what are the new guidelines for auditor independence?

Robert W. Rouse and Thomas R.Weirich

Perhaps the mostcontentiousissue to surface

during ChairmanArthur Levitt’s almosteight-year tenure atthe Securities andExchangeCommission was the topic ofindependence of auditors of reg-istrants. The final revisions wereapproved on November 15,2000, and several transitiondates are applicable for thechanges in Rule 2.01 of S-X andin Item 9 of Schedule 14A of theSecurities Act of 1934. This arti-cle reviews some of the eventsthat prompted the Commissionto revisit the issue after anabsence of 18 years, provides anoverview of the revisions, andconcludes with some observa-tions about the potential impactof the changes.

Chairman Levitt wasappointed by President Clintonas Chairman of the SEC in July1993 for a five-year term andthen reappointed for anotherfive-year term in 1998. Althoughhe could have remained on the

Commission until 2003, heelected to step down with achange of presidents.

Prior to his service asChairman, Mr. Levitt served asPresident of the AmericanStock Exchange as well asother positions that demanded akeen acumen of financialreporting. This working knowl-edge of financial reporting pre-pared him well to address theissue of independence.

INDEPENDENCE—THECOMMISSION VS. THE AICPA

The basic building block forthe credibility of financialreporting at the Commissionrests upon the tenet that auditorindependence in both fact andappearance was essential toensure the credibility of finan-

cial reporting. TheAmerican Institute ofCertified PublicAccountants (AICPA)has long accepted amore expansive defini-tion of independencethan the SEC for its

more than 300,000 members. For example, the AICPA has

permitted an auditing firm toprovide “write-up work” for aclient whose financial state-ments are subsequently auditedby the same firm withoutimpairing its independence,requiring only that the manage-ment of the client “acceptresponsibility” for the statementsas being their own. TheCommission simply has not tol-erated such an engagement,alleging that the appearance ofindependence could be impaired.

The Commission has takenthe position that if there is“close association” with themaintenance of basic accountingrecords by the auditor, eithermanually or through its comput-er services, the auditor may notbe deemed independent. While

Can you trust your auditor? Can the public trustyour auditor? The SEC was worried enough toissue new guidelines recently. What prompted SECaction? What do the new guidelines say? Andwhat will be their impact?

© 2001 John Wiley & Sons, Inc.

What Are the New Guidelines for AuditorIndependence?

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49© 2001 John Wiley & Sons, Inc.

the AICPA’s definition applied tothe practices of its membershipbroadly, the SEC’s definitionapplied to the audit engagementsof the roughly 16,000 publiclyheld companies. The SECbelieves that while the AICPA’sconcept of permitting bookkeep-ing may be acceptable in smallerand private companies, the act ofraising funds through a publicoffering or trading in a publicmarket raises the bar on therequired segregation of theauditor from maintenanceof financial records andthe preparation of finan-cial statements.

These differencesbetween “fact” and“appearance” surfacedacutely in the AICPA’spublishing a white papertitled “Servicing thePublic Interest—A NewConceptual Framework forAuditor Independence.” Thewhite paper presented little sup-port that the appearance of inde-pendence was critical to ensurethe credibility of financialreporting, arguing instead thatthe “safeguards” in place atfirms and the existence of their“reputational capital” would besufficient to assure independentaudits. Appearance was nolonger an appropriate tenet.

Commission Issac Hunt’sresponse to the white paper wasmost succinct. “I do not believethat the writers of the WhitePaper report see the core issuesthe same way that I do, and theydo not perceive the same risksthat I perceive from a failure tomaintain auditor independenceboth in fact and appearance.”

In 1998 the SEC issuedFinancial Reporting Release No.50 which acknowledged thenewly created IndependenceStandards Board (ISB) as thepromulgator of independence

standards for firms that auditregistrants. The SEC has pre-ferred to “look to” the privatesector standard setters for theappropriate standards and hadpreviously delegated suchresponsibility to the FinancialAccounting Standards Board forgenerally accepted accountingprinciples (GAAP) and theAuditing Standards Board forgenerally accepted auditing stan-dards (GAAS).

Although the SEC delegatedthese responsibilities, the legalauthority to promulgate stan-dards has always remained withthe Commission. On occasionthe Commission has resorted tothe promulgation of standardswhen the appropriate standardswere not forthcoming from theprivate sector.

The ISB turned its attentionto the development of a concep-tual framework, and few stan-dards have been issued by theBoard. (Members of the ISBwould later request theCommission to take appropriateaction in the setting of independ-ence standards.)

While the ISB was laboringwith the framework, theChairman’s concerns about thequality of financial reporting didnot diminish. The now famous“The Numbers Game” speech onSeptember 28, 1998 addressed theearnings management issue. TheChairman’s renown laundry list ofpractices he alleged were being

employed to “manage” earningsincluded big bath restructuringcharges, creative acquisitionaccounting, cookie jar reserves,immaterial misapplications ofaccounting principles, and prema-ture recognition of revenue.

The question—“Where wasthe auditor?”—prompted theChairman to suggest that theaccounting profession was fail-ing to ensure the independenceof its auditing. This volley was

heard around the world offinancial reporting andoccasioned the creation of apanel working under theauspices of the PublicOversight Board (POB) tostudy audit effectiveness.

This speech itself servedas the entrée for subsequentones by the Commission andits staff. A resulting reviewof the composition of fees

generated by the public account-ing profession, undertaken by thePanel on Audit Effectiveness,revealed that the proportion offees generated from auditing haddeclined in the face of the bur-geoning fees generated by con-sulting. In a subsequent speechthe Chairman admonished theprofession for attempting to servetwo masters—the investing publicvia the audit engagement and theregistrant via lucrative consultingengagements. In fact, only one-fourth of the registrants had boththe audit engagement and con-sulting engagements with thesame firm.

The summer of 2000 pro-duced the proposed changes toRule 2.01 of Regulation S-X andSchedule 14A. Four days of pub-lic hearings were held, and ten-sions among the Commission,certain public accounting firms,and the AICPA heightened.Overtures to Congress to with-hold funding for the Commis-sion’s efforts were made.

50 The Journal of Corporate Accounting & Finance


In 1998 the SEC issued FinancialReporting Release No. 50 whichacknowledged the newly createdIndependence Standards Board (ISB) asthe promulgator of independence stan-dards for firms that audit registrants.

While these overt efforts werebeing publicized, the staff of theCommission was working fever-ishly with leaders within the pub-lic accounting profession to reachan acceptable compromise. In lateOctober the Commissionannounced that the proposedchanges would be voted onNovember 15, 2000. The datewould not have been set unlessthe Chairman had secured thevotes necessary to pass the pro-posals, and the four sitting com-missioners approved the revisions.

THE REVISIONS TO RULE 2.01OF S-X AND SCHEDULE 14A

Regulation S-X sets forththe reporting require-ments within financialstatements submitted tothe Commission. Therequirements found inArticle 2 of S-X addressthe qualifications of theaccountants who auditthe financial statements.The Preliminary Note toRule 2.01 presents the fourbasic factors that would beapplied to a relationship thatwould be considered by theCommission to determine if anauditor’s independence isimpaired:

a. Does the relationship createa mutual or conflicting inter-est between the accountantand the audit client?

b. Does the relationship placethe accountant in the posi-tion of auditing his or herown work?

c. Does the relationship resultin the accountant’s acting asmanagement or an employeeof the audit client?

d. Does the relationship placethe accountant in a positionof being an advocate for theaudit client?

These four factors are pre-sented in a note to the rule asopposed to being included in therule itself. By doing so theCommission gave guidance tointerpreting the rule withoutincorporating the factors as partof the rule itself.

Significantly, the generalstandard in the rule now recog-nizes that an auditor must beindependent in both fact andappearance. An auditor’s inde-pendence would be impairedeither when there is direct evi-dence of subjective bias or whenthe circumstances as externallyobserved demonstrate that anauditor would not be capable ofacting without bias.

The more relevant revisionsto the rule can be summarizedinto three categories—financialrelationships, employment rela-tionships, and scope of servicesrelationships. It should be notedthat other issues addressed bythe rule—for example, unpaidfees, litigation, and indemnifi-cation—remain untouched inthe codification.

FINANCIAL RELATIONSHIPS

The general rule sets forththose financial relationships thatspecifically will impair inde-pendence. While the rule speci-fies those interests that consti-tute a direct or material indirectfinancial interest, the list is notintended to be exclusive.

The financial interestsimpair independence only if they

are financial interests of theaccounting firm, covered per-sons in the firm, or immediatefamily members of covered per-sons. Covered persons includepartners, principals, sharehold-ers, and employees of anaccounting firm (1) who aremembers of the audit engage-ment team, (2) who are in thechain of command (all personswho supervise or have directmanagement responsibility forthe audit, who evaluate or rewardthe performance of the auditengagement partner, or who pro-vide quality control or otheroversight), (3) any other personwho provides ten or more hoursof nonaudit services, and (4) any

other partner, principal, orshareholder from an officein which the lead audit part-ner primarily practices inconnection with the audit.

Immediate family mem-bers means a person’sspouse, spousal equivalent,and dependents. The latterdefinition differs from the

term, close family member,which not only includes the for-mer but also parents, nondepen-dent children, and siblings.These restrictions are viewed asbeing more liberal than past onesthat included all partners withinthe firm. Direct investments inaudit clients are prohibited andcannot be avoided through indi-rect means. Material indirectinvestments restrictions apply toindividuals and accounting firmsare not included.

The rule addresses a numberof other financial interests includ-ing loans/debtor-creditor relation-ships, savings and checkingaccounts, broker dealer accounts,credit cards, insurance products,and investments in an entity thatis a part of an investment compa-ny complex. Limited exceptionsto these rules are also provided.

May/June 2001 51


Regulation S-X sets forth the reporting requirements within financial statements submitted to the Commission.

On the other side of thecoin, certain investments in theaccounting firm or provision ofservices by the audit clientwould be considered impairmentto independence. A direct invest-ment in the accounting firm bythe client and the provision ofunderwriting services to theaccounting firm by the auditclient are exemplary of relation-ships that would impair inde-pendence.

EMPLOYMENT RELATIONSHIPS

Like the financialinterest rules, the newemployment relationshipsrules serve to reduce thepool of individuals whoare affected by the inde-pendence requirements. Anonexclusive list ofemployment relationshipsthat are inconsistent withthe general standard include thefollowing:

a. A current partner serving asa member of the board ofdirector of the audit client.

b. A sibling of a covered per-son is employed by an auditclient as the director ofinternal audit.

c. A former professional of anaccounting firm isemployed by the audit clientin an accounting role andthe former professionalreceives a pension from thefirm which is tied to firm’sprofits.

d. A former partner acceptsthe position of chiefaccounting officer at anaudit firm while maintain-ing a capital balance withthe accounting firm.

e. A former director of anaudit client becomes a part-ner of the accounting firmand participates in the audit

of the client or a period dur-ing which the individualserves as director.

The employment of relativesof the covered person extendsbeyond those included in thefinancial interest that appliedonly to the immediate familymembers of professional(spouse, spousal equivalent, anddependents). Employment rela-tionships apply not only toimmediate family members butalso to parents, nondependentchildren, and siblings as well.

SCOPE OF SERVICES

In the proposed rules thescope of nonaudit services thatcould be provided to the auditclient initially addressed tenservices. The final revisions ofthe proposals addressed nine ofthe services and eliminated theproposed provision on expertservices.

The codification of the exist-ing restrictions and prohibitionswhich were initiated by theAICPA, the SEC, the Securitiesand Exchange CommissionPractice Section (SECPS) of theAICPA, and the ISB into theexisting Rule 2.01 in S-X shouldmore quickly provide definitiveguidance regarding the provisionof nonaudit services. Any of thenonaudit services can be provid-ed to registrants that are notaudit clients.

Those nonaudit services thatare expressly prohibited are book-

keeping or other services relatedto the audit client’s accountingrecords or financial statements.Limited exceptions are availablefor foreign subsidiaries or divi-sions of audit clients. Appraisalor valuation services involving afairness opinion are also prohibit-ed with limited exceptions. Theauditor’s independence would beimpaired if the audit firm pro-vides actuarially oriented adviso-ry services if the accountantsassume a key management taskor if the services affect amountsthat are subsequently reflected in

the financial statements.Again, certain exceptionsare available.

In regard to manage-ment functions, independ-ence is considered impairedif the accountant acts—tem-porarily or permanently—asa director, officer, oremployee or performs any

decision-making, supervisory, orcontinuing monitoring function.Providing the human resourcefunction to audit clients is alsoprohibited. The new rules codifymost of the restrictions imposedby the SECPS rules.

Broker-dealer services arealso prohibited. An accountantcannot act as an underwriter orpromoter of an audit client.Acting as a broker-dealer is alsoincompatible with the provisionof the audit function.

There is a fundamental con-flict between the role of an inde-pendent auditor and that of anattorney. The former must beobjective regardless of theimpact upon the client.

The role of an attorney, how-ever, is to advance the client’sinterest and thus is incompatiblewith the need to be (and be seenas being) independent of theclient. The new rule providesthat an accountant is not inde-pendent of an audit client if the



Like the financial interest rules, thenew employment relationships rulesserve to reduce the pool of individuals who are affected by theindependence requirements.

accountant provides any serviceto an audit client under circum-stances in which the person pro-viding the service must beadmitted to practice before thecourts of a U.S. jurisdiction.

As mentioned previously, theproposal that addresses the pro-vision of expert services waseliminated in the final rules. TheAICPA Ethics Standards permitaccountants to serve as expertwitnesses. Serving as experts forclients before the InternalRevenue Service as well asbefore the SEC has long beenpermitted, and in an effort toavoid confusion and uncertainty,no restriction was adopted.

The two most contentioustypes of engagementsremain. They are engage-ments involving the finan-cial information systemsdesign and implementationand those involving theinternal audit function. Eachof these is permitted insome engagements andrestricted in others.

Designing or implementinga hardware or software systemthat aggregates source dataunderlying the financial state-ments or generates informationthat is significant to the auditclient’s financial statements,taken as a whole, will impairindependence unless certain con-ditions are met. Managementmust make all significant deci-sions in order to reduce the like-lihood that the auditor will beplaced in a position of perform-ing a management function andmust be fully responsible for theresults of the information tech-nology engagement.

Five conditions are neces-sary to ensure the above:

1. Management must convey tothe accounting firm its ownresponsibility to establish and

maintain a system of internalaccounting controls.

2. Management must specifi-cally designate thoseemployees who have theresponsibilities to make allmanagement decisions withrespect to the design andimplementation of the hard-ware or software system.

3. Management must make alldecisions concerning thesystems to be evaluated and the procedures to beimplemented.

4. Management must evaluatethe adequacy and results ofthe engagement.

5. Management must not rely onthe accountant’s work as the

primary basis for determiningthe adequacy of its internalcontrols and financial report-ing systems.

The provision of internalaudit services can be providedon a limited basis or withoutany restrictions for registrantswith assets of $200 million orless. An accounting firm is notprohibited from providing theinternal audit services forclients of the above sizebecause it was reasoned thatmany of these registrants arelocated in less populated areasand would suffer “particular”hardship unless the exceptionwas permitted.

In these engagements, how-ever, management’s responsibil-ities as well as those of theauditor must be clearly delineat-

ed to avoid an impairment ofindependence.

For those registrants whoseassets exceed $200 million, theauditor can perform up to 40percent of the audit client’s inter-nal audit work related to internalaccounting controls, financialsystems, or financial statementswithout impairing independence.The final rule does not restrictinternal audit services regardingoperational internal audits unre-lated to the above. The 40 per-cent rule is assessed relative tothe number of total hoursexpended by the audit client.

QUALITY CONTROL PROVISIONS

The Commission recog-nized that occasions couldarise where the independ-ence could inadvertentlybecome impaired. A limitedexception was adopted pur-suant to which inadvertentviolations will not impair afirm’s independence.

The accounting firmmust have in place strong qualitycontrols to deter, detect, and pro-vide as means to address impair-ments of auditor independence.The firm’s independence will notbe considered to be impaired (a) ifthe covered person did not knowof the violation, (b) if the coveredperson’s lack of independencewas corrected as promptly as pos-sible, and (c) if the quality controlsystem was in place.

DISCLOSURE OF FEES

As this article stated at thebeginning, revisions were madeto Rule 2.01 of S-X and to Item9 of Section 14A. Section 14Aaddress the disclosure require-ments of the proxy. Two addi-tional disclosures are nowrequired—fee disclosures andaudit committee disclosures.

May/June 2001 53


The provision of internal audit servicescan be provided on a limited basis orwithout any restrictions for registrantswith assets of $200 million or less.

Under the caption of AuditFees, the amount paid for theannual audit and for the review ofthe registrant’s quarterly financialstatements will be disclosed.Under the caption, FinancialInformation Systems Design andImplementation Fees, the aggre-gate fees billed for these serviceswill be disclosed. A third caption,All Other Fees, will present allother nonaudit services, includingfees for tax-related services.

RESPONSIBILITIES OF THEAUDIT COMMITTEES

The Commission has statedthat the new rules do not imposeany additional liabilities uponaudit committees. The final ruleswere modified to reflect thisintent. The audit committee mustdisclose within the proxy whetherthe committee considered theimpact of the provision of theinformation technology servicesand other nonaudit services uponthe maintenance of the accoun-tant’s independence. The conclu-sions of the audit committee’sassessments are not required.

THE POTENTIAL IMPACT OF THERULES

It is much too early to assessthe entire impact of these revi-sions to the independence rulesupon the public accounting pro-fession. Some of the transitiondates allow more than 18 monthsbefore implementation isrequired. An obvious impact ofthe revisions is that the concept of

independence both in appearanceand in fact has now been codifiedinto the Commission’s reportingregulations. Although statementsas to the potential impact—orlack thereof—are pure conjec-tures, some have been provided tothe authors.

It has been suggested that thenew disclosure requirements ofthe audit committee will place thecommittee in a position of want-ing to approve only those infor-mation technology engagementsperformed by a firm other thanthe audit firm. As already stated,only one-fourth of the registrantswere receiving this type of servicefrom the firm that was also pro-viding the audit.

Another comment involvesthe interpretation of the fifth con-dition necessary for there to be noimpairment when the auditor isproviding an information technol-ogy engagement. The conditionrequires that “management doesnot rely on the accountant’s workas the primary basis for determin-ing the adequacy of its internalcontrols and the financial report-ing system.” One could proposethat an information technologyengagement that affects materialaccounts which surface on thefinancial statement on which theauditor is opining would impairindependence.

The $200 million in assetsand the 40 percent caps will prob-ably generate some challenge. TheCommission has, in effect, estab-lished a materiality dollar/percent-age for independence. As timepasses, whether or not those num-

bers will be adjusted is subject toconjecture.

While the rules do codifyexisting requirements that werethe result of various AICPA, ISB,SEC, and SECPS actions, therevisions themselves do notappear to have restricted the pub-lic accounting profession to anygreat degree. Evidence of com-promise appears to be pervasivethroughout the revisions.

A SACRED FRANCHISE

Independence is the corner-stone on which the credibility offinancial reporting rests. Theinvesting public is entitled toreceive financial reporting whichis transparent and objective. Thegatekeepers to financial report-ing—auditors—must realize thatthis “sacred” franchise has beenbestowed upon it only because theCommission has bequeathed it.

This article has presented anoverview of those developmentsthat prompted the Commission tobecome concerned about the cred-ibility of financial reporting andto issue proposals to revise anti-quated independence regulations.The new guidance and disclosureswere then reviewed, and some ini-tial reactions and conjectures wereprovided. Only time will deter-mine if these regulations, whichwere the product of some of themost contentious deliberationsbetween the Commission and thepublic accounting profession, willaccomplish the goal of maintain-ing independence to ensure theobjectivity of financial reporting.



Robert W. Rouse, Ph.D., CPA, is a professor at the College of Charleston. He served as an academic fel-low in the Office of the Chief Accountant at the SEC. He is a member of the SEC Regulations Committeeof the AICPA. Thomas R. Weirich, Ph.D., CPA, is a professor at Central Michigan University. He has servedas an academic fellow in the Office of the Chief Accountant at the SEC. He is currently a member of theAICPA’s Technical Standards Committee-Ethics. The authors wish to thank Roy Van Brunt, director, TenEyck Associates (Washington, D.C.), for his review and comments as this article was being written.

what are the new guidelines for auditor independence?

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