SEC Issues Sarbanes-Oxley Rules
Busy Rule-Making Season Brings PCAOB, Reform to Life

The U.S. Securities and Exchange Commission finished the busiest period of rule making in its history with the introduction of regulations in compliance with last year’s Sarbanes-Oxley Act.

The SEC adopted sweeping rules last month that will change how publicly traded companies are audited, and reshape the financial reporting system as a whole.

The rules—which impact auditors, attorneys, members of audit committees, and executives—went into effect in January, with compliance dates set for the fall of 2003.

The full import of the new rules remains to be seen, especially as the new Public Company Accounting Oversight Board will not become fully operational until at least April 26, its mandated start-up date. The PCAOB will have enforcement and investigative power over firms that audit publicly traded companies, reviewing audits once every three years for all audit firms and annually for firms with 100 or more audit clients.

While the PCAOB already has begun forming an operation plan, hiring staff and settling in the former Washington offices of Andersen and Co., the real meat-andpotatoes work remains to be done, such as setting standards for audit, attest ethics and control, traditionally under the purview of the American Institute of CPAs.

Accounting firms must register with the oversight board to qualify to perform audits. Firms must disclose the names of their SEC-reporting clients, the fees they receive from them, the identities of all accountants associated with them who participate in audits, and disagreements with them that an issuer filed with the SEC in the preceding calendar year.

Auditor Independence

Most significant to CPAs are a slew of rules governing the relationship between auditors and their clients, especially the prohibition of nine specific nonaudit services.

Auditors are now prohibited from providing audit clients bookkeeping services, financial information systems design and implementation services, valuation services, actuarial services, internal audit outsourcing services, management functions and human resources services, investment advising or investment banking services, legal services, or expert services unrelated to the audit, such as expert testimony during an investigation or legal proceeding against an audit client.

Auditors can offer other nonaudit services not expressly prohibited, but preapproved by the client’s audit committee. According to the SEC, auditors may continue to provide tax compliance, tax planning and tax advice to their audit clients, except under certain circumstances when tax services impair independence, such as representing an audit client in tax court. Audit committees may form policies and procedures for preapproval as long as they are consistent with Sarbanes-Oxley.

The rules also will provide a de minimis exception if services do not account for more than 5 percent of money paid by the client to its accountant, if the services are not recognized as a nonaudit service during the engagement, and if this is brought to the audit committee’s attention and approved prior to the completion of the audit.

The client must then include in its annual report the fees paid to the accountant for audit, audit-related, tax and other services, with the audit committee’s policies for preapproval of nonaudit services and the amount paid subject to the de minimis exception.

Audit Partners

The SEC also is making rules intending to preserve auditor independence through limitations on the relationship between the auditor and the client. These focus on the audit partners—members of the engagement team—primarily, the lead and concurring partner.

The lead and concurring partners now will be subject to rotation after five years, with a five-year “time-out” period following. Additionally, partners face a one-year cooling-off period before a member of an engagement team can accept certain employment (to be defined in the final rules) with its audit client. Other audit partners will be subject to a seven-year rotation.

Firms with fewer than five audit clients and fewer than 10 partners may be exempt from the partner rotation, provided each of these engagements is subject to a special review by the PCAOB at least every three years

Significantly, these rules affect any member of the engagement team who provided more than 10 hours of audit, review or attest services for the issuer within a year preceding the commencement of the audit of the current year’s financial statements. A firm that violates the cooling-off period will be considered not independent if such an engagement team member accepts such employment.

Firms also will be considered not independent if at any point during the audit engagement period, any audit partner receives compensation based on any services other than audit, review or attest.

Audit Committees, Reports and GAAP

The SEC set out rules making the audit committee—or the board of directors, in the absence of an audit committee—responsible for the appointment and management of the auditor.

The rules require the auditor to report to the audit committee all “critical accounting policies and practices” used by the issuer, all “material alternative accounting treatments of financial information within generally accepted accounting principles (GAAP) that have been discussed with management” and the ramifications of those alternatives, and other material written communications between the firm and management.” This must be done prior to the filing of the audit report with the SEC.

The company also must disclose in its periodic report whether there is a “financial expert”—someone deemed to have an understanding of GAAP and financial statements and experience in the preparation of financial statements, among other things—on the audit committee.

There also are rules requiring reports to include off-balance-sheet transactions, arrangements obligations and other relationships that have a material effect on financial condition, liquidity, capital expenditures, resources or significant components of revenue expenses.