New PCAOB Independence Rules and Standard on Remediation of Material Weaknesses

At its open meeting on July 26, 2005, the Public Company Accounting Oversight Board (“PCAOB”) adopted (1) new ethics rules on auditor independence, focusing on tax services provided by audit firms to their audit clients and (2) a new auditing standard governing the engagement of an auditor to report on whether a previously reported material weakness continues to exist.

These are final actions by the PCAOB, but to take effect they must be adopted by the Securities and Exchange Commission following notice and a new comment period. For past PCAOB rulemaking, this has required about three months from the time of adoption by the PCAOB.

Auditor Independence and Tax Services

The PCAOB’s new ethics rules, adopted largely as proposed in December 2004, focus on tax services provided by auditors, which has been a particularly contentious area under the SEC’s auditor independence rules. But they also include two rules that are much broader in scope. One states the general principle that persons associated with a registered public accounting firm should not cause the firm to violate applicable laws, rules and standards. The second requires a registered public accounting firm and its associated persons to be independent of the firm’s audit client. The PCAOB describes this not as a new requirement but as a foundation for it to adopt new, additional independence rules, such as those on tax services.

The rules specifically addressing tax services impose requirements that are clearer and more restrictive than the applicable SEC rules. They are as follows:

· Tax services to senior officers. Under the new rules, an audit firm is not independent if it provides any tax service to a person in a financial reporting oversight role at the audit client, or to an immediate family member of any such person. The prohibition does not turn on whether the audit client or the executive pays for the service. The rule does not apply to tax services provided to directors or other employees who do not have a financial reporting oversight role. The definition of “financial reporting oversight role” follows the existing SEC definition and includes the chief executive officer, president, chief financial officer, chief operating officer, general counsel, chief accounting officer, controller, director of internal audit, director of financial reporting and treasurer of the audit client.

The PCAOB decided not to extend the rule to cover non-audit services (other than tax), or tax services provided to directors or to officers who do not have a financial reporting oversight role. It did, however, say that it will monitor the implementation of the rule. It called on audit committees to scrutinize any services provided by the auditors to any individuals in the company, and it called on auditors to notify audit committees of tax services provided to any executives.

· Contingent fees. Under another new rule, an audit firm’s independence is impaired if it receives a contingent fee or commission for any service to its audit client. The SEC’s rule on this subject has an exception for certain contingent fees in tax matters, which has been the subject of controversy between the SEC staff and the AICPA. The PCAOB’s rule does not have this exception, so its real effect will be to prohibit contingent fees for tax matters.

· Tax-motivated transactions. Another new rule provides that an audit firm is not independent if it provides services to its audit client on specified classes of tax-motivated transactions. The suspect categories are transactions with tax-advisor imposed conditions of confidentiality, and any transaction initially recommended by an auditor or tax advisor “and a significant purpose of which is tax avoidance, unless the proposed tax treatment is at least more likely than not to be allowable under applicable tax laws.” These standards are also used in federal tax legislation in applying penalties and ethical standards for written advice.

· Specific procedures for audit committee pre-approval of tax services. Tax services, like other services provided by the auditor, must be pre-approved by the audit committee. The new rules specify steps the audit firm must take in seeking pre-approval for tax services, including documentation of the auditor’s discussion of the proposed services with the audit committee.

The December 2004 proposing release included a full discussion of tax-related services that the PCAOB considers to be permitted. This guidance apparently remains valid, but it is not repeated in the adopting release. 

The effective dates for the new rules are complex. With respect to tax services for senior management, the new rules will not apply to tax services being provided pursuant to an engagement in process at the time the SEC approves the rules, provided that such services are completed on or before the later of June 30, 2006 and 10 days after the date that the SEC approves the rules.

Reporting on Whether a Material Weakness Continues to Exist

The PCAOB’s new Auditing Standard No. 4 governs the engagement of an auditor to express an opinion on whether a previously reported material weakness in the company’s internal control over financial reporting continues to exist. The new standard was proposed in March 2005 to fill a perceived gap in the PCAOB’s existing standards. If a registrant reports a material weakness as of year-end, and later wants to report that the material weakness has been remedied, it may do so. But until now there was no standard permitting an auditor to express an opinion on the matter until the next year-end audit report. AS No. 4 prescribes how the auditor may do so, stressing that a registrant is not required to seek such an interim opinion and the auditor is not required to accept the engagement. The standard does not specify how a registrant would publish the auditor’s report or the management assessment that is required to accompany it, but presumably a registrant would wish to file both documents as part of a quarterly report on Form 10-Q or in a current report on Form 8-K (or, for a foreign private issuer, a Form 6-K).

Highlights of AS No. 4 are as follows:

· Scope of engagement. Engagements are narrower in scope than an audit of internal control over financial reporting. An auditor’s testing is limited to the controls specifically identified by management as eliminating the material weakness and uses the company’s stated control objectives as the target for determining whether the material weakness continues to exist. A stated control objective is a specific control objective identified by management that, if achieved, would result in the material weakness ceasing to exist.

· Who performs the audit. To perform the engagement, the auditor must have a sufficient knowledge of the company and its internal control over financial reporting. An auditor that has audited the company’s internal control over financial reporting in accordance with AS No. 2 and has rendered an opinion on the effectiveness of the company’s internal control over financial reporting as of the company’s most recent year-end would have sufficient knowledge to perform the engagement. If the company engages a new, successor auditor for the current year, the new auditor is required to perform specified procedures to obtain a sufficient understanding of the company and its internal control over financial reporting.

· Written report of management. In order for an auditor to express an opinion, management is required to present a written report evaluating the effectiveness of the specific controls that it believes address the material weaknesses and asserting that the specific controls identified are effective in achieving the stated control objective and that the identified material weaknesses no longer exist. Management’s assertions must be supported by sufficient evidence.

· Whether some material weaknesses continue to exist may not be reported. Not all material weaknesses lend themselves to reporting whether they continue to exist:

o Reports are permitted only on material weaknesses that were previously identified in an auditor’s report on internal control over financial reporting as of year-end. A material weakness that is identified for the first time in a quarterly report on Form 10-Q, for example, cannot be the subject of an engagement under AS No. 4 until after it has been reported on in an annual report.

o The interim engagement contemplated by the standard, with its narrow scope, might not be suitable for auditor reporting on whether certain kinds of material weaknesses continue to exist. For example, when a material weakness has a pervasive effect on the company’s internal control over financial reporting, identifying the control objectives that are not being met may be difficult because of the large number of control objectives affected. A material weakness related to an ineffective control environment is an example of this circumstance.

· Auditor’s opinion. The auditor may render an opinion either that “the material weakness exists” or “the material weakness no longer exists.” To render an opinion that a material weakness no longer exists, the auditor must have obtained evidence about the design and operation of the relevant controls, determined that the material weakness no longer exists and determined that no scope limitations were placed on the auditor’s work. If the auditor concludes that a material weakness exists, the auditor is not required to issue a report. If no report is issued, however, then the auditor is required to communicate in writing its conclusion that the material weakness continues to exist to the audit committee. Qualified opinions are not permitted, and any limitations on the scope of the auditor’s work require the auditor to disclaim an opinion or withdraw.

· Flexibility. The standard permits an engagement to be undertaken at any time during the year, and not necessarily at quarter-end or in conjunction with an audit or review of financial statements. It also permits an engagement covering one material weakness or many, or covering only some of the material weaknesses the registrant has reported. Despite these elements of flexibility, AS No. 4, like AS No. 2, is conceptually complex and highly prescriptive. Since 12.7% of accelerated filers reported material weaknesses (according to data cited in the adopting release), there are many companies that may consider an engagement of this kind, particularly to avoid the risk that the auditor will disagree at year-end with the registrant’s disclosure during the course of the year that it has remedied a material weakness. However, obtaining a report under AS No. 4 may prove to be a difficult exercise in practice. 

AS No. 2 will be effective upon approval of the SEC.

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CLEARY GOTTLIEB STEEN & HAMILTON LLP