Human Capital & Careers

The SEC Rules on Auditor Independence

Commission sought to reflect input of Big 5, AICPA.
Ed ZwirnNovember 15, 2000

The Securities and Exchange Commission today voted unanimously to revamp regulations governing audit firms and the standards by which the independence of their work is to be judged.

While the regulations are more stringent than the 18-year-old rules they replace, the new rules reflect much of the input the SEC has received, particularly from Big 5 firms and professional groups such as the American Institute of Professional Certified Public Accountants.

The new rules restrict the performance of non- audit activities, such as information- technology consulting, by audit firms for the same clients. But they allow for exceptions in regard to these activities, in effect shifting much of the emphasis from regulation to disclosure and self-regulation by firms’ audit committees.

In a break for smaller firms, audit companies with assets of less than $200 million were excepted from the provisions.

Also approved were restrictions on the types of investments family members of auditors can make in the firms being audited, with significant exceptions for mutual funds, retirement plans, and other types of investments in which there is “no financial discretion involved.”

In a change in the new rules from the ones first proposed June 27, the SEC took the statement of “four principles by which to measure auditor independence” out of the rules themselves and place them inclusion in the preamble. The principles say that an auditor is not independent when the accountant has a mutual or conflicting interest with the client, audits his or her own firm’s work, functions as management or employee for the client or acts as the client’s advocate. This change was made in response to criticism that the principles were too general for inclusion in a set of regulations.

But perhaps the most significant changes the SEC made from its original proposal in June are those that govern disclosure, requiring that companies disclose in annual proxy statements fees for audit, IT consulting and other services provided by their auditors during the past fiscal year.

“Companies will also state whether the audit committee has considered whether the provision of the non-audit services is compatible with maintaining auditor’s independence,” a summary provided by the SEC states. Also, the firm would have to disclose hours worked on the audit by “persons other than the accountant’s full-time employees, if that figure exceeded 50 percent.”

SEC Chairman Arthur Levitt said he was very pleased by the way the new rules turned out and defended the commission against criticism that they “caved in to the accounting industry.”

“If you had given me a choice between our original rule [that had included] a total IT ban and the rule which has emerged, absolutely committing the audit committee to engage itself in this process, without any question I would choose the latter,” he said. “It’s one thing to make some rules which can be circumvented, [but] what we are talking about fundamentally is a very important cultural change.”

The other commissioners agreed.

“The rule that was proposed [in June] was pretty good,” said Laura S. Unger. “The rule that was passed was great.”

Commissioner Paul R. Carey praised Levitt for having put “his hand dangerously close to the third rail of SEC issues.”

Steven Silber, a spokesman for PricewaterhouseCoopers, was cautiously approving in his assessment, saying he needed time to see the specifics.

But, he told, “we’re saying: ‘It works, it’s a workable rule.”

Today’s SEC ruling caps a five-month process that began with the June 27 release of proposed rules that would have completely barred auditors from engaging in consultancy and other services for the same clients. The proposed rule would also have set strict limits on investments by auditors and their families in client firms.

The proposals, which were intended to ensure auditor independence, predictably elicited a storm of criticism, including vociferous objections by Big 5 firms. Levitt reported receiving nearly 3,000 letters on the topic.

The AICPA, in testimony submitted to the SEC, said the proposal would “dramatically curtail the ability of accounting firms to provide services other than audit and tax services to SEC audit clients.”

The AICPA also criticized the SEC for including “`catch-all’ provisions that leave [it] with broad discretion to restrict services beyond those expressly prohibited in the rules.”

Also, the criticism ran, the rules themselves gave the profession a bum rap, prohibiting business activities that have yet to cause any problems. If it ain’t broke…

“Radical changes are proposed without any empirical basis,” said the AICPA statement. “None of the studies or reports cited by the SEC concluded that the scope of services impaired audit effectiveness, or that an exclusionary ban was necessary or appropriate.”

Some CFOs, including E.I. Dupont DeNemours’ Gary M. Pfeiffer and Merck’s Judy Lewent, argued that the provisions should be issued in the form of voluntary “guidelines,” rather than rules.

At the fall hearings on the rule, Pfeiffer argued that “the complexity of business models that large companies operate in around the world and across dozens and dozens of different businesses and industries is best measured and metered by guidelines and principles.”

Lewent also echoed the concerns of many about the proposal’s complexity, calling the 109- page rule “a daunting thing.” She also worried about how the rule would curb corporations’ ability to adjust to fast changes in the business environment.

But most of the uproar was driven by bottom- line concerns.

According to the SEC, revenues for management advisory and similar services for the Big 5 alone amounted to more than $15 billion in 1999.

In addition, these advisory and consultant activities constitute the major growth segment of the auditing and accounting profession.

From 1993 to 1999, these revenues have grown at an average 26 percent annually, much more than the 9 percent recorded for audits and 13 percent for tax services. The proportion of Big 5 revenues derived in this manner has also increased exponentially, from 13 percent in 1981 to the current estimate of about half.

The comments forwarded between the release of the proposal and the end of the comment period on Sept. 25 included many calls for the softening of the consultancy restrictions, particularly as they affected the lucrative information technology segment of the industry.

And not all comments were made on behalf of the big guys. Some also called for a “de minimis” provision to exempt the activities of smaller firms.

Levitt, responding last week to many of these criticisms and to requests for delay, said that despite the heated atmosphere of the auditor independence debate, much progress has been made over recent weeks.

Reassuring Big 5 and the AICPA firms that “the final rule will reflect,” their concerns, Levitt nonetheless said that “after four days of public hearings, almost 3,000 comment letters, and months, the time has come for the Commission to act.”