SEC approves PCAOB's new ethics and independence rules

By:  Cydney Posner

The SEC has approved the PCAOB's proposed Ethics and Independence Rules Concerning Independence, Tax Services and Contingent Fees. These rules include general rules with respect to ethics and independence and provide that certain types of tax services and contingent fee arrangements would impair independence if provided by a registered public accounting firm to its audit clients. See my postings of 3/9/06, 7/28/05 and 12/14/04.

Standard of Ethical Conduct

Rule 3502 establishes a standard of ethical conduct for persons associated with registered public accounting firms. Under the rule, these persons may not take or omit to take an action knowing, or recklessly not knowing, that the act or omission would directly and substantially contribute to a violation by the accounting firm of the SOX, the rules of the PCAOB or provisions of the securities laws. The rule would be effective 10 days after the date of the SEC's order.

Contingent Fees

Rule 3521 provides that independence would be impaired if a registered public accounting firm entered into contingent fee arrangements, directly or indirectly, with its audit clients. "Contingent fee" is defined as any fee established for the sale of a product or the performance of any service pursuant to an arrangement in which no fee will be charged unless a specified finding or result is attained, or in which the amount of the fee is otherwise dependent upon the finding or result of such product or service. However, a fee is not a contingent fee if the amount is fixed by courts or other public authorities and not dependent upon a finding or result. This definition differs from the SEC’s definition (Rule 2-01(c)(5) of Reg S-X) in eliminating the exception for fees "in tax matters, if determined based on the results of judicial proceedings or the findings of government agencies," and in expressly providing that the contingent fees cannot be received "directly or indirectly" from the audit client. The rule would not be applied to contingent fee arrangements that were paid in their entirety, converted to fixed fee arrangements or otherwise unwound before 60 days after the date of the SEC's order.

Tax Transactions

Rule 3522 adds to the list of services an audit firm is prohibited from providing its audit clients in order to maintain its independence. The rule prohibits auditors from providing any non-audit services to audit clients related to the marketing, planning or opining in favor of the tax treatment of transactions that are confidential transactions under IRS regs or that would be considered to take aggressive tax positions. An "aggressive tax position" is defined by the PCAOB as those that are initially recommended, directly or indirectly, by the auditor and that have a significant purpose of tax avoidance, unless the proposed tax treatment is at least more likely than not to be allowable under applicable tax laws. These tax services were viewed by the PCAOB to present an unacceptable risk of impairing an auditor’s independence. The rule would not be applied to tax services that were completed by the accounting firm within 60 days after SEC approval of the rule.

Tax Services for Persons in a Financial Reporting Oversight Role

Rule 3523 also adds to the list of services that could impair independence. This rule prohibits audit firms from providing any tax service to any person who fills a "financial reporting oversight role" (defined identically to the SEC definition) at an audit client or an immediate family member of that person, unless the person is in that role solely because he or she is a member of the board of directors or similar management governing body. Affiliates of the audit client are included unless that affiliate is either not material to the consolidated entity or the affiliate’s financial statements are audited by another auditor. (Note that the SEC extends the definition only to significant subsidiaries,) The rule would not be applied to tax services being provided pursuant to an engagement in process at the time of SEC approval, provided that the services are completed on or before October 31, 2006. With respect to individuals that are hired or promoted into a financial reporting oversight role, the rule permits tax services in process to be completed within 180 days after the hiring or promotion.

Auditor’s Responsibility in Connection with Audit Committee Pre-Approval of Tax Services

Rule 3524 requires an auditor seeking pre-approval to perform tax services to provide to the audit committee written documentation of the scope of the proposed tax service and the fee structure for the engagement, to discuss with the audit committee the potential effects on the firm’s independence of performance of the services and to document the firm’s discussion with the audit committee. The rule would not apply to any tax service pre-approval that occurs prior to 60 days after SEC approval of the rules. Where the audit client pre-approves non-audit services under pre-approval policies and procedures, the rule will not apply to any tax service that has started within one year after SEC approval of the rules.

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