Ethics Rules Get Tighter

New PCAOB independence rules focus on tax services and contingent fees.

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 .

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.

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.

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 .

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.

  An Implementation Checklist

Here are some suggestions for implementing the new PCAOB rules:
Enlist your clients’ help in identifying and monitoring persons in FRORs and their immediate families. Provide questionnaires to facilitate data gathering and monitoring.
Communicate (via e-mail or other forums) with the professionals in your firm to inform or remind them of the new rules, effective dates and new or revised protocols.
Develop policies and procedures with full participation of all relevant practice units in your firm.
Conduct brief, focused information sessions to help professionals learn the new policies and procedures and understand their specific roles in complying with them.
Add targeted questions to your client acceptance and continuance policies and procedures to facilitate compliance with new preapproval requirements and restrictions on tax services and fees.
Develop monitoring and follow-up procedures for addressing IRS listed transactions.
Adopt a protocol to alert the clients’ audit committees of all personal services paid for by the clients. This goes beyond the technical requirements but is consistent with PCAOB recommendations and may be simpler to implement.
Provide sample documentation of audit committee preapproval disclosures to your audit and tax teams.
Initiate meetings with client audit committees to gauge their thoughts on the new rules as they may have questions or suggestions for implementation in their organizations.

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.

  Services Addressed in SEC and PCAOB Independence Rules

Bookkeeping or other services related to the accounting records or financial statements of the audit client.
Financial information systems design and implementation.
Appraisal or valuation services, fairness opinions or contribution-in-kind reports.
Actuarial services.
Internal audit outsourcing services.
Management functions.
Human resources.
Broker-dealer, investment adviser or investment banking services.
Legal services.
Expert services unrelated to the audit.
Tax services provided to persons in financial reporting oversight roles (FRORs).
Confidential or aggressive tax transactions.

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.)

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.

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.


AICPA Professional Ethics Division, .
Center for Public Company Audit Firms, .

Independence (# 739175HSJA).
Professional Ethics: The AICPA’s Comprehensive Course (# 738328HSJA).
Real World Business Ethics: How Would You React? (# 731683JA).
Selected Topics in Professional Ethics (# 738380HSJA).

Corporate Ethics for Financial Managers: Navigating with Case Studies and Practical Solutions (# 029880JA).

Other Resource
PCAOB Ethics Rules, .

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