnership, or other legal

entity) that is engaged in the practice of

public accounting and furnishes reports

or other documents filed with the

Commission or otherwise prepared

under the securities laws, and all of the

organization’s departments, divisions,

parents, subsidiaries, and associated

entities, including those located outside

of the United States.’’ The definition

also expressly includes ‘‘the

organization’s pension, retirement,

investment or similar plans.’’

The first modification is solely to

clarify the definition. We have

simplified the description of what

public accounting firms are covered

under our rule by referring only to those

that ‘‘furnish reports or other documents

filed with the Commission or otherwise

prepared under the securities laws.’’ We

believe that this description captures

the accounting firms subject to our

independence requirements. No

substantive change from the rule as

proposed is intended.

The second change is more

significant. As proposed, the definition

of ‘‘accounting firm’’ included ‘‘affiliate

of the accounting firm.’’ The term

‘‘affiliate of the accounting firm’’ was

separately defined to include a broad

group of entities that are either

financially tied to or otherwise

associated with the accounting firm

enough to warrant being treated like the

accounting firm for purposes of our

independence requirements.

Specifically, we defined as an ‘‘affiliate

of the accounting firm’’ any person

controlling, controlled by, or under

common control with the firm,

shareholders of more than five percent

of the firm’s voting securities, and

entities five percent or more of whose

securities are owned by the firm. The

proposed rule also included any officer,

director, partner, or co-partner of any of

the foregoing.

We also proposed defining as

affiliates of the accounting firm certain

entities that are business partners of the

accounting firm. In general, these

included certain (i) joint ventures in

which the accounting firm participates,

(ii) entities that provide non-audit

services to the accounting firm’s audit

clients and with which the accounting

firm has certain financial interests or

relationships, and (iii) entities involved

in ‘‘leasing’’ professional services to the

accounting firm for their audits. The

proposed definition also included all

other entities with which the accounting

firm is publicly associated in certain

ways.

The definition we proposed also

attributed to the auditor actions and

interests of certain entities involved in

joint ventures or partnerships with the

accounting firm in which the parties

agree to share revenues, ownership

interests, appreciation, or certain other

economic benefits. It also expressly

included any entity that provides nonaudit services to an audit client, if the

accounting firm has an equity interest

in, shares revenues with, loans money

to, or if any covered person has certain

direct business relationships with, the

consulting entity, as well as persons

‘‘co-branding’’ or using the same (or

substantially the same) name or logo as

the accounting firm, cross-selling

services with the accounting firm, or comanaging with the accounting firm.

Finally, the proposed definition of

‘‘affiliate of the accounting firm’’

addressed the situation where full- or

part-time employees of an entity other

than the firm signing the audit report

perform a majority of the audit

engagement. The proposal provided that

if an auditor ‘‘leases’’ personnel from an

entity to perform audit procedures or

prepare reports to be filed with the

Commission, and the ‘‘leased’’

personnel perform a majority of the

hours worked on the engagement, then

the actions and interests of the ‘‘lessor,’’

and certain persons at the lessor are

attributed to the audit firm.

Our proposed definition of ‘‘affiliate

of the accounting firm’’ proved to be one

of the most controversial aspects of our

proposed rule. Many commenters

believed that the definition was

overbroad and expressed concern over

the application of the proposed

definition to their business

arrangements. The largest accounting

firms were concerned that the

Federal Register / Vol. 65, No. 234 / Tuesday, December 5, 2000 / Rules and Regulations 76059

485See, e.g., KPMG Letter; Arthur Andersen

Letter.

486See Written Testimony of Wayne Kolins,

National Director of Assurance, BDO Seidman, LLP

(Sept. 20, 2000).

487See, e.g., Letter of Fred M. Rock, CPA (Sept.

20, 2000); Letter of Centerprise Advisors, Inc. (Sept.

25, 2000).

488See, e.g., Deloitte & Touche Letter; Testimony

of Wayne A. Kolins, BDO Seidman, LLP (Sept. 20,

2000).

489See Letter of Edmund Coulson, Chief

Accountant, SEC, to Robert Mednick, Arthur

Andersen (June 20, 1990).

490Questions of attribution in this context have

not been analyzed on the basis of ‘‘affiliation’’ in

the past. Indeed, the term ‘‘affiliate of the

accounting firm’’ is not used in our current Rule 2–

01 or in the Codification. The term was used in our

proposed rule, along with the proposed definition

of the term, to attempt to bring certainty to this

issue. Since ‘‘affiliate’’ is defined in Rule 1–02 of

Regulation S–X and we are eliminating the

definition of ‘‘affiliate of the accounting firm,’’ we

have used the term ‘‘associated’’ instead of

‘‘affiliated’’ in our final rules to make clear that,

consistent with the status quo, the entities treated

as if they were the accounting firm will not be

determined by reference to the definition of

‘‘affiliate’’ in Rule 1–02 of Regulation S–X. While

the ‘‘control’’ relationships of Rule 1–02 may be

adequate to warrant treating an entity as the

accounting firm for independence purposes, Rule

1–02 does not set forth the exclusive circumstances

in which an entity’s interests will be imputed to the

accounting firm in this context. In addition, we do

not intend for the definition of ‘‘associated’’ used

in any other context in the federal securities laws

to apply to this term.

491See, e.g., Letter of Edmund Coulson, Chief

Accountant, SEC, to Robert Mednick, Arthur

Andersen (June 20, 1990); Letter of W. Scott

Bayless, Assistant Chief Accountant, SEC, to Larry

Edgerton, Elms, Faris & Co. (June 7, 1996); Letter

of Lynn E. Turner, Chief Accountant, SEC, to Jeff

Yabuki, American Express Financial Advisors (Nov.

2, 1998); Letter of Lynn E. Turner, Chief

Accountant, SEC to Michael Gleespen, Century

Business Services (Nov. 2, 1998); Letter of Lynn E.

Turner, Chief Accountant, SEC, to Terry Putney,

H&R Block Business Services (Nov. 2, 1998); Letter

of Lynn E. Turner, Chief Accountant, SEC, to

Michael Conway, KPMG Peat Marwick LLP (Jan. 7,

1999); Letter of Lynn E. Turner, Chief Accountant,

SEC, to Nigel Buchanan, PricewaterhouseCoopers

(July 26, 1999); Letter of Lynn E. Turner, Chief

Accountant, SEC, to Kathryn A. Oberly, Esq., Ernst

& Young (May 25, 2000); Letter of Lynn E. Turner,

Chief Accountant, SEC, to Antonio Rosati, Director

of Issuers Division, Commissione Nazionale per le

Societa e la Borsa (August 24, 2000); Letter of Lynn

E. Turner, Chief Accountant, SEC, to J. Terry

Strange, KPMG (October 16, 2000); see also

Codification § 602.02.b.ii, Ex. 8; 602.02.b.iv;

602.02.c.iii; 602.02.g, Ex. 5. Cf. SECPS Manual

§ 1000.45 (discussing application of SECPS rules to

‘‘foreign associated firm[s]’’); AICPA Code of

Professional Conduct, ET § 101.16 (Interpretation

101–14) (application of independence rules to

alternative practice structures); AICPA Code of

Professional Conduct, ET § 505.03 (application of

independence rules to entities controlled by an

accounting firm or its members). In addition,

accounting firms entering into business transactions

in which they acquire equity stakes in other

companies will need to continue to consider

whether they will have a direct or material indirect

business relationship with, or a direct financial

interest or material indirect financial interest in,

any of their audit clients that are also clients of or

enter into business relationships with or invest in

or are invested in by that other company. See Letter

of Lynn E. Turner, Chief Accountant, SEC, to

Kathryn A. Oberly, Esq., Ernst & Young (May 25,

2000); Letter of Lynn E. Turner, Chief Accountant,

SEC, to J. Terry Strange, KPMG (October 16, 2000).

492See AICPA Letter; Arthur Andersen Letter.

493See Deloitte & Touche Letter.

definition, as a practical matter, would

inappropriately restrict their ability to

enter into certain types of business

relationships, including joint ventures

and co-branding arrangements.485 One

of the so-called ‘‘middle tier’’

accounting firms expressed concern that

the proposed definition would reach the

‘‘alliance’’ it has arranged with other

accounting firms and service providers

across the country.486 Many

commenters repeated the AICPA’s

comment that the definition was

‘‘overbroad.’’487 Some commenters

suggested an alternative, much narrower

definition that defined affiliates of the

accounting firm as entities that control,

are controlled by, or are under common

control with the accounting firm.488

Some firms acknowledged that, at least

with respect to the provision of nonaudit services, a test based on

significant influence may be

appropriate.

In light of these comments and after

careful consideration, we have decided

not to adopt the definition of ‘‘affiliate

of the accounting firm’’ we proposed.

The issue of what entities other than the

legal entity issuing reports or other

documents filed with the Commission

should be treated as the accounting firm

is of relatively recent origin. In recent

years, accounting firms have explored

new ‘‘alternative practice structures’’

and increasingly entered into new

business arrangements with entities not

engaged in public accounting. To date,

our staff has dealt with these questions

by interpreting the existing rules. Our

staff’s approach has been to analyze

these situations in light of all relevant

facts and circumstances.489 We

proposed a comprehensive definition

that described all the relevant facts and

circumstances that might lead us to

conclude that a separate legal entity was

sufficiently associated with the

accounting firm to warrant applying the

Commission’s independence

requirements to that entity. In light of

the comments received, we are

persuaded that the rule as proposed

could have unintended consequences,

and that varying criteria of affiliation

could be appropriate depending on the

regulatory context in which the issue of

attribution arises.

Accordingly, we have eliminated the

proposed definition of ‘‘affiliate of the

accounting firm’’ from the rule we adopt

and replaced the phrase ‘‘and affiliates

of the accounting firm’’ in the proposed

definition of ‘‘accounting firm’’ with

‘‘and associated entities, including those

located outside of the United States.’’490

We intend this phrase to reflect our

staff’s current practice of addressing

these questions in light of all relevant

facts and circumstances, looking to the

factors identified in our staff’s previous

guidance on this subject.491 While the

rules we adopt do not provide

accounting firms with the certainty of

our proposed rule, we are convinced

that a more flexible approach is

warranted as the types and nature of

accounting firms’ business arrangements

continue to develop.

3. ‘‘Affiliate of the Audit Client’’

We are adopting a modified definition

of ‘‘affiliate of the audit client.’’ As

proposed, Rule 2–01(f)(4) defined

‘‘affiliate of the audit client’’ as any

entity that has ‘‘significant influence’’

over the audit client, or any entity over

which the audit client has significant

influence. The definition was intended

to cover both ‘‘upstream’’ and

‘‘downstream’’ affiliates of the audit

client, including the audit client’s

corporate parent and subsidiary.

We received a number of comments

expressing concern about our proposed

definition of ‘‘affiliate of the audit

client.’’ Some members of the

accounting profession felt that our

proposed definition was overbroad and

would require the auditor to maintain

independence from entities far removed

from the audit client.492 Some

commenters suggested that we should

use the ‘‘control’’ test currently found in

Rule 1–02 of Regulation S–X to define

an affiliate of an audit client. At least

one commenter suggested that our

proposed definition should be limited to

only those affiliates that are ‘‘material’’

to the audit client.493

After considering these comments, we

have decided to modify substantially

our proposed rule. Under the rule we

adopt today, entities, if not part of an

investment company complex, will be

considered affiliates of the audit client

if they satisfy the criteria of one of three

paragraphs of Rule 2–01(f)(4). First,

under paragraph (4)(i), which is based

on the control definition currently in

Rule 1–02 of Regulation S–X, an entity

is an affiliate of the audit client when

the entity controls, is controlled by, or

is under common control with the audit

client. Second, paragraph (4)(ii) defines

as an affiliate of the audit client any

entity over which the audit client has

significant influence, unless that entity

is not material to the audit client. Third,

paragraph (4)(iii) includes those entities

that have significant influence over the

76060 Federal Register / Vol. 65, No. 234 / Tuesday, December 5, 2000 / Rules and Regulations

494See Codification § 602.02.b.iii (Ex. 1);

602.02.b.iv; 602.02.c.iii; 602.02.h (Ex. 9). 495See APB No. 18. 496See Letter of Stanley Keller, Esq., and Richard

Rowe, Esq., ABA Committees on Federal Regulation

of Securities Law and Accounting (Sept. 27, 2000).

497See APB No. 18, at ¶ 17. Paragraph 17 of APB

No. 18 also discusses a number of considerations

that may affect the ability of an entity to have

significant influence over an investee.

498We have, however, narrowed the definition of

‘‘investment company complex’’ from the definition

used in ISB Standard No. 2. See infra Section

IV.H.11.

499See Arthur Andersen Letter.

500Rule 2–01(f)(5)(ii)(A).

501Rule 2–01(f)(5)(ii)(B).

502See, e.g., Deloitte & Touche Letter.

503See, e.g., Deloitte & Touche Letter.

audit client, unless the audit client is

not material to that entity.

Paragraph (4)(i) now makes clear that

entities in a control relationship with

the audit client, regardless of materiality

considerations, are affiliates of the audit

client for independence purposes. This

includes the audit client’s parent and

subsidiaries and is consistent with

current Rule 2–01(b). We are not

convinced, however, that a control test

alone captures all situations in which an

entity is sufficiently related to the audit

client to require it to be treated as the

audit client’s affiliate for independence

purposes. Our Codification currently

considers entities affiliates of the audit

client in a number of situations in

which control is not present.494 As

under our proposal, we continue to

believe that a significant influence test

sets a proper baseline threshold for

audit client affiliation because, under

the equity method of accounting,495 it

results in the marriage of financial

information between the audit client

and the entity influenced by, or

influencing, the financial or operating

policies of the audit client. As urged by

commenters, however, the addition of

the materiality threshold to the

significant influence test should avoid

undue hardships to accounting firms in

situations where their audit clients have

numerous affiliates that are immaterial

to them.

As in our proposed rule, we continue

to use the term ‘‘significant influence’’

in the definition to refer to the

principles in APB No. 18. Some

commenters suggested that, since the

term ‘‘significant influence’’ is not

defined in the rules, it would be

difficult to apply.496 Many other

commenters, however, did not object to

the term or express any uncertainty as

to the term’s meaning. Given the

concept’s familiarity to the accounting

profession and its use in the

profession’s independence

requirements, we have decided to retain

its use without providing an explicit

definition in the rules we adopt.

We use the term ‘‘significant

influence’’ as it is used in APB No. 18.

It recognizes that ‘‘significant influence’’

can be exercised in several ways:

representation on the board of directors;

participation in key policy decisions;

material inter-company transactions;

interchange of personnel; or other

means. APB No. 18 also recognizes that

an important consideration is the extent

of the equity investment, particularly in

relation to the concentration of other

investments. In order to provide a

reasonable degree of uniformity in

application of this standard, the Board

concluded that,

[A]n investment (direct or indirect) of 20%

or more of the voting stock of an investee

should lead to a presumption that in the

absence of evidence to the contrary an

investor has the ability to exercise significant

influence over an investee. Conversely, an

investment of less than 20% of the voting

stock of an investee should lead to a

presumption that an investor does not have

the ability to exercise significant influence

unless such ability can be demonstrated.497

In addition, we have added a new

section to the definition of ‘‘affiliate of

an audit client’’ to deal specifically with

affiliation questions in mutual fund

complexes. Paragraph (4)(iv) provides

that when the audit client is part of an

investment company complex, each

entity in the investment company

complex is an ‘‘affiliate of the audit

client.’’ In this respect, we are following

the ISB’s Standard No. 2, ‘‘Certain

Independence Implications of Audits of

Mutual Funds and Related Entities.’’498

While this provision was not in our

proposed definition of ‘‘affiliate of the

audit client,’’ it was clearly embodied in

our proposed Rule 2–01(c)(1)(ii)(G),

which provided, ‘‘When the audit client

is an entity that is part of an investment

company complex, the accountant must

be independent of each entity in the

investment company complex.’’ As we

explained in the Proposing Release, this

provision was meant to reflect the

standard of ISB Standard No. 2. We

pointed out in the Proposing Release

that this provision applied to auditoraudit client relationships other than

financial interests, and sought comment

on whether it should be limited in any

context other than financial interests. At

least one commenter analyzed our

proposed Rule 2–01(c)(1)(ii)(G) as an

extension of the definition of ‘‘affiliate

of the audit client.’’499

While some commenters suggested

that we limit this principle through a

restriction on the scope of the

‘‘investment company complex’’

definition, few commenters disagreed

with the ISB’s basic conclusion that the

unique structure of mutual fund

complexes warrants special rules of

affiliation. After considering the

comments on this issue, we have

decided to adopt this provision

substantively as proposed, but to move

it to the definition of ‘‘affiliate of the

audit client’’ to make its purpose and

effect clearer.

4. ‘‘Audit and Professional Engagement

Period’’

We have adopted the definition of

‘‘audit and professional engagement

period’’ in Rule 2–01(f)(5), as proposed,

with one modification. As defined, the

‘audit and professional engagement

period’ is ‘‘[t]he period covered by any

financial statements being audited or

reviewed (the ‘‘audit period’’); and the

period of the engagement to audit or

review the audit client’s financial

statements or to prepare a report filed

with the Commission (the ‘professional

engagement period’’).’

The definition specifies that the

professional engagement period begins

when the accountant either signs an

initial engagement letter (or other

agreement to review or audit a client’s

financial statements) or begins review,

audit, or attest procedures, whichever is

earlier,500 and that the professional

engagement period ends when the client

or accountant notifies the Commission

that the client is no longer that

accountant’s audit client.501 Some

commenters asserted that the

professional engagement period should

begin when the accountant begins its

procedures.502 Commenters expressed

concern that ‘‘time will be needed for

covered persons and their family

members to unwind financial interests

or employment relationships.’’503 We

believe that our rule, as adopted,

provides an appropriate amount of

flexibility and certainty to the auditor

because both signing the initial

engagement letter and beginning the

audit procedures are entirely within the

control of the accountant. An

accountant may orally agree to an

engagement and then simply delay

signing an engagement letter or

beginning procedures so as to toll the

start of its professional engagement

period.

With regard to the termination of the

professional engagement period, we

note that the current rules of the SECPS

require an auditor to notify the

Commission in writing that an SEC

registrant who was a former client is no

Federal Register / Vol. 65, No. 234 / Tuesday, December 5, 2000 / Rules and Regulations 76061

504SECPS Manual § 1000.08; cf. AICPA Code of

Professional Conduct, ET § 101.02. 505See, e.g., Ernst & Young Letter (‘‘We also

would revise the definition of ‘audit and

professional engagement period’ in the Release . . .

to codify the Commission staff’s practice of only

requiring the latest audited period in initial filings

by foreign private issuers to be fully compliant with

SEC independence rules.’’).

506Arthur Young, 465 U.S. at 818.

507See, e.g., PricewaterhouseCoopers Letter. 508See, e.g., Deloitte & Touche Letter. 509See Deloitte & Touche Letter.

longer a client.504 Similarly, a domestic

registrant has an obligation to report

changes in its independent auditor on

Form 8–K. While no corollary

requirement applies to foreign private

issuers, there is certainly no prohibition

against either such an issuer or its

auditor providing us with a private

notification that would suffice to end

the professional engagement period for

purposes of our independence

assessment, should this be an issue for

the accountant or the registrant.

In response to concerns of

commenters,505 we are providing a

limited exception in the definition that

applies to foreign private issuers who

are offering or listing securities in the

United States for the first time. For

auditors of those foreign private issuers

who previously were not required to,

and did not, file any registration

statement or report with the

Commission, the ‘‘audit and

professional engagement period’’ does

not include periods ended prior to the

beginning of the last fiscal year ended

before the issuer first filed or was

required to file a registration statement

or report with us, provided that the

company has fully complied with home

country independence standards in

those prior periods.

5. ‘‘Audit Client’’

Rule 2–01(f)(6) defines ‘‘audit client.’’

We have defined this term as the entity

whose financial statements or other

information is being audited, reviewed,

or attested. We believe this is how

‘‘audit client’’ commonly is used, and

we are adopting this as part of the

definition. Use of this definition, of

course, in no way changes our position

that the auditor ‘‘owes ultimate

allegiance to the corporation’s creditors

and stockholders, as well as to the

investing public.’’506

We have made one change to the

definition. Commenters suggested

adding affiliate of the audit client,

defined above, to the definition of audit

client for the sake of simplicity, and we

have done so.507 The definition of audit

client, for purposes of paragraph (c)(1)(i)

(investments in audit clients), however,

does not include entities that are

affiliates of the audit client by virtue of

paragraph (f)(4)(ii) or paragraph

(f)(4)(iii), which define an affiliate in

terms of significant influence. As

discussed more fully above, if an entity

is an affiliate of the audit client because

of a ‘‘significant influence’’ relationship,

it is covered by the rules relating to

material indirect investments and

investments in non-client entities under

(c)(1)(i)(D) and (c)(1)(i)(E), and it is not

necessary, therefore, to include it in the

definition of audit client.

6. ‘‘Audit Engagement Team’’

Rule 2–01(f)(7) defines the term

‘‘audit engagement team.’’ The ‘‘audit

engagement team’’ includes the people

in the accounting firm who are most

directly in a position to influence the

audit. Members of the ‘‘audit

engagement team’’ are included within

the category of ‘‘covered persons in the

firm,’’ which is the term used to

indicate the persons in the firm subject

to a number of the specific provisions of

paragraph (c) of Rule 2–01.

The ‘‘audit engagement team’’

includes ‘‘all partners, principals,

shareholders, and professional

employees participating in an audit,

review, or attestation engagement of an

audit client, including those conducting

concurring or second partner reviews,

and all persons who consult with others

on the audit engagement team during

the audit, review, or attestation

engagement regarding technical or

industry-specific issues, transactions, or

events.’’

Commenters who addressed this

definition generally agreed that persons

in a position to influence the audit, such

as the audit engagement team, should be

covered persons for purposes of the

rule’s restrictions on certain

relationships with audit clients.508 We

have adopted the definition with only

one variation from the proposed

definition. The proposed definition

included the phrase ‘‘all persons who

consult, formally or informally, with

others . . . .’’ In the final rule, we have

deleted the phrase ‘‘formally or

informally,’’ to avoid unintended

overbreadth. Rather, we use the term

‘‘consult’’ to refer to meaningful

discussions related to the audit.

7. ‘‘Chain of Command’’

Rule 2–01(f)(8) defines the term

‘‘chain of command.’’ This term is

defined to refer to the group of people

in the accounting firm who, while not

directly on the audit engagement team,

are capable of influencing the audit

process either through their oversight of

the audit itself or through their

influence over the members of the audit

engagement team. Like the ‘‘audit

engagement team,’’ persons in the

‘‘chain of command’’ are included as

‘‘covered persons in the firm,’’ and

therefore are subject to a number of the

provisions in paragraph (c) of Rule 2–

01.

Based on the input of commenters, we

have modified this definition somewhat

from the proposed definition.

Commenters stated that our definition

included too broad a range of persons,

capturing people, such as managers who

could ‘‘influence the . . . compensation

of any member of the audit engagement

team,’’ whose connection to the audit is

too tenuous to reasonably conclude that

they have the ability to influence the

audit.509

We are persuaded that the proposed

definition was broader than necessary,

and we have accordingly sharpened its

focus and tried to eliminate any

ambiguity. As defined in the final rule,

‘‘chain of command’’ includes all

persons who (i) supervise or have direct

management responsibility for the audit,

including at all successively senior

levels through the accounting firm’s

chief executive; (ii) evaluate the

performance or recommend the

compensation of the audit engagement

partner; or (iii) provide quality control

or other oversight of the audit.’’

8. ‘‘Close Family Members’’

We are adopting, as proposed, Rule 2–

01(f)(9) that defines ‘‘close family

members.’’ Close family members is

defined to mean a person’s spouse,

spousal equivalent, parent, dependent,

nondependent child, and sibling. These

terms should be understood in terms of

contemporary family relationships.

Accordingly, ‘‘spouse’’ means a

husband or wife, whether by marriage or

under common law; ‘‘spousal

equivalent’’ means a cohabitant

occupying a relationship generally

equivalent to that of a spouse; ‘‘parent’’

means any biological, adoptive, or stepparent; ‘‘dependent’’ means any person

who received more than half of his or

her support for the most recent calendar

year from the relevant covered person;

‘‘child’’ means any person recognized

by law as a child or step-child; and

‘‘sibling’’ means any person who has the

same mother or father.

‘‘Close family members’’ includes the

persons separately defined as

‘‘immediate family members’’ (spouse,

spousal equivalent, and dependent), and

adds certain family members who may,

as a general matter, be thought to have

less regular, but not necessarily less

close, contact with the covered person

76062 Federal Register / Vol. 65, No. 234 / Tuesday, December 5, 2000 / Rules and Regulations

510AICPA SAS No. 22, AU § 311.046 and AUI

9311.03.

511See, e.g., Deloitte & Touche Letter; Ernst &

Young Letter.

512See, e.g., Deloitte & Touche Letter; Ernst &

Young Letter.

513For a discussion of the definition of ‘‘office,’’

see infra Section IV.H.12.

514See Deloitte & Touche Letter.

515For example, leased accounting personnel

might consult with a professional employee

participating in an audit and thereby become a

member of the audit engagement team.

in question (parent, nondependent

child, and sibling). We distinguish the

two groups, in part, because the less

immediate the family relationship to the

covered person, the more substantial

that family member’s relationship to the

audit client should be before we deem

it to impair the auditor’s independence.

Commenters, in general, raised few

issues with the proposed definition of

‘‘close family members’’ and, therefore,

we are adopting this definition as

proposed.

9. ‘‘Covered Persons in the Firm’’

Rule 2–01(f)(11) defines the term

‘‘covered persons in the firm.’’ The term

includes four basic groups. The first two

groups, the ‘‘audit engagement team’’

and the ‘‘chain of command,’’ are

described above. Their inclusion in the

category of ‘‘covered persons in the

firm’’ is unchanged from the proposed

rule.

We have modified the description of

the third category of covered persons

from our proposal. The proposed rule

referred to ‘‘any other partner, principal,

shareholder, or professional employee

of the accounting firm who is, or during

the audit client’s most recent fiscal year

was, involved in providing any

professional service to the audit client

or an affiliate of the audit client.’’ We

included this category because the

auditing literature, quite appropriately,

directs the audit engagement team to

discuss certain matters with the firm

personnel responsible for providing

such services to that client.510

In response to concerns raised by

commenters,511 we have modified the

definition of this category of covered

persons in two respects. First, we have

changed the term ‘‘professional

employee’’ to ‘‘managerial employee,’’

to encompass a somewhat narrower

scope of persons. Second, we have set

a minimum hour threshold that must be

crossed before an individual becomes a

covered person by virtue of providing a

non-audit service to an audit client.

This subpart of the definition now

includes only those individuals who

have ‘‘provided ten or more hours of

non-audit services to the audit client for

the period beginning on the date such

services are provided and ending on the

date the accounting firm signs the report

on the financial statements for the fiscal

year during which those services are

provided, or who expects to provide ten

or more hours of non-audit services to

the audit client on a recurring basis.’’

In this definition, the phrase

‘‘beginning on the date such services are

provided’’ refers to the date on which

the individual provides his or her tenth

hour of non-audit service to a particular

audit client within the space of a single

fiscal year of that client. For example, if

the client’s fiscal year runs from January

1 to December 31, and an individual

provides eight hours of non-audit

services on February 1 and two hours of

non-audit services on June 1, then the

period described above would

commence following the provision of

the services on June 1. From that date

through the date that the accounting

firm signs the report on the financial

statements for that fiscal year, that

individual is a ‘‘covered person in the

firm.’’ We reiterate: the individual’s

status as a covered person does not end

at the conclusion of the fiscal year in

question, but continues until the firm

has signed the report for the financial

statements for that fiscal year.

The proposed rule described the

fourth category of covered persons as

‘‘any other partner, principal, or

shareholder from an ‘office’ of the

accounting firm that participates in a

significant portion of the audit.’’ We

included these people on the theory that

they are the ones most likely to interact

with the audit engagement team on

substantive matters and may exert

influence over the audit engagement

team by virtue of their physical

proximity to, or relatively frequent

contact with, the audit engagement

team.

In response to concerns raised by

commenters about the breadth of the

category, particularly the inclusion of

every ‘‘office’’ that participates in a

‘‘significant portion’’ of the audit,512 we

have modified this definition. The final

rule narrows the scope of the definition

to ‘‘any other partner, principal, or

shareholder from an ‘office’ of the

accounting firm in which the lead audit

engagement partner primarily practices

in connection with the audit.’’ We are

persuaded that it is reasonable to draw

the line at partners, principals, and

shareholders, rather than at all

‘‘professional employees,’’ and that it is

also more reasonable and more

practicable to draw a clear line at the

‘‘office’’513 of the firm in which the lead

engagement partner primarily practices.

A person who is not a covered person

at the time an audit engagement begins

might nonetheless become a covered

person at any time during the audit

engagement. As soon as events or

circumstances bring a person within any

category of covered person defined

above, that person is a ‘‘covered person

in the firm.’’ An individual must be

independent of the audit client,

pursuant to the provisions of the rule,

before becoming a covered person in the

firm. That means, for example, that an

individual must dispose of any financial

interest in the audit client completely

and irrevocably before being consulted

by another covered person concerning

the audit engagement. For example, the

rule does not allow the person

consulted to participate in a discussion

about the audit engagement and then

‘‘cure’’ an independence impairment by

later disposing of an investment.

Likewise, a person who becomes a

covered person by rotating onto an

engagement or being promoted into the

chain of command must be independent

pursuant to the provisions of the rule

prior to becoming a covered person.

One commenter suggested that the

definition of ‘‘covered persons in the

firm’’ should include leased accounting

personnel.514 We note that to the extent

leased personnel otherwise fall within

any category of ‘‘covered persons in the

firm,’’ such as by being on the audit

engagement team, they will be covered

persons in the firm.515

Because the rule narrows the scope of

firm personnel to whom investment and

employment restrictions apply, an

accounting firm employee in a distant

part of the world, or even down the

street, might own an audit client’s

securities, have a family member in a

financial position at the client, or enter

into a business relationship with a

client without necessarily impairing the

firm’s independence from the audit

client. We expect that many partners

and employees who previously could

not own securities issued by an audit

client will be able to do so under the

rule.

It should be noted that insider trading

restrictions prohibit any partner,

principal, shareholder, or employee of

the firm, whether or not he or she

performs any service for the client, from

trading on the basis of any material

nonpublic information about that client.

10. ‘‘Immediate Family Members’’

We are adopting, as proposed, final

Rule 2–01(f)(13), which defines

‘‘immediate family members’’ to mean a

Federal Register / Vol. 65, No. 234 / Tuesday, December 5, 2000 / Rules and Regulations 76063

516See Written Testimony of Ronald Nielsen and

Kathleen Chapman, Iowa Accountancy Examining

Board (Sept. 20, 2000).

517 ISB Standard No. 2, supra note 226.

518See, e.g., Deloitte & Touche Letter; AICPA

Letter. 519See, e.g., Arthur Andersen Letter.

520See, e.g., Deloitte & Touche Letter; AICPA

Letter.

521See AICPA Letter.

522The ISB Exposure Draft, cited in the AICPA

Letter, states the following: the identification of the

relevant ‘‘office’’ or practice unit is based on the

facts and circumstances, including the firm’s

operating structure, and requires judgment. In a

traditional geographic practice office (one city

location with one managing partner in charge of all

operations—audit, tax, and consulting), that

location should be considered to be the office. In

addition, if there are smaller, nearby ‘‘satellite’’

offices managed under the primary city office,

broadly sharing staff, etc., those locations should

also be considered part of the primary office. On the

other hand, many firms are now structured more on

an industry specialization or line-of-service basis,

and manage offices on that basis. For example, if

Continued

person’s spouse, spousal equivalent,

and dependents. These terms have the

same meaning as they do in the

definition of ‘‘close family members.’’

‘‘Immediate family members’’ is a

narrower group than ‘‘close family

members.’’ Again, we believe that the

less immediate the family relationship

to the covered person, the more

substantial that family member’s

relationship to the audit client should

be before we deem it to impair

independence. By identifying

‘‘immediate family members,’’ we are

identifying those persons who have

such regular and close contact with a

‘‘covered person’’ that it is fair, for

independence purposes, to attribute to

the covered person any financial and

employment relationships that family

member has with the audit client.

We received a few comments on the

definition of ‘‘immediate family

members.’’ Some commenters agreed

that the definition should not include

emancipated adult children, while

others expressed concern that nondependent children were not included

in this group.516 On balance, we believe

that, for purposes of these rules,

emancipated children are sufficiently

independent of their parents to warrant

not imputing their financial interests to

their parents. We are, therefore,

adopting the definition as proposed.

11. ‘‘Investment Company Complex’’

As proposed, the definition of

‘‘investment company complex’’

focused on investment advisers and

entities in a control relationship with

the adviser, including entities under

common control with the adviser. The

proposed definition was loosely based

on ISB Standard No. 2, which defines

‘‘mutual fund complex’’ to mean ‘‘[t]he

mutual fund operation in its entirety,

including all the funds, plus the

sponsor, its ultimate parent company,

and their subsidiaries.’’517

We solicited comment on the

definition proposed, and, in particular,

on whether an alternative definition,

focusing on the fund’s principal

underwriter and administrator would be

more appropriate. Some commenters

expressed concern about the scope of

the investment company complex

definition, particularly that it included

entities that have no direct relationship

to investment company operations.518

These commenters’ concern was that all

subsidiaries of an adviser’s parent

company would also be included in the

investment company complex.

Therefore, an accounting firm could not

provide certain non-audit services to, or

invest in, subsidiaries of the parent of

the adviser, even if those subsidiaries

operated businesses unrelated to the

investment company business. Under

the proposed definition, for example, if

a parent company owned an adviser and

a manufacturing company, the

accountant that audited the adviser (or

a fund advised by the adviser) could not

invest in the manufacturing company,

even though its operations would not be

affected by the audit of the adviser (or

the fund).

In response to these comments, we

have adopted in Rule 2–01(f)(14) a

definition of investment company

complex that is more limited than the

one proposed. As adopted, the rule only

includes an entity under common

control with the adviser if the entity

provides services to an investment

company in the investment company

complex. More specifically, if a sister

entity of the investment adviser, other

than another investment adviser, does

not provide administrative, custodian,

underwriting, or transfer agent services

to the adviser or a fund, it is not part

of the investment company complex.

As proposed, an entity that would be

an investment company but for the

exclusions provided by section 3(c) of

the Investment Company Act and that is

advised by the investment adviser or

sponsored by the sponsor is part of the

investment company complex. Also, as

proposed, the definition does not

include sub-advisers whose role is

primarily portfolio management and

who provide services pursuant to a

subcontract with, or are overseen by, an

adviser in the complex. There was some

support for excluding sub-advisers from

the definition of investment company

complex.519 We have determined to

exclude sub-advisers from the definition

because a fund, or even its adviser, may

not be able to know whether the subadviser obtained any non-audit services

from the fund’s or the adviser’s auditor.

Moreover, considering a sub-adviser or

the funds it advises to be part of the

investment company complex presents

practical difficulties where the subadviser is itself an adviser in a separate

investment company complex.

12. ‘‘Office’’

Rule 2–01(f)(15) defines ‘‘office’’ to

mean a distinct sub-group within an

accounting firm, whether distinguished

along geographic or practice lines. The

term ‘‘office’’ is an integral part of the

description of one category of ‘‘covered

persons’’ and, thereby, helps identify

firm personnel who cannot have

financial or employment relationships

with a particular audit client without

impairing the firm’s independence. The

definition has not changed from the

proposed definition.

We give ‘‘office’’ a meaning that does

more than merely refer to a distinct

physical location where the firm’s

personnel work. By ‘‘office’’ we mean to

encompass any reasonably distinct subgroup within an accounting firm,

whether constituted by formal

organization or informal practice, where

the personnel who make up the subgroup generally serve the same clients,

work on the same matters, or work on

the same categories of matters. In this

sense, ‘‘office’’ may transcend physical

boundaries, and it is possible that a firm

may have a sub-group that constitutes

an ‘‘office’’ even though the personnel

making up that sub-group are stationed

at various places around the country or

the world.

At the same time, we intend for

‘‘office’’ also to include reference to a

physical location. For this reason,

‘‘office’’ will generally include a distinct

physical location where the firm’s

personnel work. We recognize, however,

that in some cases thousands of firm

personnel may work at a single, large

physical location, but physical divisions

may nonetheless effectively isolate

different sub-groups of personnel from

each other in ways that will warrant

treating each sub-group as a separate

‘‘office’’ under the proposed definition.

Some commenters raised concerns

about the definition of office.520 One

commenter asserted that the proposed

definition is unworkable and does not

provide helpful guidance.521 This

commenter expressed a preference for

the ISB’s approach to the concept of

‘‘office or practice unit,’’ in the ISB’s

Exposure Draft on Financial Interests

and Family Relationships.522

76064 Federal Register / Vol. 65, No. 234 / Tuesday, December 5, 2000 / Rules and Regulations

a financial services group were a separate practice

unit, and were operated that way with limited

contact with personnel of other local units, that

may represent a separate office for purposes of this

standard. Substance should govern the office

classification, and the expected regular personnel

interactions and assigned reporting channels of an

individual may well be more important than his or

her physical location.

523While we discuss the costs and benefits to

issuers separately from those accruing to investors,

impacts on the issuers are also likely to flow to

investors as owners of the issuers’ securities.

524 It has been suggested that the Proposing

Release did not clearly specify the baseline from

which the costs and benefits were being estimated.

The following presentation clearly establishes the

baseline: costs and benefits are compared to current

regulations.

525See supra Section III.B.

526See Written Testimony of Jack Ciesielski,

accounting analyst (Sept. 13, 2000) (‘‘I think the real

problem in attracting talent in the auditing

profession is the share ownership restrictions

placed on auditors. * * * The relaxation of share

ownership constraints that are proposed in this

document should allay most fears of future

auditors.’’).

In some respects, the definition that

we adopt overlaps with the ISB

approach. Like the ISB approach, our

definition will necessarily involve the

application of judgment, governed by

substance. And under our definition, as

under the ISB approach, expected

regular personnel interactions and

assigned reporting channels may well be

more important than an individual’s

physical location. We have determined

to adopt the definition that we

proposed, because it is unclear to us

that the ISB approach would necessarily

encompass each distinct sub-group that,

in particular circumstances, should be

encompassed.

I. Codification

As previously discussed, the

Commission’s current auditor

independence requirements are found

in various rules and interpretations.

Section 600 of the Codification provides

interpretations and guidance not

otherwise available in Rule 2–01. The

final rule articulates a number of

situations and circumstances, such as

financial relationships, employment

relationships, and non-audit services

that impair auditor independence.

Accordingly, we are deleting some

interpretations included in the

Codification, either because they are

reflected in the revised Rule 2–01 or

they have been superseded, in whole or

in part, by the rule. Because examples

have been deleted both because they are

no longer necessary and because they

are inconsistent with the final rule,

inferences should not be drawn from the

deletion of a particular example. The

revised Codification contains the

discussion of the final rule from this

release, as well as the background

information and interpretations that

may continue to be useful in situations

not specifically or definitively

addressed in paragraph (c). Examples of

these items include business

relationships, unpaid prior professional

fees, indemnification by clients, and

litigation.

V. Cost-Benefit Analysis

The amendments to Rule 2–01

modernize the rules for determining

whether an auditor is independent in

light of (i) investments by auditors or

their family members in audit clients;

(ii) employment relationships between

auditors or their family members and

audit clients; and (iii) the non-audit

services provided by audit firms to their

audit clients. In the Proposing Release,

we identified three constituencies

affected by the rule: (1) investors; (2)

issuers; and (3) accounting firms that

provide services affected by this

release.523 Below we discuss the costs

and benefits to each of these groups. In

all cases, we discuss the costs and

benefits relative to the current

regulatory environment.524

A. Costs and Benefits of the Rule

Regarding Investments in and

Employment Relationships With Audit

Clients

The final rule clarifies, and in some

cases eliminates, certain existing

requirements under which an

accountant’s independence is impaired

by investment and employment

relationships between an accountant,

covered persons, or their families, and

an audit client. As explained above,525

changes in business practices and

demographics, including an increase in

dual-career families, warrant a change

in our auditor independence

requirements to prevent an unnecessary

restriction on the employment and

investment opportunities available to

auditors and members of their families.

To this end, the rule amendments take

a more targeted approach, focusing on

those persons who are involved in or

can influence an audit. In addition, the

rule provides a limited exception for

accounting firms under which an

inadvertent violation of these rules by

certain persons will not cause a firm’s

independence to be impaired, so long as

the firm has quality controls that meet

certain conditions and the impairment

is resolved promptly.

1. Benefits

The elimination of certain investment

and employment restrictions should

benefit auditors and their families by

permitting a wider range of investment

and employment opportunities.

According to the 1999 annual reports

filed by accounting firms with the

SECPS, the five largest accounting firms

employ approximately 115,000

professionals. Other public accounting

firms that audit SEC registrants employ

an estimated 5,000 to 25,000

professional staff. The amendments we

are adopting will benefit these 120,000

to 140,000 accounting firm professional

employees and their families by

enabling them to invest in some public

companies in which, under the current

rules, they cannot invest without

impairing the independence of the

companies’ auditors. In addition, under

these amendments, audit clients and

their affiliates may, in certain

circumstances, employ family members

of some audit firm employees without

impairing the auditor’s independence.

Expanding the set of investment

opportunities available to auditors and

their family members may increase the

return they can earn on their

investments and improve their ability to

reduce risk through diversification.

Opening employment opportunities to

auditors and their family members

increases their freedom of choice with

respect to their employment

opportunities and may lead to an

increase in their compensation.

Consequently, the amendments have the

potential to improve the pecuniary and

non-pecuniary benefits of employment.

These benefits may make accounting

firms more appealing as a career choice,

and as a result may aid the firms in their

recruiting efforts.526

In addition, independence

requirements are found in various

Commission rules, Commission

interpretations, staff letters and reports,

and, in some cases, AICPA literature.

The final rule puts this guidance in an

easily accessible format that will save

interested parties costs in ascertaining

and complying with the rule.

Finally, the rule provides that an

accounting firm’s independence will not

be impaired solely because a covered

person inadvertently fails to comply

with the independence rules if the firm

has adequate independence quality

controls in place. This limited exception

should provide a benefit to accounting

firms and their employees.

2. Costs

Modification of the investment and

employment restrictions may require

accounting firms, their employees, or

others to incur transaction costs, such as

one-time costs to modify existing

systems that monitor investments and

employment relationships, and training

Federal Register / Vol. 65, No. 234 / Tuesday, December 5, 2000 / Rules and Regulations 76065

527See Rule 2–01(e)(1)(ii).

528The rules we adopt today are slightly more

restrictive than current rules with respect to certain

financial interests—such as credit cards and bank

accounts—and employment relationships as they

relate to covered persons on the audit engagement

team. We do not anticipate that these changes will

impose significant costs.

529Other public accounting firms would have the

flexibility to adopt a system to comply with the

requirement in light of the nature and size of their

practice. See SAS No. 25, AU §161.03. This is in

general conformity with GAAS, which states, ‘‘The

nature and extent of a firm’s quality control policies

and procedures depend on factors such as its size,

the degree of operating autonomy allowed its

personnel and its practice offices, the nature of its

practice, its organization, and appropriate costbenefit considerations.’’ See SAS No. 25, AU

§161.02.

530Because the threshold for the limited

exception is based on the number of audit clients

rather than professionals, certain middle-tier firms,

if they grow, may meet the threshold earlier than

they would under current SECPS requirements. See

SECPS Manual §1000.46. We note that our rule

does not require implementation of these systems,

but rather leaves it to the discretion of the firm.

531SAS No. 25, AU §161 n.1.

532AICPA Professional Standards: SQCS, QC

§20.09.

533See ‘‘International Accounting Standards,’’

Securities Act Rel. No. 7801 (Feb. 16, 2000) [65 FR

8,896]; Form 20–F, Item 8, ‘‘Financial Information,’’

17 CFR 249.220f.

534See SECPS Manual §1000.45.

535See Letter from Michael A. Conway,

Chairman, Executive Committee, SECPS, to the

Managing Partners of SECPS Member Firms, April

2000 (available at www.aicpa.org).

536See Romac International, 1999 Salary Survey

and Career Navigator: Finance & Accounting

(1999), which reports the median national public

accounting salary to be $47,300 annually. Assuming

a 2080-hour work year, we obtain $22.75 per hour.

We increase our hourly estimate to $30 to allow for

benefits and other overhead expenses.

537See supra Sections IV.D.1, IV.D.2.

538See supra Section III.B.

costs to prepare professional staff to

understand and conform to the revised

rules. With respect to the provisions

regarding employment relationships and

investments, the rule provides a

transition period and does not cover

loan contracts, insurance products, and

employment relationships undertaken

prior to the end of this transition period.

The rule does not impose any additional

costs with respect to the separations of

former partners that have occurred prior

to the effective date of this rule. Existing

rules will apply to these partners.

During the transition period, the only

cost to separating partners and their

firms relates to the timing of the

payments made as part of the

separation.527 The new rule applies only

to those that leave the firm after the new

rule becomes effective. These

modifications of the rule from our

original proposal will reduce the costs

of implementation.528

As discussed above, the rule does not

require accounting firms to establish

quality controls that conform to the rule

requirements. In the case of the largest

firms, the rule specifies minimum

characteristics of these systems.529

Because the limited exception is

elective, any related costs will be

assumed voluntarily, if at all, by

accounting firms that decide that the

benefits of this limited exception justify

the costs of any incremental changes

that are necessary to make their quality

control systems meet the rule’s

standards.

An accounting firm that chooses to

upgrade its existing quality control

system to comply with the limited

exception should incur only the

incrementally small costs of

implementing any improvements

beyond what is required by GAAS and

SECPS membership requirements.530

GAAS already requires firms to have

quality controls for their audit practices

and refers auditors to the ‘‘Statements

on Quality Control Standards’’

(‘‘SQCS’’) for guidance regarding the

elements of those systems.531 SQCS No.

2 states that firms’ controls should

provide ‘‘reasonable assurance that

personnel maintain independence (in

fact and in appearance) in all required

circumstances, perform all professional

responsibilities with integrity, and

maintain objectivity in discharging

professional responsibilities.’’532

Because foreign accounting firms

providing assurance on financial

statements filed with the SEC are

required to adhere to GAAS, they are

also subject to these same quality

control standards.533

In addition to requirements imposed

by GAAS, public accounting firms that

are SECPS members must comply with

independence quality control

membership requirements. Further,

SECPS guidelines indicate that its

members are required to assist their

foreign associated firms to conform to

‘‘U.S. independence requirements of the

SEC and ISB, and SEC rules and

regulations in areas where such rules

and regulations are pertinent.’’534

Among other things, member firms with

at least 7,500 professionals must

implement an electronic tracking system

by no later than December 31, 2000.535

The final rule supplements the GAAS

requirement for firms with more than

500 SEC registrants as audit clients by

identifying procedures that should be

part of their quality control systems.

Because an accounting firm with 500

SEC registrants will likely also meet the

SECPS’ 7,500 professionals requirement,

the rule is unlikely to impose a

requirement for quality controls that

does not already exist under GAAS and

SECPS membership requirements.

In the Proposing Release, we asked for

comments and data on the assessment of

potential costs associated with the

proposed quality control provision, but

no commenter provided specific or

empirical data on this issue. We expect

the costs associated with the

implementation of an amended quality

control system to be small. Firms may

choose to maintain the current

restrictions if they determine that the

costs of establishing the new system

exceed the benefits. We nevertheless

recognize that public accounting firms

and their employees will require some

time to familiarize themselves with, and

understand, the amended rule. A onehour review by each of the 120,000 to

140,000 public accounting professionals

would result in a $3.6 million to $4.2

million one-time transition cost.536 We

include the $4.2 million in our aggregate

cost estimation. Given that accounting

firms currently engage in on-going

training relating to auditor

independence, we believe that these

transition costs likely represent an overestimation of the true cost imposed by

this rule. Further, given that the firms

must continue the educational process

regardless of the rule, we treat this as a

one-time cost.

Commenters were generally

supportive of the proposals regarding

employment relationships between and

investments by auditors or their family

members and audit clients. As

discussed above, after considering the

comments received, we are adopting the

investment and employment rules, as

modified.537

B. Costs and Benefits of Restricting

Certain Non-Audit Services

There is increasing concern that the

growth of non-audit services provided

by auditors to audit clients affects

auditor independence.538 There is also

concern that auditors’ provision of

certain non-audit services to audit

clients creates a conflict of interest that

also affects auditor independence.

These effects on auditor independence

may be costly to investors if they lead

to, among other things, a decrease in the

quality of financial reporting, lower

investor confidence, or both.

Importantly, as a result of the conflicts

created by auditors’ provision of nonaudit services, investors may lose

confidence in the quality and integrity

of financial reports even if there are

relatively few dramatic audit failures or

restatements. Given the size of U.S.

securities markets, even a small loss in

76066 Federal Register / Vol. 65, No. 234 / Tuesday, December 5, 2000 / Rules and Regulations

539 In the Proposing Release, the proscribed

services included expert witness services. Expert

witness services have been removed from the list

of services that are per se incompatible with an

auditor’s independence.

540Under the final rule, the term ‘‘internal audit

services’’ does not include operational internal

audit services unrelated to the internal accounting

controls, financial systems, or financial statements.

Additional discussion of the impact of this

threshold appears in Section IV.D.4.b(v).

541Throughout this section we round percentages

to one decimal place. As a result some percentage

combinations, when relevant, will not add to

exactly 100.

542Our purpose in using these data is to estimate

the association between company size and the

auditors classified as Big Five, second tier and

smaller accounting firms. The Compustat Database

has two limitations for purposes of this estimate.

First, the Compustat Database does not include all

companies filing with the SEC. Second, we note

that Compustat includes American Depository

Receipts (ADRs). Some of the companies issuing

ADRs and included on Compustat may not be

required to file audited financial statements with

the SEC. The data include 499 non-bank filers who

issue ADRs; 405 are for companies with $200

million or more of assets; and 94 are companies

with less than $200 million in assets. Only 57 of

these ADR issuers are not audited by Big Five

accounting firms.

The data also include 22 bank holding companies

with $200 million or more of assets that have issued

ADRs. The database contains information on

approximately 9,414 registered companies

including bank holding companies. Compustat

applies set criteria for adding companies to the

database. The criteria vary depending upon whether

a company is domiciled in the U.S., Canada or

abroad. The net effect of these criteria is that

Compustat is heavily weighted toward larger

companies, particularly, larger North American

companies. If these criteria have the effect of

excluding smaller companies that may have assets

of less than $200 million, this analysis will

overstate the proportion of companies that will be

affected by the rule and the impact of the rule on

smaller companies. See Compustat Database,

October 31, 2000.

543The average revenue of companies with assets

of $195—$205 million is $209 million.

544See Testimony of Paul Volcker, former

Chairman, Board of Governors of the Federal

Reserve System (Sept. 13, 2000) (‘‘I know that when

. . . I was Chairman, there was still a question of

whether banks had to be audited, and they are, of

course, examined and many of the banks complain

that it would be very costly and they didn’t have

the resources for decent internal auditing efforts.

. . .’’); see also Testimony of Laurence H. Meyer,

Governor, Board of Governors of the Federal

Reserve System (Sept. 13, 2000); Testimony of John

D. Hawke, Jr., Comptroller of the Currency (July 26,

2000). Both indicated that their respective

organizations have been concerned about internal

investor confidence has large wealth

consequences for investors.

After careful consideration of the

testimony from four days of public

hearings and a review of the almost

3,000 comment letters received by the

Commission, we have narrowed the

scope of our proposals regarding nonaudit services. In the Proposing Release,

we enumerated ten services that if

provided by the auditor to an audit

client would be considered to be, in

whole or in part, incompatible with the

concept of auditor independence. As

discussed above, in many cases we

intended our proposal to track

substantially the existing independence

requirements of the profession. In

response to commenters’ concerns that

our proposals were broader than

existing requirements, we have made

certain modifications.539 As a result of

our modifications, the language in the

adopted rule substantially mirrors or

draws from existing Commission

requirements or the professional

guidance of the AICPA and SECPS with

respect to eight non-audit services (not

including internal audit services). There

should, therefore, be minimal costs

associated with our codification of the

provisions regarding these eight

services. With respect to most

information systems consulting,

auditors may continue to provide these

services to an audit client without

impairing independence, as long as

certain conditions are met.

The final rule does impose new

limitations on auditors’ ability to

provide to audit clients internal audit

services without impairing

independence. If the accounting firm

provides both the internal and external

audit, it may, in effect, be auditing its

own work. In this situation, the firm

cannot, in our view, provide a truly

independent ‘‘second opinion.’’ Without

a truly independent second opinion,

material defects in the accounting

system may not be detected as quickly,

if at all. Final Rule 2–01(c)(4)(iv) seeks

to curb these conflicting interests

without precluding companies,

particularly small companies, from

obtaining internal audit services from

their auditors where the auditor’s

independence would not be

compromised.

Under the final rule, accounting firms

may provide all internal audit services

to audit clients with assets of $200

million or less, provided certain

conditions are met. In addition,

accounting firms may provide up to

forty percent of the internal audit

services of issuers with assets in excess

of $200 million, provided the same

conditions are met.540 These conditions

are intended to create circumstances in

which the auditor can continue to

exercise objective and impartial

judgment, and the audit retains its value

as a ‘‘second opinion.’’

Relative to the Proposing Release, the

$200 million threshold in the internal

audit provision minimizes the aggregate

costs associated with the rule without

substantially reducing the benefits of

greater investor confidence in audited

financial statements. In addition, the

$200 million threshold in the internal

audit provision minimizes the impact of

the provision on smaller companies and

smaller accounting firms.

The available data indicate that most

SEC registrants are audited by one of the

largest accounting firms, sing 1999

SECPS data, we identified 16,653

registrants who filed audited company

financial statements with the

Commission.541 Of those 16,653

registrants, the Big Five accounting

firms audit 12,769 (76.7%) of these

companies; the next three largest firms

(referred to as the ‘‘second tier firms’’)

audit 942 (5.7%); the next 20 largest

accounting firms audit 730 (4.4%); and

the remaining 2,212 (13.3%) companies

are audited by smaller accounting firms.

In order to estimate the impact of the

rule on small companies and small

accounting firms, we used the

Compustat Database.542 Our analysis

indicates that of the 9,414 Compustat

covered companies, 4,326 (46%) have

assets of $200 million or more and will

be covered by the limitation, whereas

5,088 (54.1%) have assets of less than

$200 million 543 and will not be covered

by the rule. By excluding companies

with less than $200 million in assets

from application of the new limitation

on these non-audit services for audit

clients, the final rule permits, subject to

certain conditions, large and small

accounting firms to accept consulting

engagements with these small

companies that would otherwise be

prohibited.

The Compustat Database includes

8,732 non-bank companies: 3,735

(42.8%) have assets of $200 million or

more, and 4,997 (57.2%) have assets of

$200 million or less. The Compustat

data indicate that approximately 93.9%

of non-bank companies with assets in

excess of the $200 million threshold are

audited by one of the Big Five

accounting firms. Clients of second tier

accounting firms account only for 1.3%

of this group. The database specifically

identifies 107 companies or 2.9% as

audited by other smaller accounting

firms. The remaining 71 (1.9%) large

companies were not identified with an

auditor in the database. If we include

these 71 companies with the 107

identified as audited by smaller

accounting firms, at most 4.8% of the

companies with assets in excess of $200

million are audited by the smaller firms

and, therefore, potentially impacted by

the provision on internal audit services.

Conversely, 85.7% of non-Big Five audit

clients have assets below $200 million.

Current and past bank regulators

expressed concern about the effect of

our internal audit proposal on smaller

banks serving smaller communities.544

Federal Register / Vol. 65, No. 234 / Tuesday, December 5, 2000 / Rules and Regulations 76067

audit outsourcing for some time. Neither

organization has placed an absolute ban on internal

audit outsourcing. However, both have provided

guidance on the manner in which internal audit

outsourcing is to be handled.

545Professional staff of the Office of the Chief

Accountant obtained the names of bank holding

company auditors by searching Commission 10–K

filings contained in EDGAR. 10KWizard was

utilized to search the EDGAR database.

546Only ten of the 91 bank companies with less

than $200 million in assets were located in one of

the top 35 U.S. cities by population. See Compustat

Database, October 31, 2000.

547The Institute of Internal Auditors (‘‘IIA’’)

Global Auditing Information Network (‘‘GAIN’’)

cited by Larry E. Rittenberg and Mark A. Covaleski

in their monograph, The Outsourcing Dilemma:

What’s Best for Internal Auditing for IIA (1997)

(‘‘Rittenberg’’) and Manufacturers Alliance, Survey

of General Audit (2000) generally include large

companies. According to Rittenberg, companies

included in the IIA GAIN study are large, increasing

the probability that the GAIN companies are Big

Five clients. Only two of the companies responding

to the Manufacturers Alliance survey used

accounting firms other than a Big Five firm as the

primary external auditor. The Alliance survey

reported a ten percentage point increase in the

outsourcing of general audit tasks to the primary

external auditor between 1995 and 2000. Of the

companies using Big Five firms as their primary

auditor, 42.5% indicated that they outsourced

general audit work to their primary auditor. The

survey also indicates that the portion of general

audit needs that is outsourced remains fairly small,

at less than 5% for 72.9% of the respondents.

548As noted above, our definition of internal

audit is narrower than that used by Rittenberg and

Covaleski.

549Rittenberg and Covaleski provide data that

allows us to estimate the potential impact of the

40% limitation included in the rule. The Table

below uses the information above to estimate the

internal audit outsourcing and extended audit

services that the external auditor can perform for

the SEC registrant audit clients after the new rule

is in effect. According to the IIA GAIN information

in 1995 studied by Rittenberg and Covaleski, 35%

of internal audit activities were classified as

‘‘operational.’’ These activities can be fully

outsourced under the rule. The remaining services

were classified as follows: 17% compliance audit;

14% information systems; 26% financial audits; 8%

other (unspecified). The rule will allow 40% of

these services to be outsourced. Accordingly, under

the rule, 61% of internal audit services could be

outsourced.

In addition, the Manufacturers Alliance

conducted its Survey of General Audit, 2000 and

received responses from 106 companies of which

104 were audited by Big Five firms. It asked

respondents how general audit time was allocated

and received the following response: 40.2%

control/compliance, 32.3% operational audit, 5.9%

assisting external audit, 11.0% service requests,

3.4% M&A work and 7.1% other activities. While

the categories are generally not the same as those

used in the IIA GAIN reports, the operational audit

component in both surveys is similar. On the other

hand, control/compliance work is much higher for

the Alliance survey respondents than the

apparently similar category used in GAIN. This

might be attributed to classification problems and/

or the time period considered. However, in 1995 the

Alliance survey reported an even higher control/

compliance allocation at 46.9%. Further, the

Alliance survey does not break out IT work

specifically, making it difficult to compare the two

survey results on this dimension. Alliance survey

respondents did indicate that computer systems

oriented work was growing rapidly (33%) or

somewhat rapidly (59.4%). The Alliance survey

reported a rise from 20.0% in 1995 to 32.3% in

2000 in the operational audit category, a category

of internal auditing services not prohibited by the

rule.

550See Letters from Commissioner Isaac C. Hunt,

Jr., supra, note 212. Some commenters suggested

that by requesting data on the costs and benefits of

the rule, we asked the public to shoulder a burden

rightfully belonging to the regulator. See, e.g.,

Arthur Andersen Letter. We do not suggest that any

party was obligated to provide data in response to

our requests for comments. On the other hand,

where data are exclusively under the control of

commenters, our rules cannot be criticized for any

failure to take into account data to which we do not

have access. Wherever possible, we relied on

information supplied by interested parties and

other public sources of information. 551See Letter of Kim Johnson, General Counsel,

The Public Employees Retirement Association of

Colorado (September 1, 2000); Testimony of Allen

Cleveland, New Hampshire Retirement System

(Sept. 13, 2000); Testimony of John Biggs,

Chairman, President and CEO of TIAA-CREF (July

26, 2000). 552See Testimony of Kayla Gillan, General

Counsel, CalPERS (Sept. 13, 2000). 553See Testimony of Jay Eisenhofer, Partner,

Grant & Eisenhofer (Sept. 13, 2000) (‘‘Your rule, I

believe, will cut down on fraud, cut down on

auditor self-interest, and increase the reliability of

financial statements.’’).

The $200 million threshold is designed

to limit the impact of the rule to larger,

national banks. The Compustat Database

included 682 bank holding companies.

Of these, 591 (86.7%) have assets of

$200 million or more and 91 (13.3%)

have assets of less than $200 million.

Big Five accounting firms audit 382

(64.6%) of the large bank holding

companies. The next three largest

(second tier) firms audit 31 (5.2%) of the

large bank holding companies.

Compustat specifically identified 116

(19.6%) as audited by other accounting

firms. The data source did not identify

an auditor for the remaining 62 (10.5%)

companies.545 The $200 million

exemption permits the 91 smaller bank

holding companies, likely to serve

smaller communities,546 to obtain from

their auditors internal audit services.

Accordingly, as adopted, the rule

should not impose a substantial burden

on these institutions and the

communities they serve. Further, the

Compustat criteria for inclusion in the

database may understate the population

of smaller bank holding companies.

Evidence suggests that internal audit

outsourcing is provided primarily by the

largest of the public accounting firms.547

Under the adopted rule, auditors will

still be able to provide internal audit

services.548 We estimate that the auditor

could still provide on average as much

as sixty-one percent of a company’s

internal audit activity, including

internal audit activities not covered by

the rule.549

The effect of the rule changes

pertaining to internal audit outsourcing

is to reduce the costs associated with

the final rule without substantially

reducing the benefits. To the extent that

the final rule, taken as a whole,

maintains or increases investors’

confidence in the reliability of publicly

available financial information, it

increases the integrity of the U.S.

securities markets. In the Proposing

Release, we asked for comments and

data on the assessment of costs

associated with internal audit

outsourcing and information systems

consulting. While the staff garnered and

analyzed data where it could, we

received little data from public

commenters that could be used in our

analysis.550

1. Benefits

Benefits are expected to accrue to

investors, issuers, providers of

management consulting services, and

public accounting firms. Benefits

include:

• Greater confidence in auditor

independence and increased reliability

of financial statements to investors,

issuers and other users;

• Centralizing and codifying of the

independence rules; and

• Better operational and investment

decisions.

a. Investors. For the reasons explained

in this release, the Commission believes

that the rule will enhance auditor

independence. This should result in

improved reliability, credibility, and

quality of financial statements of public

companies. Quality financial statements

depend on subtle choices and

judgments in reflecting economic events

using accounting numbers. Quality

financial statements also depend upon

highly competent and independent

auditors. Investors rely on quality

financial statements in order to invest

their funds effectively and efficiently.

Therefore, the more confidence

investors have in the independence of

the auditor, the more reliance they will

place on the financial statements when

making investment decisions.

Several representatives of the largest

institutional investors in the country

testified that this rule would enhance

auditor independence, bolster

institutional and individual investor

confidence, and benefit their plan

participants.551 One institutional

investor associated poor performance

with poor quality financial reporting

and ‘‘a seemingly meek auditor.’’552 In

a similar vein, another commenter

asserted that the rule will increase

auditor independence and this, in turn,

may reduce the incidence of fraud or

lead to its more timely discovery.553

Some commenters suggested that

there is no empirical evidence that

76068 Federal Register / Vol. 65, No. 234 / Tuesday, December 5, 2000 / Rules and Regulations

554See, e.g., KPMG Letter.

555See, e.g., Arthur Andersen Letter.

556See, e.g., Deloitte & Touche Letter.

557See, e.g., Testimony of Douglas Scrivner,

General Counsel, Andersen Consulting (Sept. 20,

2000) (‘‘It is important to note that audit firms do

not provide consulting services to improve the

quality of the audits, but rather for commercial

considerations. A then CEO of one of the Big Five

audit firms was quoted recently in Business Week

saying ‘If I had to trade an auditing account for

other business, I would do it.’ ’’).

558 Despite the mixed academic results and the

difficulties in preparing unbiased survey results, it

is clear that the perception of auditor independence

is important to financial statement users and can be

affected negatively by the extent and type of nonaudit services provided by the auditor to audit

clients.

Perception is difficult to establish definitively. A

number of academics have provided evidence that

perceptions are affected by the mix of audit and

non-audit services provided to audit clients. The

academic evidence is mixed and subject to

alternative interpretation. Selected papers by

academics include: M. Firth, ‘‘Perceptions of

Auditor Independence and Official Ethical

Guidelines,’’ 55 Acct. Rev., at 451–466 (July 1980)

(‘‘Firth’’); R.A. Shockley, ‘‘Perceptions of Auditors’

Independence: An Empirical Analysis,’’ 56 Acct.

Rev., at 785–800 (October 1981) (‘‘Shockley’’); D.J.

Lowe and K. Pany, ‘‘CPA Performance of Consulting

Engagements with Audit Clients: Effects on

Financial Statement Users’ Perception and

Decisions,’’ 14 Auditing: J. of Prac. & Theory, at 35–

53 (Fall 1995) (‘‘Lowe 1995’’); D.J. Lowe and K.

Pany, ‘‘An Examination of the Effects of Type of

Engagement Materiality, and Structure on CPA

Consulting Engagements with Audit Clients,’’ 10

Acct. Horizons, at 32–52 (December 1996) (‘‘Lowe

1996’’); J.G. Jenkins and K. Krawczyk, ‘‘Perception

of the Relationship Between Nonaudit Services and

Auditor Independence,’’ North Carolina State

University, manuscript (2000) (‘‘Jenkins &

Krawczyk’’).

Generally, Firth and Shockley found that

financial statement users are more concerned than

auditors about the independence problems

associated with matters such as incentives to retain

clients in a competitive environment and/or when

non-audit services are sold to audit clients. More

recently, Lowe (1995, 1996) found that loan officers

and financial analysts appear to perceive little or no

independence problem at low levels (1% of office

revenue) of non-audit services, but did exhibit

concern as the level of office revenues from nonaudit services rose. Jenkins & Krawczyk studied

three group’s perceptions about auditor

independence and the provision of non-audit

services to audit clients. The Jenkins and Krawczyk

study groups are Big Five CPA professionals, nonBig Five CPA professionals and a group labeled

‘‘general public,’’ composed of business

professionals and graduate business students. The

CPA professionals, particularly those associated

with the Big Five, generally felt that independence

was not threatened and in some cases might be

strengthened by the provision of non-audit services

to audit clients. The ‘‘general public’’ was generally

supportive of the provision of non-audit services,

but less so than the other two groups.

Recent surveys of a variety of financial statement

users demonstrate the existence of varying degrees

of concern for auditor independence when offering

non-audit services to audit clients. The story told

by the surveys is admittedly complex. Virtually all

of the surveys that have been submitted to the

public record (Public Opinion Strategies, Brand

Finance PLC, Earnscliffe, AIMR, Penn Schoen

Survey, and Pace University) indicate some concern

for auditor independence. The degree of concern

may be, in part, a function of the timing of the

surveys, the manner in which the subjects were

queried, and the subject sample selection.

559 Duquesne Poll, supra note 110. The surveyors

asked several related questions of the subjects. First

they asked, ‘‘And from what you’ve seen, read or

heard, do you generally favor or oppose this SEC

proposal?’’ This was immediately followed by,

‘‘And do you strongly favor/oppose or just

somewhat favor/oppose the SEC proposal.’’ In

response to this question, 30% stated that they

‘‘Strongly Favor’’ and 34% that they ‘‘Somewhat

Favor’’ the SEC proposal. The surveyors then

provided a one paragraph narrative describing the

auditor’s responsibilities with respect to fair

presentation of financial statements and a one

paragraph narrative describing the SEC concerns

about the potential conflict of interest auditors face

when selling both audit and consulting services to

the same client. The subjects were then asked to

state whether they strongly/somewhat favor/oppose

a position based on this information. At this point

49% stated that they ‘‘Strongly Favor’’ and 32%

stated that they ‘‘Somewhat Favor’’ the SEC

proposal.

560See Testimony of Mauricio Kohn, CFA, CMA,

CFM, AIMR (Sept. 20, 2000).

561See Letter of Brand Finance PLC (June 13,

2000).

562See Testimony of Rajib Doogar (Sept. 13, 2000)

(‘‘Low audit credibility, in turn, will drive up costs

of capital, affecting the well functioning of capital

markets and indeed of the US economy as a

whole.’’).

563See Letter of Charles C. Cox, Kenneth R. Cone,

and Gustavo E. Bamberger, Lexecon Inc. (Sept. 25,

2000) (‘‘Lexecon Letter’’).

564See, e.g., M.C. Jensen and W.H. Meckling,

‘‘Theory of the Firm: Managerial Behavior, Agency

Costs and Ownership Structure,’’ 3 J. of Fin Econ,

at 305–360 (1976); A.A. Alchian and H. Demsetz,

‘‘Production, Information Costs, and Economic

Organization,’’ 62 Am. Econ. Rev., at 777–795

(1972). This agency conflict grows out of the

inability of investors to perfectly control by contract

managers’ behavior. The problem is exacerbated if

investors cannot monitor management’s choices.

shows that the provision of non-audit

services damages investors’ confidence

in the independence of auditors or the

accuracy of financial statements.554

Commenters suggested that there is,

therefore, no basis for our assertion that

the rule will benefit investors.555 One

such commenter suggested that the rule

might, in fact, decrease investor

confidence. This commenter argued that

investors believe that the rule may

decrease the quality of audits because

auditors will know less about the

companies they audit.556 However,

other commenters suggested that

providing consulting services does not

improve the quality of audits.557 There

is also academic and survey evidence

that users of financial statements believe

that the provision of non-audit services

may impair the auditor’s

independence.558 A public opinion poll

conducted by Public Opinion Strategies

found that approximately eighty percent

of investors favor a rule that imposes

such restrictions.559 Another survey,

conducted by AIMR, reported that over

sixty-two percent of responding analysts

believe that providing outsourcing

services would likely compromise or

impair auditor judgment.560 Brand

Finance, in a survey of U.K. analysts,

found that ninety-four percent of

respondents believed that the current

level of non-audit service fees was likely

to compromise auditor

independence.561

b. Issuers. Issuers will benefit from

the proposed scope of services

regulations in several respects. First, the

rule will eliminate some of the

uncertainties as to when a registrant’s

auditor will not be recognized as

independent. Second, since increased

investor confidence in financial

reporting may encourage investment,

the rule would facilitate capital

formation. Issuers should be able to

attract capital at lower rates of return or

in some circumstances attract

investment where they currently cannot

raise capital.562 Third, the rule will

increase the utility of annual audits to

the management of issuers.

Management of the issuer also

receives benefits from the external

audit. No less than other investors,

managers need reliable financial

information about potential investment

opportunities in order to manage their

firm’s assets. Internally, managers need

assurance of the effective functioning of

the control and reporting systems that

produce the information on which they

base their operating decisions. While

company managers may obtain the

needed assurances through internal

processes, including internal audit

groups, the external auditor also

contributes to the company managers’

assurance that the company’s internal

control processes are functioning

effectively and that financial and other

data are reliable.

One commenter asserted that to the

extent an issuer perceived that buying

non-audit services from its auditor

increased its cost of capital to such an

extent that it outweighed the benefits of

purchasing non-audit services, it could

protect itself by limiting the amount and

types of non-audit services it purchased

from its auditor.563 This argument may

not fully capture the incentives of

management or the issuer, however.

Academic literature describes how

managers’ incentives can deviate from

those of investors.564 For example, a

company manager may have a family or

financial relationship with the auditor

and may benefit from a lack of complete

independence from the company’s

auditor. It is difficult for the company

to credibly pre-commit to restricting the

purchase of non-audit services from the

auditor. Further, managers rely on

auditors that may be unaware that they

are subject to subtle biases that may

Federal Register / Vol. 65, No. 234 / Tuesday, December 5, 2000 / Rules and Regulations 76069

565See M.H. Bazerman, K.P. Morgan, and G.F.

Loewenstein, ‘‘The Impossibility of Auditor

Independence,’’ 38 Sloan Mgt. Rev. 89–94 (Summer

1997); Testimony of Professor Max H. Bazerman,

Northwestern University (July 26, 2000); Testimony

of Professor George F. Loewenstein, Carnegie

Mellon Institute (July 26, 2000); J.D. Beeler and J.E.

Hunton, ‘‘Contingent Economic Rents: Insidious

Threats to Auditor Independence,’’ manuscript

(2000); G. Trompeter, ‘‘The Effect of Partner

Compensation Schemes and Generally Accepted

Accounting Principles on Audit Partner Judgment,’’

13 Auditing: J. Prac. & Theory, at 56–68 (Fall 1994).

Trompeter provides experimental evidence that

compensation schemes can influence subject

judgments. Trompeter finds that auditors whose

rewards are based on local office revenues have a

tendency to support management views more often

than if their rewards are computed on the broader

firm revenue base. In the latter case, loss of a local

client does not necessarily lead to substantial

individual reward losses. Trompeter addresses the

incentives issue, one of the complex issues possibly

leading to subtle biases in judgment. His results

suggest a self-serving bias effects judgment. But see

Testimony of Professor Urton Anderson, University

of Texas (Sept. 21, 2000) and Professor Don N.

Kleinmuntz, University of Illinois at UrbanaChampaign (Sept. 21, 2000) for arguments that the

self-serving bias is overcome in practice by a variety

of behavioral and institutional factors. See R.R.

King, ‘‘An Experimental Investigation of SelfServing Biases in an Auditing Trust Game,’’

manuscript (2000).

566See AICPA Practice Aid Series, Make Audits

Pay: Leveraging the Audit into Consulting Services

(1999). Furthermore, as a result of the rule, issuers

may avoid marketing pressure from their auditors

to purchase certain non-audit services.

567See Testimony of John C. Whitehead, retired

Chairman, Goldman Sachs & Co. (Sept. 13, 2000).

568See Testimony of D. Bevis Longstreth, former

SEC Commissioner and Member of the O’Malley

Panel (Sept. 13, 2000).

569See, e.g., Lexecon Letter.

570See, e.g., Deloitte & Touche Letter.

571See, e.g., KPMG Letter. See supra Section

III.C.4, for a discussion of this comment. But see

Testimony of J. Michael Cook, former Chairman and

Chief Executive Officer, Deloitte & Touche (July 26,

2000) (‘‘I agree with the Commission that the

absence of ‘proof’ does not justify inaction,

particularly when such evidence cannot be

expected to be demonstrable.’’).

572See, e.g., Testimony of Richard Blumenthal,

Attorney General, State of Connecticut (Sept. 20,

2000); Testimony of Robert Morgenthau, District

Attorney for the County of New York (Sept. 13,

2000); Testimony of Charles R. Drott (Sept. 13,

2000).

573See, e.g., Lexecon Letter.

574See, e.g., Lexecon Letter. The authors cite two

studies that find accounting firms face significant

costs when government regulators criticize auditors:

M. Firth, ‘‘Auditor Reputation: The Impact of

Critical Reports Issued by Government Inspectors,’’

21 Rand J. of Econ., at 374–387 (Autumn 1990) and

L. R. Davis and D. T. Simon, ‘‘The Impact of SEC

Disciplinary Actions on Audit Fees,’’ 11 Auditing:

J. of Prac. & Theory, at 58–68 (Spring 1992). In the

former study, the loss of reputation in the U.K.

manifested itself in lower market share for the

largest accounting firms, while in the latter loss of

reputation was related to a reduction in audit fees.

We note that in both studies governmental oversight

was responsible for making public the improper

auditor behavior. It is not clear from this research

that other economic forces were (or are) sufficiently

strong to impose the costs to loss of reputation.

575See, e.g., Lexecon Letter.

576See Lexecon Letter for a discussion and

bibliography on this point.

577See SECPS Manual §1000.45 (April 2000).

578See, e.g., Testimony of Dennis Paul Spackman,

Chairman, National Association of State Boards of

Accountancy (Sept. 13, 2000); Testimony of Paul

Volcker, former Chairman, Board of Governors of

the Federal Reserve System (Sept. 13, 2000).

579See Testimony of Rajib Doogar (Sept. 13,

2000).

580See, e.g., Lexecon Letter.

affect their judgments.565 Finally,

management may be frequently

marketed to by its auditor to purchase

non-audit services.566

Although the decision of an

individual company to purchase

services from the auditor may be in the

best interest of the company’s investors,

it may not be in the interest of investors

in all companies as a whole. If decisions

by individual company management

reduce the reliability of audited

financial statements as a whole,

aggregate investment may be

misallocated even if any individual

company is acting in the best interest of

its shareholders. It is unlikely that such

concerns would enter into the company

manager’s choice of service provider

even if it were a logical consequence of

that choice.

Audit committees will also have more

concise and clearer guidance to support

their enhanced role in overseeing the

management/auditor relationship. The

amendments to the proxy rules require

disclosure of whether the audit

committee, or the board of directors if

there is no such committee, considered

whether the provision of non-audit

services by the company’s principal

accountant is compatible with

maintaining the principal accountant’s

independence. Several commenters

stated that the rule enhances the ability

of the audit committee to identify

situations in which auditor

independence may be impaired. For

example, the Co-Chairman of the Blue

Ribbon Committee stated that he

thought that ‘‘[this rule] would help

audit committees do their job better.’’567

Another commenter argued that without

this guidance audit committees must

rely primarily on auditors to determine

their own independence.568

c. Public Accounting Firms. The rule

provides a general test for, and a list of,

non-audit services that, when provided

to an audit client, will impair an

auditor’s independence. Currently,

auditor independence requirements are

found in several sources, including

AICPA guidance, the Codification on

Financial Reporting, SECPS rules, and a

variety of Commission interpretive

releases and staff no-action letters.

Consolidating many of these

requirements into one rule is an

important purpose and benefit to this

rule.

Some commenters disagreed that this

rule would clarify independence

requirements for public accounting

firms.569 These commenters argued that

the rule creates confusion and therefore

increases the amount of time that

accounting firms, and others, will need

to spend on compliance.570 We disagree.

As discussed above, in response to

comments, we have made significant

modifications that clarify the rule’s

requirements. We realize that any rule

inevitably requires some interpretation.

We believe that, as modified, this rule

will centralize and clarify independence

requirements and thus result in

increased certainty, resulting in a

benefit to public accounting firms.

Some commenters have argued that

no benefits at all will be created by the

rule. The basic argument is that no

tangible evidence exists that

independence has been impaired by

provision of these non-audit services to

audit clients.571 In testimony, however,

several individuals recounted litigation

experiences and discussed cases in

which they believed that a lack of

independence contributed to an audit

failure and financial reporting fraud.572

Others have argued that economic

forces provide sufficient incentives to

audit firms to ensure independence.573

According to one such commenter,

auditors lose market share when their

reputations are damaged, either as a

result of government action or private

litigation.574

Commenters also suggested that

auditors already have strong incentives

to maintain their reputations.575 The

auditor’s reputation is based on the

public’s belief in the auditor’s

objectivity and competence. The actual

or perceived loss of either objectivity or

competence can be expected to affect

negatively the auditor’s ability to obtain

and retain clients.576 We also note that

the SECPS mandates certain quality

controls designed to support auditors’

self-monitoring.577 However, evidence

suggests that these mechanisms may not

be sufficient.578 One commenter

concluded, based on a model of the

auditor’s incentives to maintain

independence, that under certain

circumstances when an auditor can

command sufficiently high benefits

from the mix of services, audit

credibility may be diminished.579

Some commenters have suggested that

litigation acts as an incentive for the

auditor to maintain independence.580

Conversely, another commenter noted

that the expected cost of an auditor’s

76070 Federal Register / Vol. 65, No. 234 / Tuesday, December 5, 2000 / Rules and Regulations

581See Testimony of Professor John C. Coffee, Jr.,

Columbia University (July 26, 2000).

582This effect can be observed in a simple present

value calculation. Assuming future cash flows of

$100 per period and a discount rate or required rate

of return of 10%, the present value of the cash flows

in perpetuity is $1,000. If the discount rate is

reduced to 9%, a 10% change in the discount rate,

the present value of the future cash flows is $1,111,

an 11% change in the present value. This analysis

ignores the possibility that a decrease in the

discount rate can change the investment

opportunity set and increase the per-period cash

flows.

583While we recognize that the set of firms that

may purchase such services may change from year

to year, we have received no evidence to suggest

that the fraction of companies that may actually

purchase such services in any given year is different

from our estimate.

584See GAO Report. Appendix B of the Proposing

Release, Table 4 provides a 1999 comparable figure

of 76.68%.

585See Compustat Database (October 31, 2000).

586This calculation is based on the aggregate

value of U.S. equities markets of $16.1 trillion as

of September 29, 2000 as reported by Wilshire

Associates and an additional $4.3 trillion in

corporate debt outstanding issued by U.S. firms as

of June 30, 2000 as reported by the Board of

Governors of the Federal Reserve. Therefore the

aggregate value of outstanding debt and equity

securities is $20.4 trillion.

587See ‘‘Accounting Wars,’’ Bus. Wk., at 156–168

(Sept. 25, 2000).

588See Testimony of Bill Patterson, Director,

Office of Investments, AFL-CIO (Sept. 20, 2000)

(‘‘Now, the individual investor, I think their interest

in the process is really catalyzed again around these

high profile irregularities like Cendant, Sunbeam,

Lucent, and Waste Management. I think these are

warning shots to investors that this is a problem

that has to be addressed.’’).

589See Testimony of Frank Torres, Consumers

Union (Sept. 20, 2000) (‘‘I think American

consumers, from my experience, don’t like the idea

that they might get had.’’).

590See, e.g., Letter of Jack Ciesielski, accounting

analyst (July 14, 2000); Letter of William V. Allen,

Jr. (Aug. 22, 2000); Testimony of John Biggs,

Chairman and CEO of TIAA–CREF (July 26, 2000);

Testimony of Kayla J. Gillan, General Counsel,

CalPERS (Sept. 13, 2000) (‘‘A clear, simple and

loss of independence due to litigation

declined in recent years with the

passage of the Private Securities

Litigation Reform Act of 1995.581

d. Estimation of Benefits of Restricting

Certain Non-Audit Services. The

primary benefit of this rule is increased

investor confidence in reported

financial statements. This benefit is

spread across all market participants

and may manifest itself in changes in

the investment patterns of individuals

and the borrowing costs of businesses.

Given the sheer magnitude of the U.S.

financial system, even a small change in

investor confidence manifests itself as a

large aggregate benefit.

If we measure the increase in investor

confidence by a decrease in the required

rate of return on an investment, it would

lead to increased profitability for

investment opportunities. As a result,

the change in investor confidence may

manifest itself in a revaluation of

current securities prices. Everyone in

the market benefits from this change in

confidence because all participants can

potentially take advantage of the

increased investment opportunities. All

individual investors benefit from the

general increase in market values while

businesses benefit in reconsidering their

investment opportunities within their

existing budget constraints and when

seeking additional capital from the

market. The market revaluation will be

the result of many forces, but should be

greater than the change in the required

rate of return on a percentage basis

simply because of the mathematical

relationship between cash flows,

interest rates and securities values.582

Not all market participants may

benefit equally. The extent of individual

and business benefit depends upon their

current resources and assets,

investments and investment

opportunities. It is not clear whether

these conditions would reduce the

aggregate economic benefit. Because we

cannot observe the distribution of

benefits to individuals and businesses,

we assume for the purposes of this

estimate that benefits accrue primarily

to those affected directly by all parts of

the rule. This group includes businesses

(and investors in those businesses) that

will benefit from the increased

confidence.

To obtain an estimate of the number

of individuals and businesses that may

benefit, we note that, in any given year,

approximately 74.3% of companies

purchase only auditing services from

their Big Five auditor.583 SECPS data

further indicate that consulting

revenues from SEC clients amount to

22.8% of the Big Five firms’ total

consulting revenues. It may be

reasonable, therefore, to estimate that

only twenty-five percent of audit clients

will be directly affected by the rule.

However, the Big Five accounting

firms provide audit and consulting

services to the largest companies listed

on the stock exchanges. According to a

1996 GAO report, the then largest six

accounting firms audited seventy-eight

percent of the nation’s publicly traded

companies.584 Approximately ninety

percent of all companies with more than

$200 million in assets are audited by

one of these five firms.585 Therefore it

is likely that the proportional value of

the benefits will be significantly greater

than twenty-five percent.

If an increase in investor confidence

generated by these rules leads to a

decrease in the required rate of return,

we can estimate the benefits based on

the current market capitalization. For

example, a decrease in the cost of

capital as small as a single basis point

(or one one-hundredth of one percent)

would lead to an aggregate annual

impact of approximately $2 billion.586

Although increased confidence should

benefit the entire market, we provide an

estimate that limits the benefit to those

directly affected by the rule. Even if we

measure the impact on the basis of the

proportion of companies that annually

purchase services covered by the rule

(25%), a one basis point reduction in

the required rate of return would result

in an annual benefit of approximately

$500 million.

Benefits may also accrue to the

economy in the form of more efficient

contracting, improvements in operating

and investing decisions by management,

and greater market stability. Each of

these benefits is extremely difficult to

measure. We know that many parties to

contracts rely on financial statement

data, management relies on such data

when negotiating contracts, and reliable

financial data contributes to both the

efficiency of contracting and the

effectiveness of contract enforcement.

Management needs reliable financial

information when making operational

and investment decisions, and external

auditors contribute to management’s

assurance about financial information.

Unexpected financial statement

restatements result in large market

capitalization drops. Recent examples of

large unexpected financial reports

restatements and resulting market

capitalization losses have been

reported.587 The logical consequence of

such market surprises, in addition to the

redistribution of gains and losses across

investors, is greater uncertainty in the

market place.588 The resulting

uncertainty may dissuade investors

from participating 589 or may increase

the required rate of return as a means of

ensuring against the uncertainty. We

make no separate estimate of benefits for

the above noted items.

We recognize the difficulty in

obtaining direct measures of all the

benefits associated with each aspect of

the rule to each individual or group.

Therefore, in this section, we limited

our estimate to the broad economic

impact on the capital markets that

affects all participants.

2. Costs

Some commenters suggested that the

only way to ensure that the provision of

certain services does not impair auditor

independence is to completely prohibit

the purchasing of those services from

the auditor.590 We do not believe that

Federal Register / Vol. 65, No. 234 / Tuesday, December 5, 2000 / Rules and Regulations 76071

bright line [prohibition] standard will avoid this

tendency [toward creative ways to avoid the rule],

and moreover, I have not heard anyone suggest that

there is an absence of qualified and cost effective

alternatives to the auditor performing nonaudit

consulting services to the same client.’’).

591See, e.g., Lexecon Letter.

592Some commenters suggested that the rule

would impose additional costs on small businesses

and accounting firms. The impact of the rule on

small entities is discussed below in Section VI.

593See, e.g., Arthur Andersen Letter; Deloitte &

Touche Letter.

594See Manufacturers Alliance, Survey of General

Audits (2000). In a survey of its members, the

Alliance found that just less than 96% of

respondents outsourced less than 35% of the

internal audit. This amount is within the 40%

threshold allowed by the rule.

595Memorandum to File No. S7–13–00

(September 23, 2000).

596See Testimony of William D. Travis, Managing

Partner, McGladrey and Pullen, LLP (Sept. 20,

2000). According to Mr. Travis’ testimony, 85% of

McGladrey and Pullen LLP’s total revenues are

attributable to accounting, auditing and tax.

Therefore, only 15% is attributable to all consulting

engagements. In addition the testimony indicates

that approximately 50% of the firm’s accounting

and tax clients purchase audit services and that

only 15% of its client base is made up of public

companies. Mr. Travis also notes elsewhere in his

testimony that ‘‘[t]he IT practice [] was part of what

was sold to an affiliate of Block, so the consulting

practice is owned entirely by Block.’’ See also

Compustat Database, October 31, 2000. Compustat

lists only five companies with assets of $200

million or more as audited by McGladrey and

Pullen, LLP.

597Two studies in the 1980s documented that

audit fees were generally greater, after controlling

for other factors, for clients that also purchased

non-audit services from the same public accounting

firm. See Z. V. Palmrose, ‘‘The effect of non-audit

services on the pricing of audit services,’’ 24 J. of

Acct. Res., at 405–11 (Autumn 1986); D. A.

Simunic, ‘‘Auditing, consulting, and auditor

independence,’’ 22 J. of Acct. Res., at 679–702

(Autumn 1984). Palmrose found that the positive

relationship held for both incumbent and nonincumbent auditors, suggesting that synergies may

not exist. Nevertheless, the authors of these studies

concluded that this evidence was not inconsistent

with the hypothesis that the joint provision of audit

and non-audit services may give rise to ‘‘knowledge

spillovers.’’ More recent research documents that

these higher fees are associated with increased

audit effort (in labor hours). See L. R. Davis, David

N. Ricchiute, and G. Trompeter, ‘‘Audit Effort,

Audit Fees, and the Provision of Non-audit Services

to Audit Clients,’’ 68 Acct. Rev., at 135–50 (Jan.

1993). The results of the Davis study therefore cast

further doubt on the knowledge spillover

hypothesis.

Three recent studies also address the issue of

synergies at least indirectly. See B. Arrunada, ‘‘The

Provision of Non-Audit Services by Auditors: Let

the Market Evolve and Decide,’’ 19 Intl. Rev. of Law

and Econ., at 513–31 (1999) (‘‘Arrunada’’); M.

Ezzamel, D.R. Gwilliam and K.M. Holland, ‘‘Some

Empirical Evidence from Publicly Quoted UK

Companies on the Relationship Between the Pricing

of Audit and Non-audit Services,’’ 27 Acct. and

Bus. Res., at 3–16 (1996) (‘‘Ezzamel’’); K. Pany and

P. M. J. Reckers, ‘‘Auditor Performance of MAS: A

Study of its Effects on Decisions and Perceptions,’’

Acct. Horizons, at 31–38 (June 1988) (‘‘Pany &

Reckers’’). Ezzamel in the U.K. observed a positive

relationship between audit fees and non-audit fees.

But the authors do not distinguish between

competing explanations of the observed

phenomenon. Pany & Reckers conducted an

experimental study on U.S. loan officers. They did

not find deterioration in the loan approval rate as

consulting fees increased. But they did find limited

evidence that providing MAS at a level of 90% of

audit fees for a period of three years may present

an independence perception problem among some

financial analysts. They note that in 1988, levels of

MAS fees as high as 90% of audit fees were

uncommon. Arrunada states that after examining

the effects of the provision of non-audit services on

service cost, audit competition, service quality, and

auditor independence, ‘‘[he] concludes that the

provision of non-audit services reduces total costs,

Continued

such a prohibition would serve the

investor and issuer communities.

a. Issuers. The final rule has the effect

of restricting issuers from purchasing

certain non-audit services from their

auditors. Most of the rule’s limitations,

however, are drawn from existing

limitations, including the proscription

on operating or supervising an audit

client’s information technology

function. Moreover, issuers would still

be allowed to obtain most other

information technology services and

internal audit services from their

auditor provided they comply with

certain conditions. The rule would have

the effect, however, of preventing

issuers with more than $200 million in

total assets from outsourcing more than

forty percent of certain of their internal

audit activities to their auditor.

As some commenters noted, the rule

may impose costs on some issuers.591

Issuers that do not competitively bid

non-audit services or that would have

purchased these newly proscribed nonaudit services solely from their auditors

and that are limited by the rule will

have to look to other professional

services firms, including other public

accounting firms, to provide these

services in the future. These issuers may

incur costs from the use of a separate

vendor, including the possible loss of

any synergistic benefits of having a

single provider of both audit and nonaudit services. The issuer may also

incur one-time transaction costs

associated with identifying and

choosing another vendor to provide

those services.592 Estimation of these

costs is discussed below.

Some commenters have argued that

the rule will sometimes force an audit

firm to choose between providing an

audit or non-audit service to a public

company client, and that audit firms

may forego providing audit services,

thereby reducing competition for both

audit and non-audit services.593 As to

internal audit services, in particular,

however, available evidence suggests it

is unlikely that auditors will cross the

threshold that would require them to

choose between external audit revenues

and internal audit revenues.594 Further,

it is unlikely that any individual firm

has particular exclusive expertise in the

internal audit function and therefore a

suitable number of competitors likely

exists to ensure that the issuer can

obtain these services elsewhere at a

reasonable cost.

b. Public Accounting Firms. Public

accounting firms may individually lose

a source of revenue because they will no

longer be able to sell internal audit

services to their audit clients. Any loss

may be mitigated by the opportunity to

market this service to the audit clients

of other public accounting firms. As

discussed above, the $200 million asset

exemption reduces the impact of the

rule on the Big Five and particularly on

the second tier and smaller accounting

firms.

Of the top three second-tier firms with

fewer than 1,000 clients, one firm has

stated that it does not perform internal

audit outsourcing work for its public

company audit clients.595 Another

firm’s testimony indicates that it

provides minimal proscribed non-audit

services to its public audit clients.596

Thus, it does not appear that at least two

of the next three largest firms will be

significantly affected by the rule.

c. Shared Costs. The rule might also

affect what some contend are synergies

(or ‘‘knowledge spillovers’’) that arise

from providing non-audit services to an

audit client. If they exist, spillovers may

provide issuers with a more efficient

audit or provide the auditor with

additional knowledge that will enhance

not only the concurrent audit, but other

audits as well. Since synergies may

benefit either or both parties to some

extent, we consider them a potentially

shared benefit or cost. As well, to the

extent that the proposed definition of

affiliate of the accounting firm or

affiliate of the audit client would have

reduced the market for the provision of

internal audit outsourcing, we consider

that here.

Some commenters have suggested that

the proposed rule’s definition with

respect to affiliate of the accounting firm

would be restrictive and impose

significant costs. We have not adopted

the proposed definition of an ‘‘affiliate

of the accounting firm,’’ and left in

place the existing standards for

determining those entities associated

with a firm that should be deemed to be

part of the firm for auditor

independence purposes. As such, it

imposes no additional cost.

Generally, research on enhanced

efficiency or effectiveness of providing

non-audit services to audit clients is

suggestive, but indirect and

inconclusive.597 The recent sale or

76072 Federal Register / Vol. 65, No. 234 / Tuesday, December 5, 2000 / Rules and Regulations

increases technical competence, and motivates

more intense competition. Furthermore, it does not

necessarily damage either auditor independence or

the quality of non-audit services.’’

598See Testimony of Philip A. Laskawy,

Chairman, Ernst & Young LLP (Sept. 20, 2000). Mr.

Laskawy commented on this matter as it relates to

information systems consulting: We recently sold

our practice in this area. We did so for a variety of

reasons, but one reason certainly was that although

we did not believe independence was actually

impaired by this service, we could understand that

particularly with large fees that sometimes are

involved an appearance problem could be present.

I might note that now that we have sold this

practice we have not discovered that we are

somehow enfeebled, unable to perform effective

audits or to maintain top-notch audit and tax

practices. In fact, we have found more the opposite

to be true. Without a large consulting practice to

manage we are now more targeted and more

focused on our core audit and tax business, and our

audit and tax partners feel as though they, and not

the management consultants, are in the drivers seat

at the firm. Moreover, from our clients’ perspective,

there actually may be an advantage in not having

such a practice. We have had a greater string of

wins in obtaining new audit clients since we sold

our management consulting practice than we had at

any time in recent history, four new Fortune 500

clients, including two Fortune 50 companies, just

within the last six months.

See also Testimony of James J. Schiro, Chief

Executive Officer, PricewaterhouseCoopers, before

the Panel on Audit Effectiveness (July 10, 2000)

(‘‘[Our] restructuring will allow us to rededicate

ourselves to our core principles.’’); Testimony of J.

Terry Strange, Global Managing Partner, Audit,

KPMG LLP, (July 26, 2000) (‘‘In our view, the

restructurings that are underway are driven by

market forces, not regulatory considerations.’’);

Testimony of Thomas Goodkind, CPA (Sept. 13,

2000) (responding to a question about his

experiences relating to synergies and knowledge

transfers between audit and non-audit staff,

Goodkind replied, ‘‘In my experience, a

transference of knowledge, I’ve rarely seen that in

my experience.’’); Testimony of Douglas R.

Carmichael (July 26, 2000) (‘‘The counter argument

that consulting improves audit quality is also

unproven and does not provide a basis for

eliminating the proposed restrictions.’’); Testimony

of Douglas Scrivner, General Counsel, Andersen

Consulting (Sept. 20, 2000) (‘‘It is important to note

that audit firms do not provide consulting services

to improve the quality of the audits, but rather for

commercial considerations.’’).

599See Public Accounting Report: Annual Survey

of National Accounting Firms (2000) (‘‘PAR’’). 600See Manufacturers Alliance, Survey of General

Audit (2000). We use data from table 13 and table

66 to derive this ratio. 601 Id. at table 16. 602 Id. at table 73. 603 Data are derived from PAR. The average

growth rate in non-audit service revenues in 1999

was 21% and 9% for auditing and accounting

services. Because there is uncertainty about

whether individual firms classify internal audit

outsourcing as consulting or assurance services, we

choose the larger growth rate. In the current

economy this may represent an optimistic growth

rate.

604See Testimony of Professor Rick Antle, Yale

University (July 26, 2000) (‘‘I’ll tell you now that

as far as I know there’s no systematic evidence as

to the magnitude of these economies, just none that

I know of.’’). See also Letter of Professor Rick Antle,

Yale University (Sept. 25, 2000). Professor Antle

provides analysis to estimate the aggregate cost of

lost synergies. He estimates the value of the nonaudit services as ‘‘the additional value of having the

consulting done by the audit firm.’’ He further

estimates this value at $700 million, the gross

margin attributable to all non-audit services

provided to SEC audit clients in 1999. This number

likely over-estimates the gross profits for these

services in the future for two reasons: First, it

includes revenues for non-audit services for the Big

Five firms, two or three of which have sold or are

committed to selling most of these practices.

Second, the rule does not prohibit the purchase of

all non-audit services by audit clients. In addition,

Professor Antle estimates the aggregate social

benefit of non-audit services purchased from any

provider. Because the rule does not prohibit the

purchase of any of these services, this estimate is

not relevant to the cost-benefit analysis.

605Professor Antle’s assumption about the value

of synergies to the gross profit before partner

compensation implies that the value of these

synergies is on the order of 4% of non-audit

revenues from SEC clients.

606See also Testimony of Charles Cox, Kenneth

R. Cone and Gustavo E. Bamberger, Lexecon, Inc.

(Sept. 25, 2000). These commenters also estimate

the aggregate cost of lost synergies on the order of

1%–2% of non-audit revenues from SEC clients.

607See Testimony of Stephen G. Butler, Chairman

and Chief Executive Officer, KPMG (Sept. 21, 2000).

In response to a Commissioner’s question about the

source of non-audit service revenues, Mr. Butler

commented that any statement attributing a percent

of non-audit services to SEC audit clients for his

firm would be difficult to interpret. Butler stated

that ‘‘it is difficult to look at that sort of statistic

because that’s not a constant 20% that buys that

proposed sale of the consulting

divisions of several large public

accounting firms argues against

significant knowledge spillovers. If

efficient and effective audits require

expertise most efficiently maintained

through the provision of consulting

services to audit clients, there is an

incentive to retain consulting practices.

Thus, the sale of these consulting

practices would appear inconsistent

with the existence of significant

synergies that would be negatively

affected by the rule.598

In the Proposing Release, we asked for

comment and data on our estimates of

the number of accounting firms affected

by the rule and the costs imposed by the

rule. We also sought comment and data

specifically as to the existence and

value of such synergies. We received

many comments but no data. Instead,

we estimate the potential costs

associated with the possible loss of

synergy as a percent of revenues lost

from internal audit outsourcing.

We base our cost estimates on the

total audit, accounting and tax revenues

for fiscal 1999 for the Big Five public

accounting firms.599 This estimate is

$14.9 billion. From this $14.9 billion,

we estimate the total costs of the

internal audit for Big Five audit clients

based on the relationship between

internal audit budgets and external

audit fees for firms responding to the

Manufacturers Alliance survey. On

average, firms in this sample spent 1.7

times as much on the internal audit as

they did on the external audit.600

Therefore, we estimate the aggregate

cost of internal audits for Big Five audit

clients in 1999 to be $25.6 billion.

This estimate of aggregate internal

audit costs is likely to overstate the true

costs for two reasons. First, the

aggregate revenues reported by PAR

include tax and accounting services in

addition to external audit fees. Second,

data in the Manufacturers Alliance

survey suggest that the ratio of internal

to external audit fees is smaller for

smaller companies.601 In fact, for the

smallest firms in their sample, external

audit fees exceed the internal audit

budget.

Additional information in the

Manufacturers Alliance survey indicates

that approximately two percent of

respondents outsource more than fifty

percent of their internal audit.602

Further, analysis described earlier

indicated that on average, companies

with assets greater than $200 million

could still purchase as much as sixtyone percent of their entire internal audit

budget from their external auditor.

Together, these estimates imply that at

most, the restrictions will reduce

internal audit outsourcing fees to the

auditor by 0.8%, or $207.7 million.

Finally, we apply a growth rate of

twenty-one percent to these revenues to

arrive at a year 2000 estimate of $251.3

million.603

Professor Rick Antle testified to the

effect that there is little reliable

evidence as to the size of potential

synergies from purchasing consulting

services from the audit firm, but he has

provided an estimate.604 We agree with

Professor Antle’s assessment of the

difficulties inherent in measuring these

effects. In his testimony, Professor Antle

estimated that lost synergies could be on

the order of ten percent of twice the

gross profits before partner

compensation and taxes of the

consulting practice. Further, he

estimates the gross profit margin to be

0.20.605 We acknowledge that there is

little empirical evidence to support this

estimate, but it represents the larger of

the two estimates presented by the two

representatives of the accounting

firms.606 Applying those percentages to

our estimate of revenues restricted by

the rule results in an annual estimate of

lost synergies of $10.1 million for audit

clients who will be forced to reduce

internal audit outsourcing services from

their auditors.

In addition, the rule may impose

certain transition costs to be borne by

companies that currently have long-term

consulting engagements with their

auditors for proscribed services. A

significant number of consulting

engagements are short-term projects.607

Federal Register / Vol. 65, No. 234 / Tuesday, December 5, 2000 / Rules and Regulations 76073

service from us. It might be 20% of the number of

our clients this year, it might be the same

percentage next year, but it might be a totally

different 20 percent.’’; Testimony of Robert K.

Elliott, Chairman, AICPA (Sept. 21, 2000)

(‘‘[auditing is] . . . not an annuity, [but] it is more

like an annuity than a consulting engagement

which, when it’s over, it’s over.’’).

608We assume that these costs may represent as

much as 5% of the revenues from proscribed

services purchased by each affected company. If as

many as 10% of the purchasers of proscribed

internal audit services from their auditor have

contracts in excess of eighteen months and the

entire $251.3 million represents revenues from

proscribed services, the aggregate transition costs

would be $1.3 million. Some may argue that

transition costs are substantially higher, but we note

that if transition costs are sufficiently high,

economic theory suggests the service providers

would be, on average, charging higher fees for the

same level of service to the detriment of their

clients. See, e.g., T. Nilssen, ‘‘Two Kinds of

Consumer Switching Costs,’’ 23 Rand J. of Econ., at

579–589 (Winter 1992).

609See, e.g., Arthur Andersen Letter; Deloitte &

Touche Letter.

610See, e.g., Letter of W. Steve Albrecht, Professor

and Associate Dean, Marriott School of

Management, Brigham Young University (Aug. 25,

2000); Letter of Professor James Jiambalvo,

University of Washington (Sept. 14, 2000); Written

Testimony of Professor Peter Cappelli, Wharton

School (Sept. 20, 2000).

611See, e.g., Testimony of Joseph F. Berardino,

Managing Partner, Assurance and Business

Advisory Services, Arthur Andersen (July 26, 2000);

Written Testimony of Stephen G. Butler, Chairman

and Chief Executive Officer, KPMG (Sept. 13, 2000).

612See Testimony of J. Michael Cook, former

Chairman and Chief Executive Officer, Deloitte &

Touche (July 26, 2000) (‘‘A final assertion that

quality will ultimately decline because the ‘new

audit profession’ will be unattractive to the best and

brightest people. I cannot evaluate that possibility

but would observe that the audit-dominated firms

of the future that today’s leaders express concerns

about are in many respects comparable to the firms

that attracted them (and me) to the profession

twenty or more years ago. Certainly much has

changed in that time period, but I would expect the

right leaders to be able to make such firms attractive

once again.’’).

613See Salary Survey Fall 2000, National

Association of Colleges and Employers, 2000.

Recent starting salaries for accounting graduates are

23% lower than those for information systems, 24%

for consulting and 9% for financial and treasury

analysis; See also Testimony of Robert K. Elliot,

Chairman, AICPA (Sept. 21, 2000); Testimony of

Barry Melancon, President and Chief Executive

Officer, AICPA (Sept. 21, 2000).

614See, e.g., Testimony of Douglas Scrivner,

General Counsel, Andersen Consulting (Sept. 20,

2000) (‘‘It is more likely that recruitment has been

jeopardized by the actions of the accounting firms

themselves. Some of the firms have diverted

investment and resources out of the audit function

and into non-audit services, thereby reducing the

attractiveness of the audit function as a career path.

They have created the very environment in which

accounting majors look elsewhere and audit staff

move over to the consulting side as quickly as they

can.’’); See also O’Malley Panel Report, supra note

20, at ¶ 4.4 (‘‘Focus group participants often

indicated that not only clients, but also engagement

partners and firm leaders, treat the audit negatively

as a commodity.’’). See generally the Taylor

Research and Consulting Group, Inc., Final

Quantitative Report (2000); Albrecht and R. Sack,

Accounting Education: Charting the Course through

a Perilous Future, at 23 (August 2000). AICPA

statistics presented to the O’Malley Panel indicate

that from 1992 to 1997 the number of students

obtaining bachelor degrees declined by 14%, those

obtaining finance degrees declined by 17%, those

obtaining general business degrees declined by 8%,

and those obtaining marketing degrees declined by

27%.

615See Digest of Educational Statistics, 1999.

616See, e.g., Written Testimony of Mauricio

Kohn, CFA, CMA, CFM, AIMR (Sept. 20, 2000)

(submitting survey); Letter of Mary Ellen Olivierio

and Bernard Newman, Lubin School of Business,

Pace University (Sept. 23, 2000).

The rule allows for a transition period

of eighteen months for certain non-audit

services. Over this period, audit firms

may continue to contract with their

audit clients for the newly covered nonaudit services. The firms entering into

new contracts, however, will either plan

to complete those services by the end of

the transition period or to assign or sell

those contracts to someone else before

the end of the period because at the end

of this period, audit firms may no longer

provide the newly proscribed services to

their audit clients.

In this analysis, we recognize that

some companies may face transition

costs associated with changing the

provider of non-audit services. But, for

the reasons discussed above, we believe

those costs will be small in the

aggregate. Thus, any company whose

current contract expires during the

transition period faces the same costs as

any new purchaser of the services.

Those contracting costs are captured

above in our analysis of synergies.

By extension, only companies with

contracts for the proscribed services

extending beyond the transition period

will be faced with any re-contracting

costs imposed by the rule. We note that

those re-contracting costs may be borne

by the company itself or by the auditor

in its attempt to sell the contract to

another provider. We received no

information concerning these costs from

commenters. Nevertheless, we have

included $1.3 million in the cost

estimate.608

Commenters also suggested that the

rule would generate a cost associated

with lost effectiveness on the audit and

a cost associated with recruiting and

retention of staff professionals.609 We

have seen no evidence that the rule will

lead to less effective audits. Our cost

estimates associated with lost synergies

and scope include efficiency costs, if

any, associated with an increase in cost

to accomplish an effective audit. The

sale by certain of the Big Five firms of

their consulting practices further

undermines the argument that the loss

of non-audit business will impair audit

effectiveness.

We also are skeptical about comments

that suggest that the prohibition of

certain services will make the

profession less attractive to potential

employees,610 and increase staff

recruiting and retention costs. Some

argue that less qualified individuals will

have to be hired to meet personnel

needs and that this will ultimately lead

to less effective audits, with a resulting

impact on auditing firms, issuers and

investors.611 We do not believe that the

issues of retention and recruitment are

caused by this rule.612 These problems

are not new and are more systemic.

Several commenters have noted that

starting salaries for recent accounting

graduates have failed to keep pace with

other fields such as information

systems, financial and treasury analysis

and consulting.613 Other commenters

have stated that accounting firms have

de-emphasized the audit function,

treating it more like a commodity.614 In

addition, despite increases in university

enrollments, interest in technical fields

such as accounting, engineering,

computer sciences and mathematics

have been declining.615

C. Costs and Benefits of the Disclosure

Requirements

The final rules require public

companies to disclose in their proxy

statements audit fees, fees for permitted

information systems consulting and

other fees paid to the auditor. The rule

also requires public companies to

disclose, when applicable, that

personnel who are full- or part-time

employees of an entity other than the

audit firm performed more than fifty

percent of the audit. In addition, the

audit committee or the board of

directors must state whether it has

considered whether the provision of

non-audit services by the auditor is

compatible with maintaining auditor

independence.

Many commenters argued that the

provision of information systems

consulting in and of itself does not

impair auditors’ independence.616 This

may be true where the conditions

described in the rule are met. Even

when these conditions are met, when

the information systems consulting fees

become large relative to audit fees,

auditor independence may be at risk. At

the same time, we understand that the

level where impairment may occur may

be related to other factors such as the

closeness of the auditor-client

relationship or the nature of the client’s

business and industry. Therefore, we

believe that investors and audit

committees are well-suited to determine

when provision of these services may

cause impairment.

The disclosure of fees from the

provision of information systems and

76074 Federal Register / Vol. 65, No. 234 / Tuesday, December 5, 2000 / Rules and Regulations

617See Lexecon Letter; Letter of Brand Finance

PLC (June 13, 2000).

618The Commission imposed a similar disclosure

requirement when it issued ASR 250. As noted

above, ASR 250 was withdrawn three years later.

The rule prompted some academic research at the

time. Three studies from the period and a current

study are of particular interest: J. H. Scheiner and

J.E. Kiger, ‘‘An Empirical Investigation of Auditor

Involvement in Non-Audit Services,’’ 20 J. of Acct.

Res., at 482–496 (Autumn 1982) (‘‘Scheiner &

Kiger); J. H. Scheiner,’’ ‘‘An Empirical Assessment

of the Impact of SEC Nonaudit Service Disclosure

Requirements on Independent Auditors and Their

Clients,’’ 22 J. of Acct. Res., at 789–797 (Autumn,

1984) (‘‘Scheiner’’); G.W. Glezen and J.A. Millar,

‘‘An Empirical Investigation of Stockholder

Reaction to Disclosures Required by ASR No. 250,’’

23 J. of Acct. Res., at 859–870 (Autumn 1985); M.

Ezzamel, D.R. Gwilliam and K. M. Holland, ‘‘Some

Empirical Evidence from Publicly Quoted UK

Companies on the Relationship Between the Pricing

of Audit and Non-audit Services,’’ 27 Acct. and

Bus. Res., at 3–16 (1996) (‘‘Ezzamel’’).

Scheiner and Glezen studied the impact of ASR

250 disclosure requirements on the provision of

audit and non-audit services and concluded that the

major accounting firms did not significantly reduce

the amounts of services offered. Glezen compared

stockholder approval of auditors before and after

the issuance of ASR 250 and found no significant

decline in the approval ratios across the three

periods. These authors generally conclude that

either independence is not important to

stockholders, a conclusion they consider unlikely,

or the level of non-audit services did not reach the

level at which independence was perceived to be

threatened. Scheiner allows that the firms in his

study were not providing clients many of the

services that fell within the disclosure rule.

Scheiner and Kiger find evidence that the non-audit

services provided to audit clients at that time

generally ‘‘consisted of traditional accounting

services—primarily tax services. Less traditional

services which are often questioned by critics of the

accounting profession comprise only a small part of

total non-audit services.’’ They further state that at

that time, ‘‘[t]he prohibition of non-accounting,

non-audit services would not appear to have a

substantial impact on firms because these services

do not represent a large percentage of total

revenues.’’

As we discussed in Section III.B., the level of

non-audit services in general and non-audit services

for audit clients in particular have increased

substantially in recent years. Ezzamel found in the

U.K. that substantial income was produced by nonaudit services and that ‘‘the extent of voluntary

disclosure of the breakdown on non-audit services

was limited and the existing disclosure requirement

allowed considerably variety in the manner in

which non-audit services incurred or paid abroad

were disclosed.’’

619 ISB Standard No. 1, supra note 167. In

addition, SAS No. 61 provides additional guidance

on topics that an auditor should discuss with the

audit committee (or board of directors if there is no

such committee) of each registrant. AICPA SAS No.

61, AU § 380.

620SECPS Manual § 1000.08(i).

621 In our Paperwork Reduction Act analysis in

the Proposing Release, we estimate that

approximately 9,892 respondents file proxy

statements under Schedule 14A and approximately

253 respondents file information statements under

Schedule 14C. We based the number of entities that

would complete and file each of the forms on the

actual number of filers during the 1998 fiscal year.

622See Deloitte & Touche Letter. Deloitte &

Touche provided an estimate of 3–6 hours per filing

for a small firm and 50–100 hours for a large firm,

but provided no data to support this estimate.

other non-audit services provided by a

company’s auditor is intended to assist

investors in deciding whether these

services affect the independence of the

auditor. Similar disclosures have been

provided in the United Kingdom for

several years.617 The disclosure

regarding the use of leased personnel to

perform an audit is intended to allow

investors to know when personnel of an

entity other than the audit firm

performed a majority of the audit so that

investors can consider the

independence of the other entity. Under

such circumstances, the independence

of the other entity and its personnel may

be as relevant ‘‘if not more relevant’’ to

auditor independence than the

independence of the auditor itself. As

discussed above, some commenters

believe disclosure alone would not be

sufficient to alleviate an impairment of

auditor independence.

1. Benefits

While the SECPS collects information

on non-audit and audit fees from its

member firms, it no longer publishes

this information. Accordingly, such

information is not readily available or

easily accessible to the investing public.

Further, this information provides a

description of types of services provided

by the public accounting firm for all of

its clients, rather than for each audit

client. The rule would provide aggregate

fee information for each registrant to the

market.618

The disclosure related to non-audit

services fees received by auditors would

give investors insight into the

relationship between a company and its

auditor. In so doing, the disclosure will

reduce uncertainty about the scope of

such relationships by providing facts

about the magnitude of non-audit

service fees. This information may help

shareholders decide, among other

things, how to vote their proxies in

selecting or ratifying management’s

selection of an auditor.

The disclosure regarding the auditor’s

use of another entity’s employees to

perform a majority of the audit work

also provides important information to

investors. Investors need to know when

a majority of the audit work is

performed by persons who have

financial, business, and personal

interests in addition to, or different

from, persons employed by the auditor.

This disclosure is significant because it

reveals when the ‘‘principal auditor’’

(the auditor performing a majority of the

audit work) is an entity other than the

firm signing the audit opinion.

We believe that investors benefit

jointly from the prohibition of certain

services and the disclosure discussed

above. Investors benefit under the rule

from the knowledge that the accounting

firms are not providing certain services

that impair their independence. They

will also be able to assess the relevance

of aggregate compensation to the auditor

for non-audit services. To the extent that

confidence arises from both the

prohibition and the disclosure aspects

of the rule, our estimate of annual

benefits on the order of one half to two

billion dollars includes both elements of

the rule.

2. Costs

We believe that the disclosure rule

will impose relatively minor reporting

costs on issuers. Generally, information

about auditor fees is readily available to

registrants. ISB Standard No. 1 requires

auditors to report on certain

independence issues to the audit

committees of their SEC audit.619 In

addition, the SECPS requires members

to report annually to the audit

committee, or similar body, the total

fees received from the company for

management advisory services during

the year under audit and a description

of the types of such services

rendered.620 Companies also must

report the billings from their auditors as

expenses and import this billing

information into their systems. As a

result, companies should have ready

access to the information on fees paid to

their auditor for non-audit services.

Disclosure of audit and non-audit fees

will impose a reporting burden on all

issuers subject to the proxy disclosure

rules. For the purpose of the Paperwork

Reduction Act, we estimated the

aggregate reporting cost of $272,620 to

complete the appropriate paperwork.621

Commenters suggested that this estimate

is unreasonably low.622 Some

commenters suggested that registrants

would spend more time making the

required disclosures. We do not agree;

the disclosures can be made using

information that registrants will have on

hand. We also note that the scope of the

required disclosure has been

significantly reduced from the proposal,

limiting it to only aggregate audit, IT,

and other non-audit fees. For the

purpose of providing an aggregate cost

estimate, we consider a range of

$272,620 and $1.09 million, but use

only the top of this range for the total.

The rule will not impose significant

burdens related to storing, analyzing

and compiling data, or to training

employees. Moreover, even if registrants

spend more time in making the required

disclosure, the marginal increase in cost

Federal Register / Vol. 65, No. 234 / Tuesday, December 5, 2000 / Rules and Regulations 76075

623The ongoing figure is not adjusted for inflation

or growth in consulting revenues beyond 2000.

However, we note that there is a slowdown in the

growth of these services. See, e.g., PAR, End of a

Run: National Firms’ Growth Rate Slowed In FY 99

(Mar. 31, 2000).

We note that the transition costs of $1.3 million

may be incurred at any time over the eighteenmonth transition period. We include this estimate

in the first year only for ease of presentation.

624 5 U.S.C. 603.

625 17 CFR 240.14a–101.

626See supra note 8.

will not be significant relative to the

overall costs discussed in this section.

Even assuming the burden is four times

as great to make the disclosure, the

annual cost of complying with the

disclosure portion of the rule would be

$1.09 million.

D. Estimated Aggregate Costs and

Benefits

The elements of the total quantified

cost of the rule are lost synergies for

those currently purchasing proscribed

services; transition costs for those

currently purchasing both audit and

proscribed consulting services;

professional training to learn the new

rules regarding employment,

investment, and independence; and

disclosure costs. Using assumptions and

methods that tend to overstate costs, we

estimate the aggregate cost to the U.S.

economy to be approximately $16.6

million for the first year and $12.4

million for subsequent years.623

Finally, we have quantified one

primary benefit of the rule as increased

investor confidence that may lead to a

reduction in the required rate of return.

In summary the rule benefits (i) auditors

and members of their families as a result

of changes in restrictions on investment

and employment relationships; (ii)

family members of auditors as a result

of changes in the restrictions on

employment relationships; (iii) issuers

by eliminating certain uncertainties

about their auditor’s independence, by

increasing investor confidence and thus

facilitating issuers in raising capital, and

by increasing the utility of annual audits

and quarterly reviews; (iv) public

accounting firms by clarifying the

independence rules; (v) investors who

will benefit from increased confidence

in the reported financial statements; and

(vi) all of the market participants

through more efficient contracting,

improved operating and investing

decisions, and greater market stability.

Even if the rule leads to only a very

small change in that rate of return, the

annual benefit could be in the range of

one half to two billion dollars. Benefits

may also accrue to the economy in the

form of more efficient contracting,

improvements in operating and

investing decisions by management and

greater market stability. Finally,

relaxation of the investment and

employment constraints on auditing

professionals and their families may

also lead to more efficient investments

by these persons.

VI. Final Regulatory Flexibility

Analysis

We have prepared this Final

Regulatory Flexibility Act Analysis in

accordance with the Regulatory

Flexibility Act (‘‘RFA’’).624 This analysis

relates to amendments to Rule 2–01 of

Regulation S–X and to Item 9 of

Schedule 14A 625 under the Exchange

Act. The amendments modernize our

auditor independence requirements.

The rules as adopted will not have a

significant impact on a substantial

number of small entities. The vast

majority of public companies required

under the federal securities laws to

submit reports prepared by an

independent accountant to the

Commission are not ‘‘small’’ for

purposes of the RFA. Moreover, as to

the impact on small accounting firms,

the Big Five accounting firms, which are

not small entities, provide auditing

services for the vast majority of public

companies. The major effects of these

rules, therefore, will not be on small

entities. Nevertheless, we are mindful of

the possible effect of our rules on small

entities, and we have made certain

modifications, noted below, that should

reduce significantly the impact of the

new rules on small entities.

A. Reasons for and Objectives of the

Rule Amendments

As discussed above, the federal

securities laws require registrants to file

financial statements that have been

audited, and reports that have been

prepared, by ‘‘independent’’

accountants.626 Our auditor

independence requirements are found

in Rule 2–01 and interpretations, which

have been supplemented by staff letters,

staff reports, and ethics rulings by the

accounting profession. Many of the

interpretations are reprinted in Section

600 of the Codification. We have not

amended the fact-specific examples in

the Codification since 1983. As

discussed more fully above, since that

time, there has been a dramatic

transformation of the accounting

industry. Increasingly, accounting firms

are becoming multi-disciplinary service

organizations and are entering into

novel and complex business

relationships with their audit clients. At

the same time, individual accounting

professionals have become more mobile,

while the geographic location of

personnel has become less important

due to advances in telecommunications

and the Internet. In addition, an

increasing number of American families

have two wage earners.

To protect the reliability and integrity

of the financial statements of public

companies and to promote investor

confidence, we must ensure that our

auditor independence requirements

remain relevant, effective, and fair in

light of the new business environment.

Consequently, the rule amendments

provide a general standard for

determining auditor independence and

identify relationships that render an

accountant not independent of an audit

client under the standard in Rule 2–

01(b). The relationships addressed

include, among others, financial and

employment relationships, business

relationships, and relationships where

auditors provide certain non-audit

services to their audit clients. We also

are requiring certain public companies

to disclose in their annual proxy

statements information about, among

other things, non-audit services

provided by their auditors.

Financial and Employment

Relationships. Under former

requirements, an auditor’s

independence was impaired if any

partner in the firm, any manager in an

office participating in a significant

portion of the audit, or certain of their

relatives, had a financial interest in, or

certain employment relationships with,

an audit client. As explained above,

these requirements may have

unnecessarily restricted employment

and investment opportunities for

auditors and members of their families.

The amended rule targets application

of these particular auditor

independence rules to those who can

actually influence the audit of a client.

The amended rule allows audit firm

partners, other professionals, and their

families, more freedom in their

investments and employment decisions

and will allow them to take greater

advantage of future opportunities in

these areas. The amended rule shrinks

significantly the circle of family

members and former accounting firm

personnel whose employment impairs

an auditor’s independence; the

amended rule similarly reduces

significantly the pool of firm personnel

whose investments are imputed to the

auditor. We believe that the amended

rule will maximize the opportunities

available to auditors while promoting

the public interest and protecting

investor confidence.

Non-Audit Services. We, along with

certain users of financial statements,

76076 Federal Register / Vol. 65, No. 234 / Tuesday, December 5, 2000 / Rules and Regulations

627See supra notes 215, 216.

628Letter of Jim J. Tozzi, Member, Board of

Advisors, Center for Regulatory Effectiveness (Aug.

30, 2000) (‘‘Tozzi Letter’’).

629 17 CFR 230.157.

630 15 U.S.C. § 77c(b).

631 17 CFR 270.0–10.

632 13 CFR 121.201.

633Tozzi Letter.

634See supra notes 218, 219.

have become increasingly concerned

about the effects on independence when

auditors provide both audit and nonaudit services to their audit clients.

These concerns have been exacerbated

in recent years by changes in the types

of non-audit services that accounting

firms provide as well as by dramatic

increases in the fees, in both absolute

and relative terms, for those non-audit

services. As we discuss more fully

above, the rapid growth of non-audit

services has increased the economic

incentives for the auditor to preserve a

relationship with the audit client,

thereby increasing the risk that the

auditor will be less vigilant in its

objectivity. Additionally, aggregate

economic incentives aside, certain types

of non-audit services by their very

nature can create conflicts incompatible

with objectivity. At the same time that

more and more individual investors are

participating in our capital markets,

either directly or through mutual funds,

pension plans, and retirement plans, we

have seen growing public concern about

the increasing importance of non-audit

services to accounting firms. The

amended rule identifies certain nonaudit services that, if performed by an

auditor for an SEC audit client, would

render the accountant not independent.

Disclosure. As discussed, the types of

non-audit services provided by auditors

to audit clients have changed, and the

fees paid for those services have

increased. We are adopting a proxy

statement disclosure requirement

focused on the fee relationship between

registrants and their auditors.

Independent studies and the comments

we received have shown that concerns

are likely to be raised about auditor

independence when the consulting fees

paid by a registrant are significant when

compared to the audit fees. Accordingly,

the disclosure we are mandating

addresses this area and will be useful to

investors in evaluating auditors’

independence. The amendments require

registrants to disclose in their proxy

statements their audit fees, fees for

financial information systems design

and implementation, and the fees for

other non-audit services rendered by the

principal accountant to the company. In

addition, we are requiring companies to

disclose whether their audit committees

have considered whether the provision

of financial information systems design

and implementation services and other

non-audit services provided by the

company’s principal accountant is

compatible with maintaining the

principal accountant’s independence.

Investors accordingly will have access

to this information when making

investment and voting decisions.

B. Significant Issues Raised by Public

Comment

The proposals generated significant

comment and broad debate. As we

discussed in detail above, the final rule

amendments, particularly those related

to non-audit services, have been

modified from the proposals in response

to comment letters, written and oral

testimony from four days of public

hearings, academic studies, surveys, and

other professional literature.

At the time we published the

Proposing Release, we also prepared an

Initial Regulatory Flexibility Analysis

(IRFA), a summary of which was

published in the Proposing Release. We

requested comment on the IRFA, and

we received several comments in

response. Separately, many commenters

representing small accounting firms

expressed strong support for the

proposal,627 and other commenters

representing small businesses expressed

concerns about the proposal.

With respect to procedural issues

related to the IRFA, one commenter

questioned our procedure, arguing that

we should have requested information

on the number of small entities affected

some time earlier and that neither the

Proposing Release nor the IRFA

indicates that the Small Business

Administration (‘‘SBA’’) reviewed or

commented on the IRFA.628 At the time

that we prepared the Proposing Release,

we prepared the IRFA in accordance

with the RFA and made it available to

the public as required by Section 603 of

the RFA. We submitted the IRFA to the

SBA, and the SBA had no comments on

the IRFA. The same commenter

questioned whether the agency assured

that small entities had an opportunity to

participate in the rulemaking. In

addition to soliciting extensive

comments in the Proposing Release and

holding four days of hearings at which

representatives of small accounting

firms testified, we published a summary

of the IRFA in the Federal Register, and

many small firms commented on the

proposed amendments.

C. Small Entities Subject to the Rule

For purposes of analyzing the impact

on small public companies, the

Commission has defined ‘‘small

business’’ in Rule 157 under the

Securities Act.629 Rule 157 provides that

‘‘small business’’ means any entity

whose total assets on the last day of its

most recent fiscal year were five million

dollars or less and is engaged, or

proposes to engage, in small business

financing. A registrant is considered to

be engaged, or to propose to engage, in

small business financing under this rule

if it is conducting, or proposes to

conduct, an offering of securities which

does not exceed the dollar limitation

prescribed by Section 3(b) of the

Securities Act.630 We estimated in the

IRFA that there are approximately 2,500

Exchange Act reporting companies that

are small businesses.

The Commission also has defined

small business for purposes of an

investment company in Rule 0–10 of the

Investment Company Act.631 This

definition provides that an investment

company is a ‘‘small business’’ if it has

net assets of $50 million or less as of the

end of its most recent fiscal year. In the

IRFA, we estimated that approximately

227 investment companies are small

businesses.

Our rules do not define ‘‘small

business’’ or ‘‘small organization’’ with

regard to accounting firms. The SBA,

however, has defined a small business,

for purposes of accounting firms, as

those with under $6 million in annual

revenues.632 In the IRFA, we explained

that we have limited data indicating

revenues for accounting firms, and that

we cannot estimate the number of firms

with less than $6 million in revenues.

We requested comment on the number

of accounting firms with revenues under

$6 million in order to determine the

number of small accounting firms

potentially affected by the rule

amendments but received no response.

We also requested comment generally

on the number of small entities that may

be affected by the rule amendments and

received no estimates. One commenter

believed that we had not identified the

full range of types of and number of

small entities affected or the types of

impacts, but the commenter provided

no further information.633

Several small accounting firms and

small companies expressed concern

about a possible derivative effect of our

rule on companies that are not

registered with us and on the auditors

of such companies.634 These

commenters were concerned that state

governments, state boards of

accountancy, and others may adopt

rules similar to ours without regard to

whether the companies are public or

Federal Register / Vol. 65, No. 234 / Tuesday, December 5, 2000 / Rules and Regulations 76077

635See supra note 221.

636See, e.g., AICPA Letter.

637 Id.; see also Letter of David E. Pertl, Senior

Vice President and CFO, First Choice, Inc. (Sept. 18,

2000); Letter of Kelly Schwarzbeck, CPA, Alexander

X. Kuhn & Co. (Aug. 22, 2000); Letter of Robert L.

Bunting (Aug. 22, 2000).

638See, e.g., Letter of the California Chamber of

Commerce (Sept. 15, 2000); Letter of Joseph C. King,

CPA, Faulkner & King, PSC (Sept. 13, 2000).

639See, e.g., Letter of Landon J. Brazier, Knight

Vale & Gregory (Aug. 31, 2000); Letter of Stephen

Lange Ranzini, Chairman, CEO and President,

University Bank (Sept. 9, 2000).

640See, e.g., Letter of Dean R. Heintz, CPA, Casey

Peterson & Assoc., Ltd. (Aug. 8, 2000); Letter of

Patrick J. Day, CPA (Aug. 10, 2000).

641Letter of Patrick J. Day, CPA (Aug. 10, 2000).

642See Testimony of Larry Gelfond, CPA, CVA,

CFE, former President of the Colorado State Board

of Accountancy (Sept. 13, 2000); Letter of John

Mitchell, CPA (Aug. 14, 2000).

643See Public Accounting Report, Special

Supplement: Annual Survey of National

Accounting Firms—2000 (March 31, 2000); Annual

Reports to SECPS, Annual reports filed with AICPA

Division for CPA firms; SECPS Reports, Reports

prepared by the AICPA Division for CPA firms.

private. As we explained above, the

rules apply to public companies and

other entities registered with the

Commission or otherwise required to

file audited financial statements with

the Commission. In addition, the rules

are not intended to alter the relationship

between federal and state agencies, and

they do not affect the ability of the states

to adopt their own rules. Moreover,

commenters pointed out that state

boards have a strong independent

tradition.635 We expect that the state

boards of accountancy will continue

their practice of exercising independent

judgment in determining the extent to

which our rules should be imported into

their regulatory regimes.

D. Projected Reporting, Recordkeeping,

and Other Compliance Requirements

The new rules could potentially affect

two primary groups—registrants and

auditors. The rules could affect these

two groups differently, but in neither

case do we expect that the rules would

result in significant reporting,

recordkeeping or other compliance

requirements. The possible effects of the

rules on these two groups are as follows:

Investments and Family

Relationships. The rule amendments

regarding investments and employment

relationships liberalize restrictions on

investments by, and employment

available to, accountants and their

families without impairing the

accountant’s independence. We stated

in the IRFA that in this sense, therefore,

we are relaxing compliance

requirements. One commenter noted

that although we correctly state that we

are relaxing certain requirements, the

proposed threshold regarding a material

indirect investment and the proposed

definition of affiliate of the accounting

firm would restrict the ability of small

businesses to invest in, or enter business

relationships with, other firms.636

We recognize these concerns, and we

have revised the rules, in part, to take

them into account. As described above,

the rule governing a material indirect

investment in an audit client is

intended to carry over the existing

proscription on material indirect

investments in audit clients. In

addition, in part because of concerns

that the definition of ‘‘affiliate of the

accounting firm’’ would have

unintended consequences on alliances

of small accounting firms, we have

modified our approach to avoid this

result.

Non-Audit Services. The IRFA

discussed whether the proposed rule on

non-audit services would have a

significant effect on small entities. Some

commenters expressed concern about

the effects of the rules on small

registrants that rely on the special

expertise of their auditors or that lack

resources to engage a second accounting

firm to provide non-audit services.637

Other commenters stated that small

businesses have long-term relationships

with auditors that provide non-audit

services, or are located in an area with

few firms able to provide such

services.638 Some small businesses in

rural areas may lack the ability to

perform the internal audit function on

their own.639

We are sensitive to these concerns

and we have modified the rule so that

eight of the non-audit service provisions

parallel or draw from current

independence requirements regarding

those services. We also determined not

to adopt a restriction on ‘‘expert

services. Accordingly, with respect to

the eight non-audit services, therefore,

we do not believe that the rules would

have a significant effect on small

businesses.

We have amended our rule regarding

financial information systems design

and implementation. The rule proposal

would have prevented audit firms from

providing some information technology

consulting to their audit clients without

impairing the firm’s independence. The

final rule singles out certain services as

impairing independence and identifies

other categories of such services that

will not impair independence if certain

conditions are met that are designed to

ensure that the audit client’s

management retains responsibility for

decision-making authority over the

client’s financial information systems.

Accordingly, if the conditions are met,

a small entity could obtain financial

information systems design and

implementation services.

With regard to internal audit services,

we have revised the rule from what we

proposed so that the internal audit

restrictions do not apply to registrants

with less than $200 million in assets, as

long as the registrant follows certain

conditions. This, of course, largely

eliminates the effect of the rule

amendments on small entities with

respect to the auditor’s provision of

internal audit services to small entities.

This change from the proposed rule

would lower the burden on smaller

businesses that are not defined as small

under our rules. It also has the effect of

almost completely excepting smaller

accounting firms from the coverage of

this provision of the rule, since the

firms that audit those companies tend to

be smaller. Our analysis indicates that

approximately fifty-four percent of

registrants have assets of less than $200

million, which, of course, would

exclude all companies defined as ‘‘small

businesses’’ for purposes of the RFA.

The IRFA also stated that we did not

believe that the non-audit services

provision would have a significant

impact on a substantial number of small

accounting firms and requested

comment on the impact. Some

commenters stated that the rules could

harm firms that must offer both audit

and non-audit services to stay in

business,640 and one commenter

recommended that firms with $1

million or less in revenue be exempt.641

Other commenters supported the rule

amendments relating to non-audit

services. Some noted that rather than

harming small accountants, the rules

could provide smaller firms with new

business opportunities to provide nonaudit services to companies that

previously used their auditors for these

services.642

Although we lacked definitive data,

the IRFA provided information on

accounting firms that were likely to be

small accounting firms, and the number

of SEC clients of those firms. The

majority of SEC registrants are audited

by one of the Big Five firms, which are

not small entities. We have data

regarding the approximately 776

accounting firms with fewer than 20

SEC audit clients.643 Accounting firms

with fewer than 20 SEC audit clients

tend to be smaller accounting firms, and

we estimate that fewer than twenty

percent of these firms provide any

consulting or non-audit services to their

SEC audit clients. Only ten to twelve

percent of the accounting firms with

two or fewer SEC audit clients provide

76078 Federal Register / Vol. 65, No. 234 / Tuesday, December 5, 2000 / Rules and Regulations

644See Compustat Database, Oct. 31, 2000. The

85% figure excludes clients that are bank holding

companies. For further analysis, see the cost-benefit

analysis in Section V.B above. 645See supra note 476.

646See supra Section IV.G.

647See, e.g., Letter of Donald G. Mantyla, CPA

(Sept. 25, 2000).

any consulting or non-audit services to

their SEC audit clients. We also

estimated that the fees of the firms with

20 or fewer SEC audit clients that come

from consulting and non-audit services

provided to SEC audit clients average

less than 7.5% of the firms’ total fees for

non-audit services, and less than one

percent of their total fees. We estimated

that small accounting firms obtain nonaudit or consulting fees, on average,

from less than one SEC audit client.

In addition, the change from the

proposed rule discussed above—

eliminating restrictions on internal

audit services for registrants with less

than $200 million in assets—would

lower the burden on smaller accounting

firms. We estimate that approximately

eighty-five percent of the clients of nonBig Five firms have assets of less than

$200 million.644 Thus, as long as certain

conditions are met, the rule

amendments regarding internal audit

services would not apply to eighty-five

percent of audit clients of all but the Big

Five firms.

While we understand that some small

businesses may incur some costs as a

result of the rule amendments, we

believe that few small businesses will be

affected, and that any effects will be

minimal. The changes we have made in

the rules as adopted should ameliorate

any burden on small firms significantly.

Moreover, while some small businesses

may be required to engage a new firm

to perform certain functions, there is no

comparatively greater effect on small

firms with respect to costs incurred to

choose a new accounting firm. Such

costs apply equally to larger registrants

as to smaller registrants.

Quality Controls. The new rules

establish a limited exception pursuant

to which inadvertent violations of the

rules by covered persons in the

accounting firm will not render the firm

not independent if the accounting firm

maintains certain quality controls and

satisfies other conditions. SECPS

membership requirements and GAAS

already require firms to have quality

controls over their audit practices, so

there should be little additional burden

on accounting firms that want to take

advantage of the exception.

Disclosure. The new proxy disclosure

rules require all companies subject to

our proxy rules to disclose information

to shareholders regarding fees for audit

services, fees for services related to

financial information systems design

and implementation, and fees for all

other non-audit services. Companies

also must disclose if the audit

committee considered whether the

provision of non-audit services by the

company’s principal accountant is

compatible with maintaining the

principal accountant’s independence.

These requirements would apply to

small businesses that are subject to the

proxy rules, which we estimate to be no

more than most of the 2,500 small

registrants that file periodic reports, and

227 investment companies.

The rules as proposed required,

among other things, a description of

each professional service provided by

the principal accountant, disclosure of

the fee for each, and disclosure of

whether the audit committee approved

the service. We have modified the

disclosure requirement to eliminate the

requirements that companies describe

each non-audit service provided by their

auditors and the fee for each such

service. We believe that by making these

changes, we have accommodated

commenters’ concerns while ensuring

that investors have the information they

need to make judgments about whether

the registrant has an independent

auditor. In addition, the information

required should be readily available to

the registrant because of the

requirements under ISB Standard No. 1

and the rules of SECPS.645

E. Agency Action to Minimize Effect on

Small Entities

The RFA directs us to consider

significant alternatives that would

accomplish the stated objectives, while

minimizing any significant adverse

impact on small entities. We considered

several alternatives, including the

following referenced in the RFA: (i) The

establishment of differing compliance or

reporting requirements or timetables

that take into account the resources of

small entities; (ii) the clarification,

consolidation or simplification of

compliance and reporting requirements

for small entities; (iii) the use of

performance rather than design

standards; and (iv) an exemption from

coverage of the new rules, or parts of the

new rules, for small entities.

We considered each of the four

alternatives, and a variety of alternatives

to our provisions on non-audit services.

With respect to the first alternative—

establishment of differing compliance or

reporting requirements—we stated in

the IRFA that, with respect to

investments and employment

relationships, we believe that the impact

of the rules in this area on small entities

was already minimal. We did not

believe, therefore, that establishing

differing requirements would materially

decrease the impact of the rules on

small businesses, and we did not make

special provisions. The IRFA discussed

establishing differing standards in the

area of non-audit services, and further

discussed the three other alternatives

contained in the RFA, mentioned above.

Regarding the provision of non-audit

and consulting services by small

accounting firms, we considered several

approaches. As discussed above,

however, we have determined that our

two-pronged approach of requiring

disclosure and identifying particular

non-audit services that are incompatible

with independence best protects the

audit process.646 In addition, because of

the limited amount of non-audit

services that small accounting firms

provide to their SEC audit clients, we

believe that the adoption of any of these

approaches would not have a significant

impact on a substantial number of small

businesses or small accounting firms.

The second alternative—the

clarification, consolidation or

simplification of compliance and

reporting requirements for small

entities—is addressed below in

connection with our discussion of our

consideration of the fourth alternative.

We have exempted small entities from

certain provisions of the rules, which

simplifies compliance requirements for

those entities.

The third alternative mentioned

above—use of performance rather than

design standards—would be difficult, in

part, to implement in this context. As to

the quality controls exception we did

implement such a performance

standard. As to the other components of

the rule changes, performance standards

would not carry out the Commission’s

statutory mandate to ensure that

registrants file financial statements and

reports with us that have been certified

by independent public accountants.

Rather, we must identify and address

influences that impair independence.

Some commenters suggested that we

adopt the last alternative—an exemption

from coverage of the new rules, or parts

of the new rules, for small entities.647

Other commenters suggested that our

rules not apply to audits of smaller

public companies, regardless of the size

of the auditor. These commenters stated

that small public companies may be in

greater need of consulting assistance

and may not be able to obtain the

assistance from anyone other than their

Federal Register / Vol. 65, No. 234 / Tuesday, December 5, 2000 / Rules and Regulations 76079

648Letter of Stanley Keller, Chair, Committee on

Federal Regulation of Securities, American Bar

Association (Sept. 27, 2000); Letter of Robert

Bunting (Sept. 6, 2000); Letter of P. Gerard

Sokoloski, CPA, President, NY State Society of

Certified Public Accountants (Sept. 25, 2000).

649 44 U.S.C. 3501 et seq.

650One commenter raised a number of issues

related to OMB’s processing and review of our

submission. Because OMB has reviewed and

approved our submission, we do not address these

comments here.

651See, e.g., Letter of Center for Regulatory

Effectiveness: CRE Report Card on the SEC’s

Proposed Rule on Auditor Independence (‘‘CRE

Report Card’’).

652See, e.g., Letter of Douglas R. Cox, Gibson,

Dunn and Crutcher (Aug. 22, 2000) (‘‘Cox Letter’’).

This commenter suggested, among other things, that

the rule mandates disclosure of information that

would appear irrelevant to the selection of auditors

because a vote to ratify auditors is not required by

the federal securities laws or many state laws. The

commenter noted that the rule requires disclosure

on Schedule 14C which does not ask investors to

vote on any matter. Deloitte & Touche, in its

comment letter, suggested that the Commission

could minimize the burden imposed by the rule by

requiring disclosure only when the stockholders

vote on the approval or ratification of the

company’s accounting firm. Deloitte & Touche

Letter. The disclosure rule serves a broader purpose

than assisting shareholders in votes to ratify the

selection of an auditor. The disclosure rule is one

component of our auditor independence rules, the

purpose of which is to promote the integrity of

financial statements and promote investor

confidence. Thus, the disclosure is aimed not only

at a registrant’s existing shareholders but at

prospective shareholders as well.

653Tozzi Letter.

654CRE Report Card.

655See Section IV.G for further discussion of the

disclosure requirement, including discussion of

comments received concerning that requirement.

656As discussed in the Proposing Release (see

Section II.C.4 and note 156 of this release), from

1978 to 1982, we required companies to disclose in

their proxy statements all non-audit services

provided by their auditors but later rescinded the

requirement. Among other reasons, our review of

proxy disclosures convinced us that accounting

firms then, in contrast to now, were not providing

extensive non-audit services to their audit clients.

In addition, we noted that, even without the proxy

statement requirement, investors had access to

useful data provided to and made public by the

SECPS.

657As noted above, the SECPS has stopped

publishing information about audit firms’ provision

of non-audit services.

658See supra Section IV.G.

659See, e.g., Deloitte & Touche Letter; Cox Letter.

660See, e.g., Deloitte & Touche Letter. Deloitte &

Touche stated in its comment letter that it ‘‘is

difficult to estimate the average hours without an

empirical study,’’ but suggested that disclosure

would require approximately three to six hours for

companies with basic reporting systems and

approximately 50–100 hours for companies with

more complex reporting systems. As discussed

below, we have modified the disclosure

requirement, and we do not agree that the required

disclosure will create more than a minimal

additional burden to companies already preparing

Schedules 14A or 14C.

661Cox Letter.

auditors.648 We appreciate this concern

and we have made certain changes to

the rule.

The changes we have made recognize

that, for some small companies, the

company’s auditor may be the only

reasonably available service provider for

certain services. The final rules,

therefore, take into account that small

firms may need internal audit services

from their auditors and provide an

exception for companies under $200

million in assets, subject to certain

conditions. For the reasons discussed

above, aside from these limited areas,

we do not believe that a further

exemption for small entities is

appropriate.

VII. Paperwork Reduction Act

Certain of the provisions in the

amendment to Item 9 of Schedule 14A

contain ‘‘collection of information’’

requirements within the meaning of the

Paperwork Reduction Act of 1995.649

We published notice soliciting

comments on the collection of

information requirements in the

Proposing Release and submitted these

requirements to the Office of

Management and Budget (‘‘OMB’’) for

review in accordance with 44 U.S.C.

§ 3507(d) and 5 CFR 1320.11. The

collections of information are titled

‘‘Regulation 14A (Commission Rules

14a–1 through 14b–2 and Schedule

14A)’’ and ‘‘Regulation 14C

(Commission Rules 14c–1 through 14c–

7 and Schedule 14C).’’

OMB approved the rule’s collection of

information requirements.650 Regulation

14A (OMB Control No. 3235–0059) was

adopted pursuant to Section 14(a) of the

Exchange Act and prescribes

information that a company must

include in its proxy statement to ensure

that shareholders are provided

information that is material to their

voting decisions. Regulation 14C (OMB

Control No. 3235–0057) was adopted

pursuant to Section 14(c) of the

Exchange Act and prescribes

information that a company must

include in an information statement

when a shareholder vote is to be held

but proxies are not being solicited.

Schedule 14A requires certain

disclosure related to a company’s

independent accountants and Schedule

14C refers to Schedule 14A for the

disclosure requirements related to the

company’s independent accountants.

The final rule requires issuers to

disclose in Schedules 14A and 14C,

among other things, the aggregate fees

billed for audit services, for financial

information systems design and

implementation services, and for other

non-audit services provided by the

issuer’s principal accountant, and

certain disclosures regarding the

company’s audit committee.

The Commission received comments

concerning the proposed collection of

information requirements. Some

commenters suggested that the

collections of information lacks

practical utility and noted that we

rescinded an earlier requirement that

issuers disclose information concerning

non-audit services provided by their

auditors.651 These commenters

generally argued that the proposed

disclosure was unnecessary and would

be confusing to registrants and

investors.652 Commenters also argued

that we had not adequately

demonstrated the need for the

disclosure requirement.653 One

commenter suggested that the proposed

collection of information is duplicative

of information available to the

Commission from the SECPS.654

We believe that the disclosure

requirement is necessary, practical, and

useful. As discussed more fully above,

in recent years there has been a

dramatic growth in the absolute and

relative size of fees charged for nonaudit services provided to audit

clients.655 At the same time, information

about audit firms’ provision of nonaudit services is not as readily available

as it was when we rescinded an earlier

disclosure requirement.656 The

disclosure we seek is not, contrary to

one commenter’s assertion, readily

available through industry sources.657

Under circumstances where investors

have less information about a matter

that has become more important, we

believe that the disclosure requirement

will prove useful to investors. Further,

we have modified the rule from that

proposed to make the disclosed

information more understandable to

investors.658 For example, under the

rule as adopted, registrants will not

disclose a line-by-line description of

each non-audit service, but rather will

disclose relevant amounts in the

aggregate. Investors will be able to

determine quickly the amounts spent on

non-audit services relative to the

amount spent on audit services. As

discussed below, these modifications

lower the already minor burden on

registrants of making this disclosure.

Commenters also questioned our

estimate of the burden imposed by the

new disclosure requirement.659

Specifically, commenters suggested that

issuers will spend more than one hour

on completing the new disclosure

requirements.660 Some commenters

suggested that in calculating the burden,

we did not consider all of the relevant

factors.661 Among other things, some

commenters suggested that we failed to

76080 Federal Register / Vol. 65, No. 234 / Tuesday, December 5, 2000 / Rules and Regulations

662CRE Report Card; AICPA Letter. 663See, e.g., Cox Letter. 664 Id.

665See, e.g., CRE Report Card.

666See Deloitte & Touche Letter.

667We do not believe that the new disclosure

requirement will cause registrants significant

burdens associated with administrative tasks such

as collecting, storing, and formatting the

information, nor do we believe that compliance

with the disclosure rule will require significant

employee training.

668The proposed rule required disclosure of each

professional service during the most recent fiscal

year. Under the proposed rule, a service did not

have to be disclosed if the fee for that service was

less than $50,000 or ten percent of that registrant’s

audit fee. Commenters suggested that these

thresholds were too low, and would result in

disclosures of insignificant services. As adopted,

the rule does not require disclosure of each

professional service.

669As proposed, the rule would have required

registrants to disclose whether the audit committee

approved each disclosed non-audit service and

considered the possible effect on the principal

accountant’s independence. As adopted, the rule

requires disclosure of whether the audit committee

considered whether the provision of the non-audit

services by the principal accountant is compatible

with maintaining the principal accountant’s

independence. We do not believe that this

requirement imposes a significant burden.

670As noted above, audit committees currently

receive information about the auditor’s provision of

non-audit services under ISB Standard No. 1 and

SECPS Manual §1000.08. See supra note 476.

671 In its comment letter, the AICPA suggested

that the proposed rule’s definition of ‘‘affiliate of

the accounting firm’’ created ambiguities that made

the disclosure requirement potentially overbroad

and burdensome. In response to commenters’

concerns, we have removed the definition of

‘‘affiliate of the accounting firm’’ from the rule as

adopted. Instead, the rule relies on existing

guidance concerning when an entity is associated

with the accounting firm. We believe that, with this

modification, the disclosure requirement in the

final rule is targeted to its purpose and is not

unduly burdensome.

672 15 U.S.C. 77b(b); 15 U.S.C. 78c(f); 15 U.S.C.

80a–2(c).

673See, e.g., KPMG Letter.

674See supra Sections III.C.1, III.C.3.

675See supra Section IV.B.1.

consider burdens relating to storing and

analyzing the information, training

personnel, hiring outside assistance,

and putting the information into a

reporting format.662 Further,

commenters disagreed with our

assertion in the Proposing Release that

the information required to make the

disclosure should be readily available to

respondents.663

Commenters also disagreed with our

estimate of the number of registrants

that would be affected by the disclosure

requirement. In the Proposing Release,

we stated the burden would fall

primarily on one-quarter of registrants

because only one-quarter of registrants

receive non-audit services from their

accountants in any given year. Some

commenters disagreed. While it may be

true, these commenters suggested, that

only twenty-five percent of registrants

receive non-audit services in any given

year, a larger percentage receives nonaudit services in some years and not

others.664 Commenters suggested that

the percentage of registrants that would

have to maintain records related to the

disclosure requirements would therefore

be greater than twenty-five percent.665

At least one commenter stated that all

registrants would have to check their

records to determine whether they must

disclose more than just audit fees.666

We believe that our estimate of the

burden imposed by the disclosure

requirement is reasonable. While all

registrants will have to disclose audit

fees under the new rule, and, where

applicable, registrants must make

disclosures concerning the use of leased

personnel on the audit, we believe that

the time and expense required to make

such disclosures will be minimal. In

calculating our estimate of the burden

imposed by the new disclosure

requirement, we carefully considered

the relevant factors.667 Further, as

discussed above, we have reduced the

amount and narrowed the scope of

disclosure that registrants will be

required to make. These modifications

reduce the amount of time spent in

making disclosure. For example, as

proposed, the rule would have required

a registrant to describe each professional

service rendered by its accounting firm,

and to disclose the fee paid for each

service.668 Instead, the rule as adopted

requires a registrant to disclose the

aggregate fees paid for audit,

information technology, and other nonaudit services.669 This information is

readily accessible to issuers; 670 it is an

incremental addition to previously

required disclosure about the identity of

a company’s auditor. In addition, we

believe that a registrant will know how

much it spent during the previous fiscal

year on its audit. A registrant should be

able to determine quickly the amounts

paid to its auditor for information

technology and other non-auditservices

by consulting its internal records. The

rule should not require registrants to

seek significant outside assistance, or

substantially modify their systems to

maintain and collect data. We therefore

believe that 2,536 hours is a reasonable

estimate of the paperwork burden

imposed by the rule.671

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

disclosure requirements is mandatory.

There is no mandatory retention period

for the information disclosed, and

responses to the disclosure

requirements will not be kept

confidential.

VIII.Consideration of Impact on the

Economy, Burden on Competition, and

Promotion of Efficiency, Competition,

and Capital Formation

Sections 2(b) of the Securities Act, 3(f)

of the Exchange Act, and 2(c) of the

Investment Company Act 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, also to consider whether the

action will promote efficiency,

competition, and capital formation.672

The rule amendments update our

independence requirements in light of

developments in the accounting

profession and in society generally. The

rule amendments affect the scope of

services an auditor may provide to an

audit client without impairing the

auditor’s independence and also affect

the financial, employment and business

relationships that an auditor (and

certain other persons) may have with an

audit client without impairing

independence. The purpose of the

amendments is to promote investor

confidence in the integrity of the audit

process and in the audited financial

statements that investors use to make

investment decisions. As discussed

above, investor confidence promotes

market efficiency and capital formation.

Competition is discussed below.

With respect to the scope of services

provisions, some commenters suggested

that there is no evidence that auditors’

provision to audit clients of non-audit

services affects auditor independence or

investors’ perceptions of auditor

independence, and they therefore

argued that the rule will not increase

investor confidence.673 Academic

studies and other surveys, however,

suggest that certain users of financial

statements have long believed that an

auditor’s provision to an audit client of

non-audit services could affect both the

auditor’s objectivity and investor

confidence in the financial

statements.674 Furthermore, even a

relatively modest increase in investor

confidence could have a significant,

positive effect on the economy, 675 while

a relatively modest decrease in investor

confidence could have significant

consequences for the capital formation

process.

Federal Register / Vol. 65, No. 234 / Tuesday, December 5, 2000 / Rules and Regulations 76081

676See, e.g., Arthur Andersen Letter.

677Cf. Testimony of Alfred M. King, Valuation

Research Corporation (July 26, 2000).

678See supra Section V.B.2(c).

679 Id.

680 15 U.S.C. 78w(a)(2).

681See, e.g., Arthur Andersen Letter; Deloitte &

Touche Letter.

682See Deloitte & Touche Letter. As discussed

above, some firms had already split off, or

announced the split-off of, their consulting

practices prior to our Proposing Release. The rule

does not dictate any particular business model for

accounting firms. Rather, firms remain free to

determine their own structure, consistent with the

law.

683See, e.g., Testimony of Wayne A. Kolins,

National Director of Assurance, BDO Seidman, LLP

(Sept. 20, 2000). As discussed in more detail in this

release, we have removed the definition of ‘‘affiliate

of the accounting firm’’ from the rule as adopted.

Instead, the rule relies on existing guidance

concerning when an entity is associated with the

accounting firm. We believe that this modification

addresses commenters’ concerns in this area.

684See id.

685See, e.g., Testimony of Larry Gelfond, CPA,

CVA, CFE, Colorado Accountancy Board,

September 13, 2000 (‘‘I do not believe that [the rule]

will in any way hinder our [small] firm. In many

respects, it may even benefit our firm. . . . I look

at this, frankly, as an opportunity, particularly in

the internal audit functions to step in, and given

our experience, to work with management and with

their respective independent auditor, let’s say a Big

Five firm, that this is an area that we can frankly

look at as a new revenue generator.’’).

686See, e.g., AICPA Letter; Letter of David E.

Pertl, Senior Vice President and CFO, First Choice,

Inc. (Sept. 18, 2000); Letter of Kelly Schwarzbeck,

CPA, Alexander X. Kuhn & Co. (Aug. 22, 2000);

Letter of Robert L. Bunting (Sept. 6, 2000); Letter

of Bruce C. Holbrook, Vice Chairman, Goodman &

Company, LLP (July 25, 2000); Letter of William W.

Traynham, CPA, President, Community Bankshares

Inc. (Aug. 14, 2000).

687See, e.g., Letter of the California Chamber of

Commerce (Sept. 15, 2000); Letter of Joseph C. King,

CPA, Faulkner & King, PSC (Sept. 13, 2000).

688See, e.g., Letter of Jeffry T. Herbst (Sept. 11,

2000); Letter of Richard P. Thornton (Sept. 13,

2000); Letter of Marc J. Garofalo, Mayor, Derby,

Conn. (Sept. 18, 2000).

689See Compustat Database, October 31, 2000.

The 85% figure excludes clients that are bank

holding companies. For further analysis, see supra

Section V.B (cost-benefit analysis).

Commenters suggested that the

proposals would impede efficiency

because the rule may prevent audit

clients from selecting the most efficient

service provider.676 As adopted,

however, the rule in large part codifies

existing limitations on auditors’

provision to audit clients of non-audit

services. To the extent these existing

limitations or new limitations from our

rule prevent the choice of the least

costly service provider in some

situations, we believe such limitations

are warranted to achieve our goal of

enhancing auditor independence.677

With respect to the claim that

synergies are created by the auditor’s

provision of both audit and non-audit

services, research on the evidence of

such synergies is inconclusive.678

Moreover, the recent sales or proposed

sales by large accounting firms of their

consulting divisions 679 suggest that

audit firms’ provision of at least certain

non-audit services creates, at most,

limited synergies.

Section 23(a) of the Exchange Act

requires the Commission, when

adopting rules under the Exchange Act,

to consider the impact on competition

of any rule it adopts.680 Some

commenters suggested that the rule

would inhibit competition. Some of

these commenters argued that, in

response to the proposed rule,

accounting firms would choose not to

provide audit services in favor of

providing non-audit services, and that

firms already providing the audit might

not bid on that client’s non-audit

work.681 They suggested that this would

lead to reduced competition for both

audit and non-audit services, reducing

issuers’ choices and increasing their

costs. One commenter further suggested

that reduced competition in the bidding

process would place firms that chose to

split off their consulting competencies

at a competitive advantage over those

that chose to stay together, and

ultimately cause firms to consider

splitting off their consulting groups.682

The rule as adopted, however, allows

issuers to purchase more non-audit

services from their auditors than would

have been allowed under the rule as

proposed. This modification should

reduce the effect on competition about

which commenters were most

concerned.

Some commenters suggested that the

proposed rule would hinder the ability

of small accounting firms to compete.

They argued that the definition of

‘‘affiliate of the accounting firm’’ in the

proposal would restrict small firms from

participating in alliances and other

business relationships, thereby

providing larger firms with a

competitive advantage by limiting the

scope of services available to clients of

small firms.683 Still other commenters

suggested that if the rule results in a

reshuffling of clients, medium-sized and

small firms may suffer a net loss of nonaudit service clients. According to these

commenters, displaced clients of these

firms may be more likely to engage a

better-known firm for non-audit services

than another small or medium-sized

firm.684 On the other hand, some

commenters stated that the proposal

would not be harmful to small

accounting firms, but rather would

allow small accounting firms to compete

for audit or non-audit services that

could no longer be provided by a

company’s auditor.685

Commenters also suggested that the

rule would make it difficult for small

businesses to compete. Some expressed

concern about the effects of the rules on

small businesses that rely on the special

expertise of their auditors or that lack

the resources to engage a second

accounting firm to provide non-audit

services; they commented that small

registrants would be required to either

choose a new accounting firm to

perform audits or to provide non-audit

services.686 Other commenters stated

that small businesses have long-term

relationships with auditors that provide

non-audit services, or are located in a

geographic area with few firms able to

provide such services.687 Commenters

also suggested that accounting firms

other than the Big Five may stop serving

SEC registrants, or they may stop

providing audit services, in both cases

leading to less choice and

competition.688

As discussed elsewhere in this

release, we have modified the rule so

that the provisions regarding most

affected non-audit services do no more

than codify existing restrictions. For

example, under the rule as adopted, all

registrants may purchase most

information technology consulting

services from their auditors, so long as

the stated conditions are met. With

respect to internal audit services, the

adopted provision does not restrict

registrants with $200 or less in assets, as

long as certain conditions are met. As a

result, small businesses should be able

to obtain the services they need.

In addition, approximately eighty-five

percent of the public company audit

clients of non-Big Five accounting firms

have assets of $200 million or less.689

Accordingly, as long as certain

conditions are met, the rule will not

preclude smaller firms from providing

internal audit services to the vast

majority of their public company

clients. This modification should

alleviate many of the commenters’

concerns about the rule’s impact on

small accounting firms’ ability to

compete. In any event, to the extent the

rule has any anti-competitive effect, we

believe it is necessary and appropriate

in furtherance of the goals of the

Exchange Act.

IX. Codification Update

The ‘‘Codification of Financial

Reporting Policies’’ announced in

Financial Reporting Release No. 1 (April

15, 1982) is amended as follows:

1. By removing section 602.01.

2. By amending section 602.02 by

removing the preamble paragraph

immediately preceding the introduction.

76082 Federal Register / Vol. 65, No. 234 / Tuesday, December 5, 2000 / Rules and Regulations

3. By amending section 602.02.b.i to

remove paragraphs 2 and 3.

4. By amending section 602.02.b.ii to

remove examples 1, 2, 3, 4, 6, 7, 8, and

10, and redesignate examples 5 and 9 as

examples 1 and 2.

5. By amending section 602.02.b.iii to

remove examples 1, 2, and 4, and

redesignate example 3 as example 1.

6. By removing section 602.02.b.iv.

7. By amending section 602.02.b.v to

remove example 4.

8. By amending section 602.02.c.i to

remove the last two paragraphs.

9. By removing section 602.02.c.ii.

10. By removing section 602.02.c.iii.

11. By removing section 602.02.d.

12. By removing section 602.02.e.ii.

13. By removing section 602.02.e.iii.

14. By removing section 602.02.f.

15. By amending examples 2, 3, 4, 5,

6, 7, 8, 10, 13, 15, 16, 20, and 23 in

section 602.02.g by replacing the

references to ‘‘partner,’’ ‘‘partners,’’

‘‘certifying accountant,’’ or

‘‘accountant’’ to ‘‘covered person,’’

‘‘covered persons,’’ ‘‘covered person’’

and ‘‘covered person,’’ respectively,

except no change should be made where

references to ‘‘partner’’ are preceded by

the word ‘‘limited’’ or ‘‘general.’’

16. By amending section 602.02.g to

replace the reference to Rule 2–01(b) in

the last sentence of the first introductory

paragraph with ‘‘Rule 2–01’’ and to

remove examples 17, 18, 19, and 22 and

redesignate examples 20, 21, 23, and 24

as examples 17, 18, 19, and 20,

respectively.

17. By removing section 602.02.h.

18. By adding a new section 602.01,

captioned ‘‘Discussion of Rule 2–01,’’ to

include the text in Section IV of this

release.

19. By amending Section 601.03 to

include, at the end, the text in Section

III.C.6 of this release.

20. By amending section 602.02 to

redesignate sections 602.02.b.v,

602.02.e.i, 602.02.e.iv, 602.02.g,

602.02.i.i, and 602.02.i.ii as sections

602.02.b.iv, 602.02.d.i, 602.02.d.ii,

602.02.e, 602.02.f.i, and 602.02.f.ii,

respectively.

The Codification is a separate

publication of the Commission. It will

not be published in the Code of Federal

Regulations.

X. Statutory Bases and Text of

Amendments

We are adopting amendments to Rule

2–01 of Regulation S-X and Item 9 of

Schedule 14A 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.

List of Subjects

17 CFR Part 210

Accountants, Accounting.

17 CFR Part 240

Reporting and recordkeeping

requirements, Securities.

Text of Amendments

In accordance with the foregoing,

Title 17, Chapter II of the Code of

Federal Regulations is 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 heading for Part 210 is revised

as set forth above.

2. The authority citation for Part 210

is revised 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.

3. By amending § 210.2–01 by adding

a preliminary note and paragraphs (d),

(e) and (f) and revising paragraphs (b)

and (c) to read as follows:

§ 210.2–01 Qualifications of accountants.

Preliminary Note to § 210.2–01

1. Section 210.2–01 is designed to ensure

that auditors are qualified and independent

of their audit clients both in fact and in

appearance. Accordingly, the rule sets forth

restrictions on financial, employment, and

business relationships between an

accountant and an audit client and

restrictions on an accountant providing

certain non-audit services to an audit client.

2. Section 210.2–01(b) sets forth the

general standard of auditor independence.

Paragraphs (c)(1) to (c)(5) reflect the

application of the general standard to

particular circumstances. The rule does not

purport to, and the Commission could not,

consider all circumstances that raise

independence concerns, and these are subject

to the general standard in § 210.2–01(b). In

considering this standard, the Commission

looks in the first instance to whether a

relationship or the provision of a service:

creates a mutual or conflicting interest

between the accountant and the audit client;

places the accountant in the position of

auditing his or her own work; results in the

accountant acting as management or an

employee of the audit client; or places the

accountant in a position of being an advocate

for the audit client.

3. These factors are general guidance only

and their application may depend on

particular facts and circumstances. For that

reason, § 210.2–01 provides that, in

determining whether an accountant is

independent, the Commission will consider

all relevant facts and circumstances. For the

same reason, registrants and accountants are

encouraged to consult with the Commission’s

Office of the Chief Accountant before

entering into relationships, including

relationships involving the provision of

services, that are not explicitly described in

the rule.

(a) * * *

(b) The Commission will not

recognize an accountant as

independent, with respect to an audit

client, if the accountant is not, or a

reasonable investor with knowledge of

all relevant facts and circumstances

would conclude that the accountant is

not, capable of exercising objective and

impartial judgment on all issues

encompassed within the accountant’s

engagement. In determining whether an

accountant is independent, the

Commission will consider all relevant

circumstances, including all

relationships between the accountant

and the audit client, and not just those

relating to reports filed with the

Commission.

(c) This paragraph sets forth a nonexclusive specification of circumstances

inconsistent with paragraph (b) of this

section.

(1) Financial relationships. An

accountant is not independent if, at any

point during the audit and professional

engagement period, the accountant has

a direct financial interest or a material

indirect financial interest in the

accountant’s audit client, such as:

(i) Investments in audit clients. An

accountant is not independent when:

(A) The accounting firm, any covered

person in the firm, or any of his or her

immediate family members, has any

direct investment in an audit client,

such as stocks, bonds, notes, options, or

other securities. The term direct

investment includes an investment in an

audit client through an intermediary if:

(1) The accounting firm, covered

person, or immediate family member,

alone or together with other persons,

supervises or participates in the

intermediary’s investment decisions or

has control over the intermediary; or

(2) The intermediary is not a

diversified management investment

company, as defined by section 5(b)(1)

of the Investment Company Act of 1940,

Federal Register / Vol. 65, No. 234 / Tuesday, December 5, 2000 / Rules and Regulations 76083

15 U.S.C. 80a–5(b)(1), and has an

investment in the audit client that

amounts to 20% or more of the value of

the intermediary’s total investments.

(B) Any partner, principal,

shareholder, or professional employee

of the accounting firm, any of his or her

immediate family members, any close

family member of a covered person in

the firm, or any group of the above

persons has filed a Schedule 13D or 13G

(17 CFR 240.13d–101 or 240.13d–102)

with the Commission indicating

beneficial ownership of more than five

percent of an audit client’s equity

securities or controls an audit client, or

a close family member of a partner,

principal, or shareholder of the

accounting firm controls an audit client.

(C) The accounting firm, any covered

person in the firm, or any of his or her

immediate family members, serves as

voting trustee of a trust, or executor of

an estate, containing the securities of an

audit client, unless the accounting firm,

covered person in the firm, or

immediate family member has no

authority to make investment decisions

for the trust or estate.

(D) The accounting firm, any covered

person in the firm, any of his or her

immediate family members, or any

group of the above persons has any

material indirect investment in an audit

client. For purposes of this paragraph,

the term material indirect investment

does not include ownership by any

covered person in the firm, any of his

or her immediate family members, or

any group of the above persons of 5%

or less of the outstanding shares of a

diversified management investment

company, as defined by section 5(b)(1)

of the Investment Company Act of 1940,

15 U.S.C. 80a–5(b)(1), that invests in an

audit client.

(E) The accounting firm, any covered

person in the firm, or any of his or her

immediate family members:

(1) Has any direct or material indirect

investment in an entity where:

(i) An audit client has an investment

in that entity that is material to the audit

client and has the ability to exercise

significant influence over that entity; or

(ii) The entity has an investment in an

audit client that is material to that entity

and has the ability to exercise

significant influence over that audit

client;

(2) Has any material investment in an

entity over which an audit client has the

ability to exercise significant influence;

or

(3) Has the ability to exercise

significant influence over an entity that

has the ability to exercise significant

influence over an audit client.

(ii) Other financial interests in audit

client. An accountant is not

independent when the accounting firm,

any covered person in the firm, or any

of his or her immediate family members

has:

(A) Loans/debtor-creditor

relationship. Any loan (including any

margin loan) to or from an audit client,

or an audit client’s officers, directors, or

record or beneficial owners of more than

ten percent of the audit client’s equity

securities, except for the following loans

obtained from a financial institution

under its normal lending procedures,

terms, and requirements:

(1) Automobile loans and leases

collateralized by the automobile;

(2) Loans fully collateralized by the

cash surrender value of an insurance

policy;

(3) Loans fully collateralized by cash

deposits at the same financial

institution; and

(4) A mortgage loan collateralized by

the borrower’s primary residence

provided the loan was not obtained

while the covered person in the firm

was a covered person.

(B) Savings and checking accounts.

Any savings, checking, or similar

account at a bank, savings and loan, or

similar institution that is an audit client,

if the account has a balance that exceeds

the amount insured by the Federal

Deposit Insurance Corporation or any

similar insurer, except that an

accounting firm account may have an

uninsured balance provided that the

likelihood of the bank, savings and loan,

or similar institution experiencing

financial difficulties is remote.

(C) Broker-dealer accounts. Brokerage

or similar accounts maintained with a

broker-dealer that is an audit client, if:

(1) Any such account includes any

asset other than cash or securities

(within the meaning of ‘‘security’’

provided in the Securities Investor

Protection Act of 1970 (‘‘SIPA’’) (15

U.S.C. 78aaa et seq.));

(2) The value of assets in the accounts

exceeds the amount that is subject to a

Securities Investor Protection

Corporation advance, for those

accounts, under Section 9 of SIPA (15

U.S.C. 78fff-3); or

(3) With respect to non-U.S. accounts

not subject to SIPA protection, the value

of assets in the accounts exceeds the

amount insured or protected by a

program similar to SIPA.

(D) Futures commission merchant

accounts. Any futures, commodity, or

similar account maintained with a

futures commission merchant that is an

audit client.

(E) Credit cards. Any aggregate

outstanding credit card balance owed to

a lender that is an audit client that is not

reduced to $10,000 or less on a current

basis taking into consideration the

payment due date and any available

grace period.

(F) Insurance products. Any

individual policy issued by an insurer

that is an audit client unless:

(1) The policy was obtained at a time

when the covered person in the firm

was not a covered person in the firm;

and

(2) The likelihood of the insurer

becoming insolvent is remote.

(G) Investment companies. Any

financial interest in an entity that is part

of an investment company complex that

includes an audit client.

(iii) Exceptions. Notwithstanding

paragraphs (c)(1)(i) and (c)(1)(ii) of this

section, an accountant will not be

deemed not independent if:

(A) Inheritance and gift. Any person

acquires an unsolicited financial

interest, such as through an unsolicited

gift or inheritance, that would cause an

accountant to be not independent under

paragraph (c)(1)(i) or (c)(1)(ii) of this

section, and the financial interest is

disposed of as soon as practicable, but

no later than 30 days after the person

has knowledge of and the right to

dispose of the financial interest.

(B) New audit engagement. Any

person has a financial interest that

would cause an accountant to be not

independent under paragraph (c)(1)(i) or

(c)(1)(ii) of this section, and:

(1) The accountant did not audit the

client’s financial statements for the

immediately preceding fiscal year; and

(2) The accountant is independent

under paragraph (c)(1)(i) and (c)(1)(ii) of

this section before the earlier of:

(i) Signing an initial engagement letter

or other agreement to provide audit,

review, or attest services to the audit

client; or

(ii) Commencing any audit, review, or

attest procedures (including planning

the audit of the client’s financial

statements).

(C) Employee compensation and

benefit plans. An immediate family

member of a person who is a covered

person in the firm only by virtue of

paragraphs (f)(11)(iii) or (f)(11)(iv) of

this section has a financial interest that

would cause an accountant to be not

independent under paragraph (c)(1)(i) or

(c)(1)(ii) of this section, and the

acquisition of the financial interest was

an unavoidable consequence of

participation in his or her employer’s

employee compensation or benefits

program, provided that the financial

interest, other than unexercised

employee stock options, is disposed of

as soon as practicable, but no later than

76084 Federal Register / Vol. 65, No. 234 / Tuesday, December 5, 2000 / Rules and Regulations

30 days after the person has the right to

dispose of the financial interest.

(iv) Audit clients’ financial

relationships. An accountant is not

independent when:

(A) Investments by the audit client in

the accounting firm. An audit client has,

or has agreed to acquire, any direct

investment in the accounting firm, such

as stocks, bonds, notes, options, or other

securities, or the audit client’s officers

or directors are record or beneficial

owners of more than 5% of the equity

securities of the accounting firm.

(B) Underwriting. An accounting firm

engages an audit client to act as an

underwriter, broker-dealer, marketmaker, promoter, or analyst with respect

to securities issued by the accounting

firm.

(2) Employment relationships. An

accountant is not independent if, at any

point during the audit and professional

engagement period, the accountant has

an employment relationship with an

audit client, such as:

(i) Employment at audit client of

accountant. A current partner,

principal, shareholder, or professional

employee of the accounting firm is

employed by the audit client or serves

as a member of the board of directors or

similar management or governing body

of the audit client.

(ii) Employment at audit client of

certain relatives of accountant. A close

family member of a covered person in

the firm is in an accounting role or

financial reporting oversight role at an

audit client, or was in such a role during

any period covered by an audit for

which the covered person in the firm is

a covered person.

(iii) Employment at audit client of

former employee of accounting firm. A

former partner, principal, shareholder,

or professional employee of an

accounting firm is in an accounting role

or financial reporting oversight role at

an audit client, unless the individual:

(A) Does not influence the accounting

firm’s operations or financial policies;

(B) Has no capital balances in the

accounting firm; and

(C) 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):

(1) Pursuant to a fully funded

retirement plan, rabbi trust, or, in

jurisdictions in which a rabbi trust does

not exist, a similar vehicle; or

(2) 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.

(iv) Employment at accounting firm of

former employee of audit client. A

former officer, director, or employee of

an audit client becomes a partner,

principal, shareholder, or professional

employee of the accounting firm, unless

the individual does not participate in,

and is not in a position to influence, the

audit of the financial statements of the

audit client covering any period during

which he or she was employed by or

associated with that audit client.

(3) Business relationships. An

accountant is not independent if, at any

point during the audit and professional

engagement period, the accounting firm

or any covered person in the firm has

any direct or material indirect business

relationship with an audit client, or

with persons associated with the audit

client in a decision-making capacity,

such as an audit client’s officers,

directors, or substantial stockholders.

The relationships described in this

paragraph do not include a relationship

in which the accounting firm or covered

person in the firm provides professional

services to an audit client or is a

consumer in the ordinary course of

business.

(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 audit client’s accounting

records or financial statements.

(A) Any service involving:

(1) Maintaining or preparing the audit

client’s accounting records;

(2) 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

(3) Preparing or originating source

data underlying the audit client’s

financial statements.

(B) Notwithstanding paragraph

(c)(4)(i)(A) of this section, the

accountant’s independence will not be

impaired when the accountant provides

these services:

(1) In emergency or other unusual

situations, provided the accountant does

not undertake any managerial actions or

make any managerial decisions; or

(2) For foreign divisions or

subsidiaries of an audit client, provided

that:

(i) The services are limited, routine, or

ministerial;

(ii) It is impractical for the foreign

division or subsidiary to make other

arrangements;

(iii) The foreign division or subsidiary

is not material to the consolidated

financial statements;

(iv) The foreign division or subsidiary

does not have employees capable or

competent to perform the services;

(v) The services performed are

consistent with local professional ethics

rules; and

(vi) The fees for all such services

collectively (for the entire group of

companies) do not exceed the greater of

1% of the consolidated audit fee or

$10,000.

(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 taken

as a whole, unless:

(1) The audit client’s management has

acknowledged in writing to the

accounting firm and the audit client’s

audit committee, or if there is no such

committee then the board of directors,

the audit client’s responsibility to

establish and maintain a system of

internal accounting controls in

compliance with section 13(b)(2) of the

Securities Exchange Act of 1934 (15

U.S.C. 78m(b)(2));

(2) The audit client’s management

designates a competent employee or

employees, preferably within senior

management, with the responsibility to

make all management decisions with

respect to the design and

implementation of the hardware or

software system;

(3) The audit client’s management

makes all management decisions with

respect to the design and

implementation of the hardware or

software system including, but not

limited to, decisions concerning the

systems to be evaluated and selected,

the controls and system procedures to

be implemented, the scope and

timetable of system implementation,

and the testing, training, and conversion

plans;

(4) The audit client’s management

evaluates the adequacy and results of

the design and implementation of the

hardware or software system; and

(5) The audit client’s management

does not rely on the accountant’s work

as the primary basis for determining the

Federal Register / Vol. 65, No. 234 / Tuesday, December 5, 2000 / Rules and Regulations 76085

adequacy of its internal controls and

financial reporting systems.

(C) Nothing in this paragraph (c)(4)(ii)

shall limit services an accountant

performs in connection with the

assessment, design, and implementation

of internal accounting controls and risk

management controls, provided the

auditor does not act as an employee or

perform management functions.

(iii) Appraisal or valuation services or

fairness opinions.

(A) Any appraisal service, valuation

service, or any service involving a

fairness opinion for an audit client,

where it is reasonably likely that the

results of these services, individually or

in the aggregate, would be material to

the financial statements, or where the

results of these services will be audited

by the accountant during an audit of the

audit client’s financial statements.

(B) Notwithstanding paragraph

(c)(4)(iii)(A) of this section, the

accountant’s independence will not be

impaired when:

(1) The accounting firm’s valuation

expert reviews the work of the audit

client or a specialist employed by the

audit client, and the audit client or the

specialist provides the primary support

for the balances recorded in the client’s

financial statements;

(2) The accounting firm’s actuaries

value an audit client’s pension, other

post-employment benefit, or similar

liabilities, provided that the audit client

has determined and taken responsibility

for all significant assumptions and data;

(3) The valuation is performed in the

context of the planning and

implementation of a tax-planning

strategy or for tax compliance services;

or

(4) The valuation is for non-financial

purposes where the results of the

valuation do not affect the financial

statements.

(iv) Actuarial services.

(A) Any actuarially-oriented advisory

service involving the determination of

insurance company policy reserves and

related accounts for the audit client,

unless:

(1) The audit client uses its own

actuaries or third-party actuaries to

provide management with the primary

actuarial capabilities;

(2) Management accepts responsibility

for any significant actuarial methods

and assumptions; and

(3) The accountant’s involvement is

not continuous.

(B) Subject to complying with

paragraph (c)(4)(iv)(A)(1)–(3) of this

section, the accountant’s independence

will not be impaired if the accountant:

(1) Assists management to develop

appropriate methods, assumptions, and

amounts for policy and loss reserves

and other actuarial items presented in

financial reports based on the audit

client’s historical experience, current

practice, and future plans;

(2) Assists management in the

conversion of financial statements from

a statutory basis to one conforming with

generally accepted accounting

principles;

(3) Analyzes actuarial considerations

and alternatives in federal income tax

planning; or

(4) Assists management in the

financial analysis of various matters,

such as proposed new policies, new

markets, business acquisitions, and

reinsurance needs.

(v) Internal audit services. Either of:

(A) Internal audit services in an

amount greater than 40% of the total

hours expended on the audit client’s

internal audit activities in any one fiscal

year, unless the audit client has less

than $200 million in total assets. (For

purposes of this paragraph, the term

internal audit services does not include

operational internal audit services

unrelated to the internal accounting

controls, financial systems, or financial

statements.); or

(B) Any internal audit services, or any

operational internal audit services

unrelated to the internal accounting

controls, financial systems, or financial

statements, for an audit client, unless:

(1) The audit client’s management has

acknowledged in writing to the

accounting firm and the audit client’s

audit committee, or if there is no such

committee then the board of directors,

the audit client’s responsibility to

establish and maintain a system of

internal accounting controls in

compliance with section 13(b)(2) of the

Securities Exchange Act of 1934 (15

U.S.C. 78m(b)(2));

(2) The audit client’s management

designates a competent employee or

employees, preferably within senior

management, to be responsible for the

internal audit function;

(3) The audit client’s management

determines the scope, risk, and

frequency of internal audit activities,

including those to be performed by the

accountant;

(4) The audit client’s management

evaluates the findings and results

arising from the internal audit activities,

including those performed by the

accountant;

(5) The audit client’s management

evaluates the adequacy of the audit

procedures performed and the findings

resulting from the performance of those

procedures by, among other things,

obtaining reports from the accountant;

and

(6) The audit client’s management

does not rely on the accountant’s work

as the primary basis for determining the

adequacy of its internal controls.

(vi) Management functions. Acting,

temporarily or permanently, as a

director, officer, or employee of an audit

client, or performing any decisionmaking, 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 services. Acting as

a broker-dealer, 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 under

circumstances in which the person

providing the service must be admitted

to practice before the courts of a United

States jurisdiction.

(5) Contingent fees. An accountant is

not independent if, at any point during

the audit and professional engagement

period, the accountant provides any

service or product to an audit client for

a contingent fee or a commission, or

receives a contingent fee or commission

from an audit client.

(d) Quality controls. An accounting

firm’s independence will not be

impaired solely because a covered

person in the firm is not independent of

an audit client provided:

(1) The covered person did not know

of the circumstances giving rise to the

lack of independence;

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(2) The covered person’s lack of

independence was corrected as

promptly as possible under the relevant

circumstances after the covered person

or accounting firm became aware of it;

and

(3) The accounting firm has a quality

control system in place that provides

reasonable assurance, taking into

account the size and nature of the

accounting firm’s practice, that the

accounting firm and its employees do

not lack independence, and that covers

at least all employees and associated

entities of the accounting firm

participating in the engagement,

including employees and associated

entities located outside of the United

States.

(4) For an accounting firm that

annually provides audit, review, or

attest services to more than 500

companies with a class of securities

registered with the Commission under

section 12 of the Securities Exchange

Act of 1934 (15 U.S.C. 78l), a quality

control system will not provide such

reasonable assurance unless it has at

least the following features:

(i) Written independence policies and

procedures;

(ii) With respect to partners and

managerial employees, an automated

system to identify their investments in

securities that might impair the

accountant’s independence;

(iii) With respect to all professionals,

a system that provides timely

information about entities from which

the accountant is required to maintain

independence;

(iv) An annual or on-going firm-wide

training program about auditor

independence;

(v) An annual internal inspection and

testing program to monitor adherence to

independence requirements;

(vi) Notification to all accounting firm

members, officers, directors, and

employees of the name and title of the

member of senior management

responsible for compliance with auditor

independence requirements;

(vii) Written policies and procedures

requiring all partners and covered

persons to report promptly to the

accounting firm when they are engaged

in employment negotiations with an

audit client, and requiring the firm to

remove immediately any such

professional from that audit client’s

engagement and to review promptly all

work the professional performed related

to that audit client’s engagement; and

(viii) A disciplinary mechanism to

ensure compliance with this section.

(e) Transition and grandfathering.

(1) Transition.

(i) Appraisal or valuation services or

fairness opinions and internal audit

services. Until August 5, 2002,

providing to an audit client the nonaudit services set forth in paragraphs

(c)(4)(iii) and (c)(4)(v) of this section

will not impair an accountant’s

independence with respect to the audit

client if performing those services did

not impair the accountant’s

independence under pre-existing

requirements of the Commission, the

Independence Standards Boards, or the

accounting profession in the United

States.

(ii) Other financial interests and

employment relationships. Until May 7,

2001, having the financial interests set

forth in paragraph (c)(1)(ii) of this

section or the employment relationships

set forth in paragraph (c)(2) of this

section will not impair an accountant’s

independence with respect to the audit

client if having those financial interests

or employment relationships did not

impair the accountant’s independence

under pre-existing requirements of the

Commission, the Independence

Standards Board, or the accounting

profession in the United States.

(iii) Quality controls. Until December

31, 2002, paragraph (d)(4) of this section

shall not apply to offices of the

accounting firm located outside of the

United States.

(2) Grandfathering. Financial interests

included in paragraphs (c)(1)(ii)(A) and

(c)(1)(ii)(F) of this section and

employment relationships included in

paragraph (c)(2) of this section in

existence on May 7, 2001, and contracts

for the provision of services described

in paragraph (c)(4)(ii) of this section in

existence on February 5, 2001 will not

be deemed to impair an accountant’s

independence if they did not impair the

accountant’s independence under preexisting requirements of the

Commission, the Independence

Standards Board, or the accounting

profession in the United States.

(3) Settling financial arrangements

with former professionals. To the extent

not required by pre-existing

requirements of the Commission, the

Independence Standards Board, or the

accounting profession in the United

States, the requirement in paragraph

(c)(2)(iii) of this section to settle

financial arrangements with former

professionals applies to situations that

arise after the effective date of this

section.

(f) Definitions of terms. For purposes

of this section:

(1) Accountant, as used in paragraphs

(b) through (e) of this section, means a

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.

(2) Accounting firm means an

organization (whether it is a sole

proprietorship, incorporated

association, partnership, corporation,

limited liability company, limited

liability partnership, or other legal

entity) that is engaged in the practice of

public accounting and furnishes reports

or other documents filed with the

Commission or otherwise prepared

under the securities laws, and all of the

organization’s departments, divisions,

parents, subsidiaries, and associated

entities, including those located outside

of the United States. Accounting firm

also includes the organization’s

pension, retirement, investment, or

similar plans.

(3) Accounting role or financial

reporting oversight role means a role in

which a person is in a position to or

does:

(i) Exercise more than minimal

influence over the contents of the

accounting records or anyone who

prepares them; or

(ii) 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, vice president of marketing, or

any equivalent position.

(4) Affiliate of the audit client means:

(i) An entity that has control over the

audit client, or over which the audit

client has control, or which is under

common control with the audit client,

including the audit client’s parents and

subsidiaries;

(ii) An entity over which the audit

client has significant influence, unless

the entity is not material to the audit

client;

(iii) An entity that has significant

influence over the audit client, unless

the audit client is not material to the

entity; and

(iv) Each entity in the investment

company complex when the audit client

is an entity that is part of an investment

company complex.

(5) Audit and professional

engagement period includes both:

(i) The period covered by any

financial statements being audited or

reviewed (the ‘‘audit period’’); and

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(ii) The period of the engagement to

audit or review the audit client’s

financial statements or to prepare a

report filed with the Commission (the

‘‘professional engagement period’’):

(A) The professional engagement

period begins when the accountant

either signs an initial engagement letter

(or other agreement to review or audit

a client’s financial statements) or begins

audit, review, or attest procedures,

whichever is earlier; and

(B) The professional engagement

period ends when the audit client or the

accountant notifies the Commission that

the client is no longer that accountant’s

audit client.

(iii) For audits of the financial

statements of foreign private issuers, the

‘‘audit and professional engagement

period’’ does not include periods ended

prior to the first day of the last fiscal

year before the foreign private issuer

first filed, or was required to file, a

registration statement or report with the

Commission, provided there has been

full compliance with home country

independence standards in all prior

periods covered by any registration

statement or report filed with the

Commission.

(6) Audit client means the entity

whose financial statements or other

information is being audited, reviewed,

or attested and any affiliates of the audit

client, other than, for purposes of

paragraph (c)(1)(i) of this section,

entities that are affiliates of the audit

client only by virtue of paragraph

(f)(4)(ii) or (f)(4)(iii) of this section.

(7) Audit engagement team means all

partners, principals, shareholders, and

professional employees participating in

an audit, review, or attestation

engagement of an audit client, including

those conducting concurring or second

partner reviews and all persons who

consult with others on the audit

engagement team during the audit,

review, or attestation engagement

regarding technical or industry-specific

issues, transactions, or events.

(8) Chain of command means all

persons who:

(i) Supervise or have direct

management responsibility for the audit,

including at all successively senior

levels through the accounting firm’s

chief executive;

(ii) Evaluate the performance or

recommend the compensation of the

audit engagement partner; or

(iii) Provide quality control or other

oversight of the audit.

(9) Close family members means a

person’s spouse, spousal equivalent,

parent, dependent, nondependent child,

and sibling.

(10) Contingent fee means, except as

stated in the next sentence, any fee

established for the sale of a product or

the performance of any service pursuant

to an arrangement in which no fee will

be charged unless a specified finding or

result is attained, or in which the

amount of the fee is otherwise

dependent upon the finding or result of

such product or service. Solely for the

purposes of this section, a fee is not a

‘‘contingent fee’’ if it is fixed by courts

or other public authorities, or, in tax

matters, if determined based on the

results of judicial proceedings or the

findings of governmental agencies. Fees

may vary depending, for example, on

the complexity of services rendered.

(11) Covered persons in the firm

means the following partners,

principals, shareholders, and employees

of an accounting firm:

(i) The ‘‘audit engagement team’’;

(ii) The ‘‘chain of command’’;

(iii) Any other partner, principal,

shareholder, or managerial employee of

the accounting firm who has provided

ten or more hours of non-audit services

to the audit client for the period

beginning on the date such services are

provided and ending on the date the

accounting firm signs the report on the

financial statements for the fiscal year

during which those services are

provided, or who expects to provide ten

or more hours of non-audit services to

the audit client on a recurring basis; and

(iv) Any other partner, principal, or

shareholder from an ‘‘office’’ of the

accounting firm in which the lead audit

engagement partner primarily practices

in connection with the audit.

(12) Group means two or more

persons who act together for the

purposes of acquiring, holding, voting,

or disposing of securities of a registrant.

(13) Immediate family members

means a person’s spouse, spousal

equivalent, and dependents.

(14) Investment company complex.

(i) ‘‘Investment company complex’’

includes:

(A) An investment company and its

investment adviser or sponsor;

(B) Any entity controlled by or

controlling an investment adviser or

sponsor in paragraph (f)(14)(i)(A) of this

section, or any entity under common

control with an investment adviser or

sponsor in paragraph (f)(14)(i)(A) of this

section if the entity:

(1) Is an investment adviser or

sponsor; or

(2) Is engaged in the business of

providing administrative, custodian,

underwriting, or transfer agent services

to any investment company, investment

adviser, or sponsor; and

(C) Any investment company or entity

that would be an investment company

but for the exclusions provided by

section 3(c) of the Investment Company

Act of 1940 (15 U.S.C. 80a–3(c)) that has

an investment adviser or sponsor

included in this definition by either

paragraph (f)(14)(i)(A) or (f)(14)(i)(B) of

this section.

(ii) An investment adviser, for

purposes of this definition, does not

include a sub-adviser whose role is

primarily portfolio management and is

subcontracted with or overseen by

another investment adviser.

(iii) Sponsor, for purposes of this

definition, is an entity that establishes a

unit investment trust.

(15) Office means a distinct sub-group

within an accounting firm, whether

distinguished along geographic or

practice lines.

(16) Rabbi trust means an irrevocable

trust whose assets are not accessible to

the accounting firm until all benefit

obligations have been met, but are

subject to the claims of creditors in

bankruptcy or insolvency.

PART 240—GENERAL RULES AND

REGULATIONS, SECURITIES

EXCHANGE ACT OF 1934

4. The general authority citation for

Part 240 is revised 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, 78f, 78i, 78j, 78j–1,

78k, 78k–1, 78l, 78m, 78n, 78o, 78p, 78q, 78s,

78u–5, 78w, 78x, 78ll, 78mm, 79q, 79t, 80a–

20, 80a–23, 80a–29, 80a–37, 80b–3, 80b–4

and 80b–11, unless otherwise noted.

* * * * *

5. By amending § 240.14a–101 to add

paragraph (e) to Item 9 to read as

follows:

§ 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 professional

services rendered for the audit of the

registrant’s annual financial statements for

the most recent fiscal year and the reviews

of the financial statements included in the

registrant’s Forms 10–Q (17 CFR 249.308a) or

10–QSB (17 CFR 249.308b) for that fiscal

year.

(2) Disclose, under the caption Financial

Information Systems Design and

Implementation Fees, the aggregate fees

billed for the professional services described

in Paragraph (c)(4)(ii) of Rule 2–01 of

Regulation S–X (17 CFR 210.2–01(c)(4)(ii))

rendered by the principal accountant for the

most recent fiscal year. For purposes of this

disclosure item, registrants that are

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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.

(3) Disclose, under the caption All Other

Fees, the aggregate fees billed for services

rendered by the principal accountant, other

than the services covered in paragraphs (e)(1)

and (e)(2) of this section, for the most recent

fiscal year. For purposes of this disclosure

item, 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.

(4) Disclose whether the audit committee

of the board of directors, or if there is no such

committee then the board of directors, has

considered whether the provision of the

services covered in paragraphs (e)(2) and

(e)(3) of this section is compatible with

maintaining the principal accountant’s

independence.

(5) If greater than 50 percent, disclose the

percentage of the 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.

Dated: November 21, 2000.

By the Commission.

Jonathan G. Katz,

Secretary.

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[FR Doc. 00–30244 Filed 12–4–00; 8:45 am]

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