(The news featured below is a selection from the news covered in the Federal Securities Report Letter, which is distributed to subscribers of the Federal Securities Law Reports.)

SEC Provides Guidance on Elements of Auditor Independence

The SEC staff has set forth a series of questions and answers in an effort to interpret many of the components of the Commission's auditor independence rules, which were adopted earlier this year pursuant to a Sarbanes-Oxley mandate. Some of the areas covered by the guidance are audit partner rotation, communications with the audit committee, disclosure of fees and audit committee pre-approval of auditor services.

SEC rules require the audit committee to pre-approve all services provided by the independent auditor. The rules include three requirements that must be followed. First, the audit committee's pre-approval policies and procedures must be detailed as to the particular services to be provided. Second, the audit committee must be informed about each service. Third, the policies and procedures cannot result in the delegation of the audit committee's authority to management.

Interpreting these elements, the SEC said that the audit committee cannot use monetary limits as the only basis for its pre-approval policies and procedures. The Commission reasoned that the establishment of monetary limits would not, alone, constitute policies that are detailed as to the particular services to be provided, nor would monetary limits ensure that the audit committee would be informed about each service.

In addition, the audit committee's pre-approval policies and procedures cannot provide for broad, categorical approvals, such as tax compliance services. In the SEC's view, the use of broad, categorical approvals would not meet the requirement that the policies be detailed as to the particular services to be provided.

The SEC also explained that pre-approval policies must be designed to ensure that the audit committee knows precisely what services it is being asked to pre-approve so that it can make a well-reasoned assessment of the impact of the service on the auditor's independence. For example, a schedule or cover sheet given to the audit committee describing services to be pre-approved must be accompanied by detailed back-up documentation on the specific services to be provided.

The SEC rules prohibit a number of non-audit services, such as bookkeeping, valuation services and information system design and implementation. Tax services are generally not prohibited. Thus, an accounting firm can license or sell its proprietary income tax preparation software to an audit client, subject to audit committee approval, so long as the functionality is limited to preparation of tax returns for filing.

If the software performs additional functions, instructed the SEC, each function should be evaluated for its potential effect on the auditor's independence. In this context, the SEC bans software extending the functionality beyond mere tax preparation to generating the information needed to prepare the income tax disclosures that will appear in the company's financial statements. This is because the Commission views licensing or selling this module to an audit client as constituting the design and implementation of a financial information system, which is a prohibited non-audit service.

The SEC will allow the audit committee of a parent company with wholly-owned subsidiaries that do not have committees to function as the audit committee of the subsidiaries for purposes of satisfying the pre-approval requirements. In this situation, the subsidiary's disclosure should include its pre-approval policies and procedures, as well as those of its parent. The SEC cautioned, however, that an investment adviser's audit committee cannot pre-approve non-audit work on behalf of mutual funds.

SEC rules require lead and concurring partners to rotate off an audit engagement after a maximum of five years in either capacity and, upon rotation, remain off the engagement for five years. Other audit partners are subject to rotation after seven years on the engagement and must be off the engagement for two years.

The SEC explained that a primary objective of audit partner rotation is to allow the firm to take a "fresh look" at the company. This principle guided the SEC staff in two different scenarios involving an IPO and a re-audit of a new client. Thus, an accounting firm that served as the auditor of a non-public company for more than three years using the same partners would, when the client goes public, have to count the service time prior to the IPO towards the rotation requirements to the extent earlier audited financial statements are included in the filing. Thus, if a filing included three years of audited financial statements, noted the SEC, those three years must be counted as prior service in determining the rotation requirements.

However, if a firm accepts a new audit client that had previously been audited by another firm and, in the course of auditing the current financial statements, it determined that the prior two periods should be re-audited, the engagement would constitute only one year for determining partner rotation. The SEC staff viewed this as a different situation from the IPO situation since in the latter the firm and its partners had an established relationship with the client for more than three years before the company went public. In the re-audit situation, there was no previous relationship with the client. Thus, there would be a fresh look despite the multiple audits. The same would be true for a company preparing its IPO where it had never had its previous financial statements audited and the auditor concurrently audited all three periods included in the IPO.

SEC rules require that auditors communicate to the audit committee alternative applications of GAAP relating to material items that have been discussed with management. The auditor must communicate with the audit committee before the audit report is filed with the Commission.

When a filing contains the report of a successor audit firm and a predecessor audit firm, only the successor auditor is required to communicate with the audit committee. However, if a portion of the company's financial statements were audited by a firm other than the principal accountant, and the principal accountant decides to make reference to the other accountant, both the audit opinions of the principal accountant and the other accountant must be filed, and the other accountant is required to make the specified communications with the audit committee.

The SEC has established a new disclosure category for audit-related fees, which is designed to more transparently present the company's audit fee relationship with the principal accountant. In general, explained the Commission, such fees are assurance and related services, traditionally performed by the independent accountant, that are reasonably related to the audit's performance or to the review of the financial statements. According to the SEC, audit-related fees would include, among others, employee benefit plan audits, due diligence related to mergers and acquisitions, accounting consultations and audits in connection with acquisitions, internal control reviews, attest services related to financial reporting that are not required by statute or regulation and consultation concerning financial accounting and reporting standards.

However, fees paid to the audit firm for operational audits, which generally relate to the auditing of business processes or operations, are not audit-related fees. Instead, fees for operational audit services should be included in the "all other fees" category.

¨ The staff response is reported at ¶86,956 .