EXECUTIVE
SUMMARY | The PCAOB in April
2006 issued a set of seven
rules for auditors of public companies.
The rules focus primarily on tax services,
but also address contingent fees, audit
committee preapproval of tax services and
fundamental requirements for ethics and
independence.
Individuals who
contribute directly and
substantially to their firm’s violation
of the Sarbanes-Oxley Act, PCAOB rules,
professional standards or securities
laws can be held personally accountable.
Individuals are responsible for
compliance with the new standards
whether they knew their actions (or
failure to act) would cause a violation
or were recklessly ignorant of such
facts.
Auditors cannot
accept commissions or
contingent fees from audit clients
during the audit and professional
engagement period. Both direct and
indirect fees, including those paid to
“affiliates of the accounting firm” by
the audit client or any other party on
behalf of the audit client, are
prohibited. The one allowable exception
is for noncontingent fees set by a
public authority acting in the public
interest.
While tax services
that are approved by a
client’s audit committee and meet
existing SEC standards generally can be
provided to audit clients, the PCAOB
adopted two explicit exceptions:
confidential or aggressive tax
transactions, and personal tax services
provided to the audit client’s financial
management.
Preapproval of tax
services now requires
auditors to (1) provide a detailed
description of the proposed services,
related fee and other arrangements to
the audit committee; (2) discuss the
proposal and the potential impact on
independence with the audit committee;
and (3) document the substance of the
discussion.
Catherine Allen
writes, teaches and consults on
auditor independence, professional
ethics and related compliance matters
through her consulting firm, Audit
Conduct. Formerly, Ms. Allen was a
senior staff member of the American
Institute of Certified Public
Accountant’s (AICPA) Professional
Ethics Division and director of
independence for two of the Big Four
accounting firms. Her e-mail address
is
callen@auditconduct.com
.
|
n its first major
rule-making initiative on independence and ethics,
the Public Company Accounting Oversight Board
(PCAOB) in April 2006 issued a set of seven rules
for auditors of public companies. The rules focus
primarily on tax services, but also address
contingent fees, audit committee preapproval of
tax services and fundamental requirements for
ethics and independence. We’ll outline the key
points of the new rules and give you some tips on
how to implement them. Investor
Interests
Of about 800 letters sent to the
PCAOB commenting on the new
independence and ethics rules, 740
were from individual investors
expressing strong support for the
proposal. Source:
PCAOB Release no. 2005-014.
|
LAYING THE FOUNDATION
Rule 3520, “Auditor Independence,” requires
that an audit firm and its associated persons be
independent throughout the audit and professional
engagement period. According to Rule 3501(a)(iii),
“Audit and Professional Engagement Period,” the
period has two components. The “professional
engagement period” relates to the client. It
begins when the auditor accepts a new audit or
attestation client upon signing the engagement
letter (or other agreement to review or audit a
client’s financial statements) or begins services,
whichever is sooner, and ends when the auditor or
the client terminates the relationship. The “audit
period” relates to the audit or other attestation
service itself and comprises, for example, the
period of the financial statements under
audit—often multiple years. While these
are not new terms (the PCAOB adopted the existing
SEC definition from Rule 2-01 of SEC Regulation
S-X), they are fundamental to applying the rules.
For example, prohibitions against a financial
relationship between the audit firm and
client—such as stock ownership and loans—apply
during the professional engagement period, but do
not apply to any audit period that precedes the
professional engagement period, which is generally
the case in a new attestation engagement. For an
existing attest client (for example, for the
annual audit), the professional engagement period
is ongoing—that is, it does not end each year when
the audit opinion is issued. Nonaudit services,
fee and business relationship rules, on the other
hand, apply during the entire audit and
professional engagement period, meaning they apply
retroactively to new attestation engagements. As a
result, firms may have difficulty meeting these
rules for the relevant prior periods. Rule
3502, “Responsibility Not to Knowingly or
Recklessly Contribute to Violations,” provides a
mechanism that allows the PCAOB to assert
disciplinary actions against individuals who
contribute directly and substantially to their
firm’s violation of the Sarbanes-Oxley Act, PCAOB
rules, professional standards or provisions of the
securities laws relating to the preparation and
issuance of audit reports. Under this rule
associated persons in a firm can be held
accountable if they take an action (or fail to
take an action) that is found to contribute to
violations—whether they knowingly, directly and
substantially contributed to a violation or were
reckless in not knowing that a violation would
result.
| What If a Tax
Transaction Becomes Listed?
A n accounting firm may
make a well-reasoned
assessment that a transaction
is not an aggressive tax
transaction subject to rule
3522 because it satisfies the
“more likely than not”
standard and is not a listed
transaction. But what if the
transaction subsequently
becomes listed? Is
independence impaired?
The PCAOB addressed this
question and concluded that
the auditor’s provision of
services in favor of the
transaction does not
necessarily impair
independence. However, the
auditor should discuss the
matter with the company’s
audit committee to determine
whether a reasonable investor
would likely question the
auditor’s objectivity under
the circumstances. For
example, an auditor may be
forced to defend its previous
opinion that the transaction
met the appropriate standard
or the client may sue the
audit firm. Depending on the
circumstances, the situation
may place the auditor and the
client’s management at either
mutual or adverse interests
and the appearance of
independence would warrant
careful consideration.
In its official release
approving the PCAOB rules, the
SEC encouraged the PCAOB to
provide additional guidance
regarding the independence
considerations surrounding a
subsequent listing of a
transaction.
| |
CLARIFYING CONTINGENT FEES
PCAOB rule 3521, “Contingent Fees,” was
adapted from the SEC independence rules regarding
contingent fees received for certain tax services
and adds the notion of an “indirect” fee. The rule
says an accounting firm is not independent if,
during the audit and professional engagement
period, the firm or any affiliate of the firm
provides any product or service to the audit
client for a commission or contingent fee, or
receives a commission or contingent fee from the
audit client either directly or indirectly.
Contingent fees often are associated with tax
services. In a contingent fee arrangement, the
client pays a fee only if a specific finding or
result is attained, or the fee otherwise depends
on the findings or results of the services.
Because the parties both stand to gain in the
“success” of the product or service, the PCAOB
considers these types of fee arrangements to
create inappropriate relationships between firms
and their audit clients. The rule
prohibits both direct and indirect fee
arrangements. When the client pays the auditor, it
is a direct fee. A fee paid by anyone other than
the client is an indirect fee. Currently,
the rule exempts fees fixed by a public authority
acting in the public interest if the fees do not
relate to findings or results of an accounting
firm’s services. For example, a bankruptcy court
may set the amount of the CPA firm’s fees. The
fees are not considered to be contingent because
the court is acting in the public’s interest by
prescribing the fees and the fees are not
conditioned on any findings or results relating to
the accountant’s services. As the firm has no
influence in the determination of its fees, such
an arrangement removes any mutuality of interests
between the firm and the client. Rule 3521
also eliminates an exemption to the SEC
independence rules for certain tax matters that
are determined on the basis of judicial
proceedings or findings of government agencies.
Concerned that firms may have been misapplying
this exemption, the SEC in 2004 clarified its
position that fees determined on the basis of such
findings or results were indeed contingent and
impaired the auditor’s independence. Therefore,
many CPAs expected this change. This rule, similar
to many other SEC and PCAOB independence rules,
also applies to affiliates of accounting firms.
| Affiliate of the
Accounting Firm PCAOB rule
3501, “Definition of Terms,”
adopted several terms from the
SEC rules, including
affiliate of the
accounting firm. The
SEC defines such affiliates as
parents, subsidiaries,
divisions, departments,
pension funds and other
“associated entities” of the
firm. Although the SEC had
attempted to define
associated entity
in its 2000 rule-making
effort, it opted instead to
continue its practice of
evaluating matters on a
case-by-case basis and
encouraged firms to consult
with SEC staff when needed.
The SEC also advised
accounting firms to consider
factors outlined in its
no-action letters, which are
available at
www.sec.gov/info/accountants/independref.shtml
.
| |
TWO NEW RESTRICTIONS ON TAX SERVICES
Although most tax services continue to be
allowable following the general precedent of the
SEC rules, rules 3522 and 3523 significantly
restrict specific types of tax services—those
involving confidential or aggressive tax
transactions, and personal services provided to a
person in a financial reporting oversight role at
the audit client. Otherwise, auditors in
compliance with existing SEC independence rules
generally may continue to provide tax services,
such as compliance and advisory work, provided
they are preapproved by the client’s audit
committee.
Potentially abusive tax transactions.
Rule 3522, “Tax Transactions,”
addresses from an independence standpoint the
controversial issue of an auditor’s involvement
with a confidential or aggressive tax transaction.
It adds to the list of nonaudit services spelled
out in the SEC’s 2003 Independence Rules Release
that CPA firms are prohibited or significantly
restricted from performing for audit clients
during the audit and professional engagement
period. The new rule applies to services involving
all types of tax law, whether federal, state,
local, foreign or otherwise. Under rule
3522, an auditor’s independence is impaired if,
during the period of the audit and professional
engagement, the auditor provided services to an
audit client involving marketing, planning or
opining in favor of a confidential transaction or
an aggressive tax position transaction. The PCAOB
believes that opining in favor of such a
transaction causes the auditor and the client to
have an inappropriate mutuality of interests in
the results of the transaction because of the high
likelihood that the tax authority will question
and possibly disallow the transaction. The rule
does not apply if an auditor’s services involve
opining against a tax position, because
this would not align the interests of the firm and
client.
Confidential transactions.
Based largely on the U.S. Treasury’s
definition, a confidential transaction is
one in which the client pays a fee to an adviser
and agrees, at the adviser’s request, not to
disclose the adviser’s strategy, tax treatment or
structuring. The IRS believes such confidential
arrangements suggest potentially abusive
transactions. However, a transaction would not be
deemed confidential under the rule if the client
imposed the confidentiality restrictions.
Aggressive tax transactions.
If a CPA firm recommends a
transaction whose significant purpose is tax
avoidance, it may be deemed an aggressive tax
transaction. The PCAOB deliberately set the
threshold very low, referring to the Internal
Revenue Code’s provisions relating to tax shelters
and substantial underpayment of income. The rule
broadly applies to tax transactions, including
income deferral and deduction acceleration to
reduce taxes. For a transaction not to be
deemed an aggressive tax transaction, the
accounting firm must conclude, on the basis of a
reasonable and objective analysis of the relevant
facts and applicable tax law and other
authorities, that it satisfies the “more likely
than not” standard described in the Internal
Revenue Code. Meeting this standard means that a
tax position has a greater than 50% chance of
prevailing under an IRS challenge. The firm must
make its own assessment; securing a third-party
opinion does not reduce the firm’s responsibility
and is not required. Aggressive tax
transactions also include transactions the
accounting firm recommends indirectly, as when a
firm affiliate or subsidiary makes the
recommendation to the client. The IRS
periodically publicizes tax transactions it deems
to be potentially abusive. All listed
transactions—and any that are substantially
similar to listed transactions—are aggressive tax
transactions under rule 3522. |
Which Rules to Follow?
PCAOB Rule 3600T, “Interim
Independence Standards,”
requires firms to adhere to
the most restrictive of SEC,
PCAOB, AICPA and Independence
Standards Board (ISB)
independence standards. Prior
to the creation of the PCAOB,
SEC regulations served as the
primary independence authority
for auditors of public
companies. SEC rules continue
in full force and PCAOB
inspectors now review the
practices of registered public
accounting firms for
compliance with both SEC and
PCAOB rules, in addition to
the interim independence and
ethics standards adopted by
the PCAOB shortly after its
inception in 2003. So, the
principle is: Follow the most
restrictive guidance on any
particular issue.
| |
Some personal tax services banned.
Under Rule 3523, “Tax Services for
Persons in Financial Reporting Oversight Roles,”
independence is impaired if, during the period of
the audit and professional engagement, an
accounting firm or any affiliate of the firm,
provides tax services to a person in a financial
reporting oversight role (FROR) or to his or her
spouse or dependents. Providing tax services to
persons responsible for the client’s financial
reporting—upon which the auditor opines—creates
the appearance of mutual interests between the
company’s financial management and the firm.
Properly identifying persons in FRORs is vital
to applying this rule. A person in an FROR is one
who exercises influence over the people who
prepare financial statements or over the contents
of the financial statements themselves, including
related information that is included in SEC
filings, such as management’s discussion and
analysis. Members of senior management who are
directly responsible for setting accounting
policies or designing internal accounting
controls—the CEO, controller, CFO and director of
internal audit—clearly are in FRORs. A person’s
title or job description may not tell the whole
story, though. When determining whether a person
is in an FROR, CPAs should carefully evaluate the
substance of a person’s role.
Exclusions. Rule 3523 does
not consider persons to be in FRORs solely because
they sit on a client’s board of directors or a
board committee. The PCAOB chose not to extend
this rule beyond the individual and his or her
immediate family members to companies in which a
person in an FROR owns a controlling interest. The
rule also does not extend to nontax services
provided to these persons. CPA firms are
encouraged, however, to make their clients’ audit
committees aware of these matters.
In-process engagements.
Rule 3523 allows accounting firms
180 days to complete an engagement that was in
process when an individual who was not in an FROR
when the engagement began assumes an FROR. An
engagement is in process if the engagement letter
is fully executed and substantive work has begun.
|
Brief Summary of the New PCAOB
Rules |
Rule
| Summary
|
3501, “Definition
of Terms” | Adopted
existing SEC terms
(affiliate of
the accounting firm;
affiliate of the
audit client; audit
and professional
engagement period;
audit client;
financial reporting
oversight role;
immediate family
member; investment
company complex),
one new term
(confidential
transaction),
and one term
adapted from the SEC
rules but clarified
(contingent
fee).
Effective: April
29, 2006 (10 days
after SEC approval
on April 19, 2006)
|
3502,
“Responsibility Not to
Knowingly or
Recklessly Contribute
to Violations” |
Individuals
associated with a firm
can be held
accountable for acts
or omissions that
directly and
substantially
contribute to the
firm’s violation of
applicable rules, laws
and standards. Applies
whether the individual
acted knowingly or was
recklessly ignorant.
Effective: April
29, 2006 (10 days
after SEC approval
on April 19, 2006)
|
3520, “Auditor
Independence” |
A firm
and its associated
persons should be
independent of the
firm’s audit clients
throughout the audit
and professional
engagement period.
This period
encompasses periods
covered by the firm’s
audit (or other
attestation services)
and is also ongoing,
spanning from the
beginning to the end
of the audit
relationship.
Effective: April
29, 2006 (10 days
after SEC approval
on April 19, 2006)
|
3521, “Contingent
Fees” | Firms may
not have direct or
indirect contingent
fee or commission
arrangements with
audit clients. Applies
to fee arrangements
made between the audit
client (or its
affiliates) and the
firm (or its
affiliates) during the
audit and professional
engagement period.
Only noncontingent fee
arrangements set by
public authorities
acting in the public
interest are allowed.
Effective: June
18, 2006 (60 days
after SEC approval
on April 19, 2006)
|
3522, “Tax
Transactions” |
Prohibits
marketing, planning,
or opining in favor of
the tax treatment of a
transaction that is a
confidential tax
transaction or
involves an aggressive
tax position. Applies
to services involving
all types of tax law
that are provided to
the audit client (or
its affiliates) by the
firm (or its
affiliates) during the
audit and professional
engagement period.
Effective: June
18, 2006 (60 days
after SEC approval
on April 19, 2006)
|
3523, “Tax
Services for Persons
in Financial Reporting
Oversight Roles” |
Prohibits
tax services to senior
staff in financial
reporting oversight
roles with the audit
client (or its
affiliates) during the
audit and professional
engagement period.
Effective: For
existing audit
clients, does not
apply to tax
services that were
in process on April
19, 2006, if the
services were
completed on or
before October 31,
2006. For new audit
clients, until April
30, 2007, does not
apply to services
provided during the
audit period if they
are completed before
the professional
engagement period
begins. (PCAOB
intends to
reevaluate the rule
as it applies to new
audit clients.)
|
3524, “Audit
Committee Pre-Approval
of Certain Tax
Services” | In seeking
preapproval of tax
services, firms should
(1) provide audit
committees a
description of the
proposed services and
related fee and other
arrangements; (2)
discuss the proposal
and its potential
impact on independence
with the committee;
and (3) document the
discussion.
Effective dates
vary depending on
the audit
committee’s method
for preapproving tax
services:
For audit
committees that
approve tax services
individually (by
engagement): June
18, 2006 (60 days
after SEC approval
on April 19, 2006)
For audit
committees that
approve tax services
under policies and
procedures: April
20, 2007 (1 year
after SEC approval
on April 19, 2006)
(The
transition period
allows most tax
services considered
in an annual audit
committee review
process that
occurred prior to
SEC approval to
proceed without the
need for a firm to
seek new
preapproval.)
| | |
TAX SERVICE PREAPPROVAL SUBJECT TO
ADDITIONAL STEPS
With an eye toward improving the quality of
information auditors provide to audit committees,
the PCAOB adopted Rule 3524, “Audit Committee
Pre-Approval of Certain Tax Services.” It requires
auditors seeking preapproval of tax services to
follow a three-step process:
Provide the audit committee a
written, detailed description of the scope of the
proposal, related fee and other arrangements
(whether oral or written and including, for
example, compensation arrangement, referral
agreement, fee-sharing arrangement, and so on).
Discuss the proposal and the
potential impact on independence and ethics with
the audit committee.
Document the substance of the
discussion in a uniform format. As in the
past, audit committees may choose whether to
preapprove tax services on a case-by-case basis or
in accordance with the company’s existing policies
and procedures. Describing rule 3524 as an
appropriate complement to the existing services
preapproval rules, the PCAOB decided not to expand
it to other nonaudit services or persons. For now,
the PCAOB will observe how auditors implement rule
3524 through its inspection process, among other
things, and seek feedback from its constituents on
whether to expand its scope. The PCAOB also
recommends that firms consider informing audit
committees when they are being paid to provide
other nonprohibited services (for example,
personal financial planning) to persons associated
with the client.
LOOKING FORWARD
The new PCAOB ethics and independence rules
present certain challenges for accounting firms
and their public company audit clients. But these
challenges must be met to protect the public
interest and maintain stakeholder confidence in
corporate financial reporting. Firms can achieve
these important objectives by carefully
considering the rules and how they affect their
practices and by adopting policies and procedures
to implement the rules in the most effective
manner. |