SEC's Final Rule on Auditor Independence Generally Reflects Negotiated Compromise.

Input from AICPA Members Made a Difference

Having received input from a wide spectrum of AICPA members critical of its proposed rule on auditor independence, the Securities and Exchange Commission worked with the AICPA and its members to arrive at a compromise that would lessen the final rule's effect on the majority of the membership -- in particular on smaller firms. Now that the final rule has been released, we can tell you it generally reflects that compromise (The CPA Letter, Dec. 2000). In the end, many of the more overly restrictive provisions of the proposed rule were jettisoned, modified or otherwise improved.

But this is no rime to celebrate. Parts of the rule remain of real concern. We will have to see how the SEC interprets the rule in practice. Continued vigilance will be essential.

Here's how the profession came out on the key issues. Keep in mind that the SEC's rule pertains only to accounting firms in the context of their audit clients who are SEC registrants. However, should state boards of accountancy adopt the SEC's rule, it could apply to audits performed for any client.

A major objective of the rule was to restrict the non-audit services a firm may provide to its SEC audit clients. The SEC initially proposed to completely prohibit firms from providing information technology and internal audit outsourcing services.

Regarding IT, the final rule generally permits continuation of the service in the same manner as engagements presently are performed. The rule is designed to ensure that the client retains management responsibility. In essence, the rule adopted the AICPA's current framework.

In the area of internal audit outsourcing, under the new rule an audit firm will be allowed to perform up to 40% of an audit client's internal audit work when the client has $200 million or more in assets. There is no limit on the amount of internal audit work for a client with less than $200 million in assets. While this approach is not what we were seeking, in that it departs from current AICPA standards, it is a vast improvement over the proposed blanket ban. Obviously, the SEC recognized, as a result of comment letters and testimony in its public hearings, that internal audit outsourcing is a very important service, especially for smaller accounting firms that tend to audit smaller businesses.

The final rule closely reflects current AICPA, SECPS or SEC restrictions for the seven additional non-audit services (those other than information technology and internal audit outsourcing) that it covers. The other initially prohibited service area, "expert services," was dropped altogether from the final rule, again in recognition of the legitimate concerns of the profession and the public.

This brings us to the second major impact of the new rule: proxy statement disclosures. Public companies will be required to disclose all fees paid to their auditors during the past fiscal year, divided into three categories: audit, IT consulting, and all other services. They also will be required to state whether the audit committee considered whether provision of these non-audit services was compatible with maintaining the auditor's independence. Here, too, the final rule substantially reduces the disclosure burden the proposed rule would have imposed.

Among the other issues the AICPA focused its efforts on was the SEC's proposed definition of an "affiliate" of an accounting firm. The proposed rule had a definition of an accounting firm "affiliate" that would have prohibited virtually any business association or relationship, including interfirm networks. We were successful here; the rule abandoned the overly broad definition, and existing guidance will continue to be followed.

As discussed last month, the general independence standard specified by the SEC is troublesome in that it now will be based on both "tact" and "appearance." We are concerned the "appearance" element of the standard could be misapplied. Its language is just too broad and subjective. On top of that, a preliminary note to the rule contains what the SEC calls "four principles" that will be used as general guidance in assessing independence issues. I personally believe that at least two of these "principles" (mutuality or conflicts of interest and acting as an advocate for an audit client) are not principles at ail, and are confusing and contrary to actual practice. For example, the profession has a mutual interest with clients in obtaining good financial reporting; there may also be a conflict of interest about whether to issue a report that one party does not want to issue. Such mutual or conflicting interests are built into the system; they are proper and acceptable. In another example, we frequently act as advocates for our clients in the tax area.

Provisions in the final rule relaxing and modernizing the restrictions on financial interests in and employment relationships with clients had always been supported by the AICPA and were long overdue. The new rule's restrictions substantially narrow the group of professionals to whom they apply, principally to those who work on or can influence the audit and their immediate families. Similarly, restrictions on employment relationships involving family members working for audit clients are sharply reduced.

Members are encouraged to read the lengthy rule themselves, as it contains the specific language to follow and the various effective dates to abide by. You can download it from www.sec.gov/rules/final/33-7919.htm. We also will be posting on our Web site (www.aicpa.org) a more detailed summary of the new rule, with an accompanying letter that highlights changes from the original proposal.

Again, the AICPA thanks those of you who participated in the successful effort to help us negotiate on behalf of all our members.