PCAOB Rules on Independence and Personal Tax Services
Current Guidance for Public Company Auditors

By Catherine R. Allen

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FEBRUARY 2007 - In 2005, the Public Company Accounting Oversight Board (PCAOB) adopted Ethics and Independence Rules Concerning Independence, Tax Services and Contingent Fees (PCAOB Release 2005-014, July 26, 2005). This omnibus release, the PCAOB’s first independence and ethics rulemaking document, addressed tax services, contingent fees, personal accountability for independence infractions, and certain general independence and ethics rules. The SEC approved the rules on April 19, 2006, after a brief public comment period provided for under the framework created by the Sarbanes-Oxley Act (SOX).

The PCAOB rulemaking was prompted by concerns over two types of tax services: auditors’ promotion of potentially abusive tax-shelter products to their public company audit clients, and their promotion of these and other tax services to public company executives. To help the PCAOB fully understand the various viewpoints and concerns regarding these and similar issues, prior to rulemaking the board held a public roundtable on the effect of tax services on auditor independence. Subsequently, it concluded that a broad ban on tax services was not necessary to safeguard independence. The board proposed (among other things) rules that restrict an auditor’s involvement in certain aggressive tax-position transactions, rules that restrict tax services provided to a company’s senior financial management, and new procedures for audit committee preapproval of tax services. The PCAOB received more than 800 comment letters from the investing, accounting, academic, and regulatory communities, which largely supported the proposed rules.

Rule 3523: Tax Services for Persons in Financial Reporting Oversight Roles

What is rule 3523? This rule states that if auditors or their affiliates provide tax services to public company managers in financial reporting oversight roles (FROR) during the audit and professional engagement period, their independence is impaired. The term “audit and professional engagement period,” adopted in this rulemaking and based on the SEC’s existing rules, has two components. The professional engagement period starts when an auditor is initially engaged to perform audit, review, or other attestation services (or begins performing any of these attest services, if earlier) and lasts until the auditor or client officially terminates the relationship by notifying the SEC. The audit period is the period covered by the financial statements or other information under audit.

The rule generally prohibits an auditor from providing tax services to persons in FRORs during this period, to eliminate any perception that the auditor and the client’s senior financial management share a joint interest, which may diminish, or appear to diminish, the auditor’s ability to conduct an unbiased audit.

What is a financial reporting oversight role (FROR)? FROR is not a new term; it comes from the SEC independence rules and is, simply, a position in which an individual influences a company’s financial reporting. An individual in an FROR influences the contents of a company’s financial statements and related information filed with the SEC, either directly or by overseeing persons responsible for preparing the information. Examples of FRORs include the executives who oversee the preparation of the financial statements and those who are responsible for designing and maintaining the company’s system of internal controls.

How can FRORs be identified? While auditors likely will be well acquainted with the key financial players in a company, it is imperative that they—ideally, with the client’s help—evaluate and identify all possible FROR candidates. This is particularly important for large multinational companies that have numerous affiliates. Otherwise, both the auditor and the client risk violating the rule.

When assessing FRORs, it is very important to look beyond an employee’s title and evaluate the substance of the person’s roles and responsibilities and the organization’s financial reporting hierarchy. The overriding question should be whether the employee has direct influence over the consolidated financial statements and other information filed with the SEC.

Does the rule apply to any other persons or entities? Where rule 3523 applies to an individual, it also applies to the individual’s immediate family, specifically a spouse, spousal “equivalent” (e.g., common-law spouse or domestic partner), and any dependents. The PCAOB extended the rules to immediate family to address concerns that excluding immediate family from the rule would allow auditors to circumvent the rule by providing services to an executive’s closest kin.

Does the rule have any exceptions? Yes, a few notable exceptions to the rule exist:

  • Board and committee members. The rule does not apply to members of a company’s board of directors (including members of audit, compensation, governance, or other board committees) who are not otherwise in an FROR. The SEC rules (e.g., cooling-off provisions and other employment restrictions) include directors in the FROR definition because of their broad influence over company policy. The intent of rule 3523, however, is to identify only those persons who directly oversee a company’s financial reporting. Therefore, nonexecutive board members are generally excluded.
  • Immaterial affiliates of the audit client. Generally, the rule applies to persons in FRORs of the audit client and its material affiliates, such as parent companies and subsidiaries. Employees of immaterial affiliates of the company are not subject to the rule. For example, the chief audit executive (CAE) of a subsidiary that constitutes less than 1% of a parent-company audit client’s assets and income presumably would have little influence over the parent’s consolidated financial statements. Accordingly, the auditor may provide personal tax services to the CAE of the subsidiary.
  • Affiliates audited by other accounting firms. Persons in FRORs employed by an affiliate of an audit client are exempt from the rule if the affiliate is audited by an unrelated accounting firm. For example, suppose that Auditor A provides personal tax services to a CFO of a material subsidiary of its audit client. Auditor B, a separate, unrelated accounting firm (with regard to both Auditor A and its associated persons, such as A’s partners and professional employees), audits the subsidiary. As parent-company auditor, Auditor A would not be prohibited from providing personal tax services to the subsidiary’s CFO, because the performance of audit procedures by Auditor B would mitigate any risk that Auditor A and the CFO client share a mutual interest that would impact A’s independence. This would be the case regardless of whether Auditor B issues a separate audit report on the subsidiary’s financial statements.
  • Entities controlled by the employee. Although concerns about possible circumvention of rule 3523 by entities controlled by persons subject to the rule arose during the comment period, the board chose not to prohibit audit firms from providing tax services to these affiliated entities.
  • PCAOB-suggested practice. The PCAOB has encouraged auditors to discuss with clients’ audit committees any tax-service relationships involving certain individuals or affiliates that are exempt from the rule. For example, the CFO of an audit client may be the general partner of a partnership that is a tax client of the firm. Or, the auditor may provide tax services to a nonexecutive member of the board of directors. Auditors may use the Independence Standards Board (ISB) Standard 1 process or other less-formal means to ensure that audit committees are aware of relationships that, while not prohibited under existing rules, may need to be evaluated in light of the specific facts and circumstances.

May auditors provide other nontax services? Auditors may continue to provide other nontax services, such as financial planning, to persons in FRORs and their immediate families. If the company will pay for these services for any individual (not only persons in FRORs), audit committees should review them as they would any other service proposal.

What if personal tax services are in process when a person assumes a FROR? The PCAOB provided a transition period for personal tax services that are in process when an individual first assumes an FROR in a company due to an employment event (e.g., the individual is hired or promoted, or his responsibilities change). An in-process engagement means that the engagement letter has been fully executed and substantive work has begun. In these instances, auditors have 180 days from the date of the employment event to complete the tax service without impairing their independence.

May an auditor assist with a tax matter related to previously provided services? Some have asked the PCAOB whether an accounting firm that prepared a tax return for an executive in an FROR prior to the rule’s effective date could assist the executive in responding to an IRS or other governmental examination of the return once the rule became operative. The PCAOB’s position is that if the service was provided prior to the effective date of rule 3523, the firm could respond to questions and offer other assistance to the executive with regards to the return, provided the firm complied with all other applicable independence rules.

When did rule 3523 become effective? Until April 30, 2007, the effective date of rule 3523 depends on whether the client is a new or an existing audit client. For existing audit clients, the rule became fully effective on November 1, 2006; a transitional provision allowed in-process tax engagements to be completed by October 31, 2006. For new audit clients, however, the rule is only partially effective, pursuant to the PCAOB’s decision to reevaluate one aspect of the rule. That is, until April 30, 2007, rule 3523 applies to the professional engagement period, but not the audit period, when an accounting firm first becomes a company’s auditor.

Consider the following example: In November 2006, ABC Corp. seeks to engage Firm X as its auditor; the first audit period will cover financial statements for calendar years 2004 through 2006. Since January 2006, Firm X has been providing personal tax services to several ABC Corp. executives, including the treasurer and others persons in FRORs. As originally adopted by the PCAOB, the rule would bar Firm X from auditing the 2006 financial statements of ABC because the firm provided tax services to persons in FRORs during that part of the audit period. Until April 30, 2007, however, while the board reconsiders this portion of the rule, Firm X would not be precluded from auditing the 2006 financial statement period as long as it ceases providing tax services to persons in FRORs at ABC prior to the start of the professional engagement period, that is, before Firm X is officially engaged or begins to perform audit services for the client.

Rule 3524: Audit Committee Preapproval of Tax Services

What is rule 3524? Since 2003, the SEC has required that the audit committee preapprove all services to be provided by the company’s principal auditor via one of two methods: individually, where the audit committee reviews each proposed engagement, or in accordance with the audit committee’s detailed policies and procedures. The latter method generally uses a committee delegate to review and preapprove services, which can expedite the process when service proposals surface during the year.

In addition to this basic requirement, rule 3524 also requires auditors to do the following:

  • Provide the audit committee a written description of the proposal. Auditors should describe the scope of their services, the fee structure, and any other related agreements, such as side letters between the firm and the client. Adapted from the IRS rules of practice, the document must disclose to the audit committee the terms of any agreements between the firm, including its affiliates, and any third parties involving a referral fee or fee-sharing arrangement for promoting, marketing, or recommending a transaction covered by the tax service.
  • Discuss with the audit committee the potential impact of the services on the auditor’s independence. There is no hard-and-fast rule that auditors must follow in analyzing or evaluating independence with the audit committee. In fact, the PCAOB stressed that the scope of discussions should be flexible and adapted to the particular circumstances. Auditors should aim to provide audit committees with enough detail about the services and forethought regarding the services’ potential impact on independence to foster a meaningful discussion about independence in the eyes of the reasonable investor.
  • Document the substance of the discussion. Once the audit firm and the audit committee have discussed the services and their potential impact on the auditor’s independence, the firm should document the salient points of the discussion.

When should information about a proposed tax service be provided? Rule 3524 does not require that the auditor provide the audit committee with information about a proposed tax service at a particular time. Each audit committee should apply its own method and schedule for preapproving the auditor’s tax services. In general, auditors should ensure that the decision-maker—whether the entire audit committee or a committee delegate—receives the detailed, written description required under the rule and that a discussion of the issues is held. In cases where a delegate has preapproved tax services under the committee’s policies and procedures, the services should be discussed with the entire audit committee when it reviews such matters.

Why did the PCAOB believe these additional steps were necessary? Referring to the rule as “an appropriate complement to the SEC’s pre-approval rule,” the PCAOB’s primary goal was to improve the quality of information that audit firms provide audit committees when making decisions about the potential impact of tax services on independence. To improve the quality of information, the PCAOB expects accounting firms to provide audit committees with greater detail and an analysis of the issues surrounding proposed tax services.

Does it matter who pays for the services? The PCAOB acknowledged that audit committee preapproval is technically not required when an executive—as opposed to the company—pays the company’s auditor for personal tax services. As in other instances where a per se prohibition of the rules does not exist, the PCAOB recommends that auditors consider whether bringing the matter to the audit committee’s attention is appropriate.

When does rule 3524 take effect? The new preapproval requirements apply to services proposed after June 18, 2006, if services are approved on a case-by-case basis. Services preapproved under a company’s policies and procedures become subject to the rule after April 20, 2007. This longer transition period was provided as a practical matter to allow most tax services considered in an annual audit committee review process that occurred before the SEC approved the PCAOB rule in April 2006 to proceed without the need for a new preapproval.

Future Rulemaking

The board has stated that it will closely monitor the implementation of these rules via its inspection process; time will tell whether the rules have gone far enough. If the PCAOB is not satisfied with the results of future inspections, it seems likely that it will initiate further rulemaking to reassess the impact of tax and other services on auditor independence. Accordingly, firms should strive to apply the new rules in both letter and spirit.

By applying these rules diligently and incorporating the PCAOB’s best-practice suggestions, auditors will be taking a valuable opportunity to protect their independence and to work with audit committees on matters of great importance to the investing public.

Catherine R. Allen, CPA, writes, teaches and consults on auditor independence, professional ethics, and related compliance matters through her consulting firm, Audit Conduct (www.auditconduct.com). Formerly, Allen was a senior staff member of the AICPA’s Professional Ethics Division and director of independence for two of the big four accounting firms. She can be reached at callen@auditconduct.com.




















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