Financial Reporting


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Financial Reporting

  1. 1. BDO Seidman, LLP Accountants and Consultants Financial Reporting February 2001 Contents General..............................................1 SEC Revises Independence Non-Audit Services..........................2 Rules New Disclosures in Proxy and Information Statements ..................3 Financial and Employment After months of intense debate and significant Relationships ...................................4 Business Relationships...................5 publicity, the SEC recently issued a watered- Affiliates ............................................5 down version of the highly controversial set of Contingent Fee Arrangements and Commissions ............................5 proposed independence rules that it had Effective Date and Transition .........5 exposed for public comment in mid-2000. Quality Controls...............................6 Implementation Guidance..............6 The final rules, which generally went into effect February 5, 2001: • Identify certain non-audit services which would impair accounting profession, including BDO Seidman, LLP auditor independence1; (BDO) and the American Institute of Certified Public • Permit SEC-reporting companies to receive, under Accountants (AICPA), to more closely align with the com- specified conditions, information technology consult- mon goal of protecting the public interest. The proposal ing and internal audit services from their auditors generated about 3,000 comment letters and led to four (which the proposal would have banned outright); days of often heated public hearings. • Place reliance on audit committees to determine The remainder of this newsletter summarizes key pro- whether a particular non-audit service raises indepen- visions of the final rules. As many of the provisions are dence problems; extremely detailed, the entire text of the new rules should • Require separate disclosure in annual proxy and infor- be consulted at to mation statements of the amount of fees for audit, resolve particular compliance questions. information technology consulting and other non- audit services; and General The rules are based on the premise that an auditor must • Modernize the independence requirements for audi- be independent both “in fact” and “in appearance.” While tors by significantly reducing the number of firm pro- avoiding a definition of “in appearance” because of its fessionals and their family members whose invest- subjectivity, the new rules state that an auditor’s indepen- ments in, or employment with, clients would impair dence is impaired when, in light of all relevant facts and the firm’s independence. circumstances, a reasonable investor would conclude By and large, the final rules were changed from the that the auditor would not be capable of acting without proposal to reflect many of the concerns expressed by the bias. In making independence determinations, the SEC 1 “Auditor” or “auditors” means an SEC-reporting company’s auditing firm, as well as certain of the firm’s professionals and their family members who are required to be independent with respect to that client.
  2. 2. will consider all such facts and cir- Financial information systems as an employee or perform manage- cumstances, as well as four general design and implementation ment functions. principles. These principles include As financial information systems whether a particular relationship or have become larger and increasing- Internal audit services non-audit service: ly more complex, public companies Some public companies “out- have reached out to professional source” their internal audit (IA) • Creates a mutual or conflicting service firms, including their own work to their external auditors. interest between the auditors auditors, for help in systems design Since the IA function is essentially and the client; and implementation. Since such an arm of management, the SEC • Puts the auditor in the position of systems often generate the finan- has questioned the independence auditing his or her own work; cial statements that are eventually of auditors that provide IA services • Results in the auditor acting as audited, the SEC has questioned to their clients. management or an employee of While the proposed rules would the client; or the firm’s independence in these cases. have prohibited auditors from per- • Places the auditor in a position forming any IA services for an SEC of being an advocate for the While the proposed rules would have prohibited auditors from per- client, the final rules allow them to client. perform certain amounts of IA ser- forming most consulting services These principles are quite relative to a client’s information vices, provided that: broad, allowing the SEC staff con- technology (IT) systems, the final • The client’s management ack- siderable discretion in their appli- rules only prohibit them from (a) nowledges in writing, to the cation. operating or supervising the opera- auditors and the audit commit- tion of the client’s IT systems, (b) tee, the client’s responsibility to Non-Audit Services establish and maintain a system managing its local area network, The rules codify the non-audit ser- of internal accounting controls; and (c) assuming management vices that may be deemed inconsis- • The client’s management may responsibilities. Auditors are, how- not rely on the auditors’ work as tent with a firm’s independence. ever, permitted to design or imple- the primary basis for determining Most are already prohibited or ment a system that provides infor- the adequacy of its internal restricted by the AICPA, its SEC mation relevant to the financial accounting controls; and Practice Section (SECPS) or the statements, provided that the • The client complies with certain SEC. These include, to varying client’s management: other conditions designed to degrees: • Acknowledges in writing, to the ensure that the client retains auditors and audit committee, • Financial Information Systems management responsibility for management's responsibility Design and Implementation such services. for the client’s system of inter- • Internal Audit Services nal controls; Assuming all of the aforemen- • Bookkeeping or Other Services • Identifies a competent person tioned conditions are met, auditors Related to the Audit Client's within management to make all may perform (a) up to 40% of the Accounting Records or Financial management decisions with client's IA work, measured in hours, Statements respect to the project; if the client has assets of $200 mil- • Appraisal or Valuation Services • Makes all the significant deci- lion or more, and (b) any amount of or Fairness Opinions sions with respect to the IT pro- IA work if the client has assets • Actuarial Services ject; of less than $200 million. The • Management Functions • Evaluates the adequacy and 40% limitation does not apply to • Human Resources Services results of the project; and operational-type internal audits • Does not rely on the auditors’ (i.e., those unrelated to internal • Broker-Dealer Services work as the primary basis for accounting controls, financial • Legal Services determining the adequacy of its systems or financial statements). Omitted from the final rules is financial reporting system. Bookkeeping or other services the SEC’s proposed ban against a Further, an auditor may perform, related to the audit client's firm providing currently permitted without limitation, IT services in accounting records or financial expert services. This proposed ban connection with the assessment, statements would have hindered the long- design and implementation of a Closely paralleling the previous standing and widely accepted prac- client’s internal accounting controls prohibition on bookkeeping, the tice of auditors representing clients and risk management controls, pro- rules bar auditors from (a) main- before taxing authorities. vided that the auditor does not act taining or preparing the client's 2 COPYRIGHT 2001, BDO SEIDMAN, LLP
  3. 3. accounting records, or (b) prepar- • The valuation is for planning Broker-dealer services ing the client's financial statements and implementation of a tax An auditor is barred from serving as that are either filed with the SEC or planning strategy or for tax a broker-dealer, promoter or under- form the basis of such financial compliance services; or writer of a client; making invest- statements, including underlying • The valuation is for non-finan- ment decisions for it; executing source data, except for (1) emer- cial purposes that do not affect transactions to buy or sell invest- gencies, provided the accountant the financial statements. ments on its behalf; or having cus- does not undertake any managerial tody of its assets. actions or make any managerial Actuarial services decisions, and (2) limited or rou- Closely tracking the SECPS prohibi- Legal services tine bookkeeping services for tion on actuarial services, actuarial- The new rules prohibit an auditor immaterial foreign divisions or sub- oriented advisory services would be from providing any service to a sidiaries of an audit client where permitted only when they involve client that would require the per- certain criteria are met. the determination of insurance son providing the service to be company policy reserves and relat- admitted to practice before the Appraisal or valuation services or ed accounts, and if the client uses courts of a U.S. jurisdiction. fairness opinions its own actuaries or third-party The SEC has questioned the inde- actuaries to provide management New Disclosures in pendence of auditors that provide with the primary actuarial capabili- Proxy and Information appraisal or valuation services or ties and certain other conditions fairness opinions to their clients are met. Statements because of its perception that the Reflecting the SEC’s view that auditors are, in effect, reporting on Management functions enhanced disclosure can help an auditor-produced amounts. Consistent with previous SEC rules, investor to evaluate auditor inde- While the proposed rules would an auditor's independence would pendence, the rules require compa- have banned all valuation and be impaired when he or she, either nies to disclose: appraisal services and fairness temporarily or permanently, acts as • Total fees, including out-of- opinions for clients, the final rules a director, officer or employee of a pocket expenses, billed and prohibit such services only where it client, or performs any decision- expected to be billed by the is reasonably likely that the results making, supervisory or ongoing principal auditor, for the most of such services would be material monitoring function for the client. recent fiscal year, broken down to the client’s financial statements, into three categories: or where the auditors would audit Human resources services Paralleling the current SECPS rules a. Auditing, including quar- the results. regarding recruiting and other terly reviews of financial The previous rules, in contrast, human resources services for statements, attendance at permitted auditors to provide clients, the new SEC rules prohibit audit committee meetings immaterial appraisal or valuation an auditor from: at which matters related to services. This “immateriality” excep- tion will still apply with respect to • Recruiting prospective candi- the audits or reviews are assistance concerning immaterial dates for managerial, executive discussed, and preparation purchase-price allocations. or director positions; of a “management letter”; The restrictions imposed by the • Acting as a negotiator on the b. IT consulting; and final rules do not apply where: audit client's behalf; c. All other services, including • The auditors’ valuation expert • Developing employee testing or work performed in connec- reviews the work of the client or evaluation programs; tion with registration state- a third-party specialist, and the • Recommending or advising that ments, such as issuance of client or specialist provides the the audit client hire a specific “comfort letters,” due dili- primary support for the bal- candidate for a specific job; or gence procedures performed ances recorded in the financial • Performing reference checks for in connection with mergers statements; prospective clients for executive and acquisitions, income tax • The auditors’ actuaries value a or director positions. services other than those client’s pension, other post- directly related to the audit employment benefit or similar If requested, an auditor may, of the income tax accrual, liabilities, provided the client however, interview candidates and internal control advisory ser- determines and takes responsi- advise the client on the candidate's vices outside of the scope of bility for all significant assump- competence for financial accounting, the audit, risk management tions and data; administrative or control positions. advisory services, internal BDO SEIDMAN, LLP, FINANCIAL REPORTING 3
  4. 4. audit services, statutory Financial and ber own 5% or more of a public audits of immaterial foreign company client. subsidiaries where such Employment A “covered person” is generally audits are not necessary Relationships one who is directly involved in the under U.S. generally accepted The previous rules on financial and audit, or if not directly involved in auditing standards, and employment relationships of audi- the audit, could influence the out- audits of employee ben- tors were developed largely when come of the audit (e.g., firm’s man- efit plans. (The fees in this firms were much smaller and less aging partner, national audit part- category may be shown in diversified, and family demograph- ner or any partner located in the total or broken down by the ics were much different from those same office as the lead audit part- nature of services.) of today. Such rules, for example, ner). • A statement as to whether the prohibited the spouse of a partner, Besides direct and material indi- audit committee, or its equiva- having no connection with the rect investments, the new rules lent, considered the compatibili- audit, from holding certain posi- extend to a variety of other financial ty of the non-audit services pro- tions at an audit client or stock in relationships with audit clients. vided by the firm with the firm’s the client. A number of exceptions are provided, independence. Substantial changes over the as long as the financial interest is • The percentage of hours worked years in the profession, the busi- disposed of within 30 days (e.g., on the audit engagement by ness environment and family where the interest had been acquired persons other than the firm’s demographics have underscored before the client-auditor relationship full-time, permanent employ- ees (e.g., leased employees or the need for the SEC to re-address was established, by inheritance consultants), if that figure its rules in these areas, which had or unsolicited gift, or where the exceeded 50%. been widely viewed as outdated acquisition was the unavoidable con- and overly restrictive and a disin- sequence of participation in an BDO’s engagement teams are centive for individuals contemplat- employment benefit program by an prepared to provide clients with ing careers in public accounting. immediate family member of a cov- sufficient information to enable Consequently, the final rules for ered person who performed non- them to make these disclosures, a financial and employment relation- audit service to the audit client). sample of which follows. These dis- ships have been liberalized as dis- The new SEC rules relating to closures might be included under a cussed below. financial interests are now more heading called “Services Provided liberal than the existing rules of the by the Company’s Auditors.” Financial relationships AICPA and certain other regulatory For the year ended December The new rules in the area of finan- bodies, that are expected to liberal- 31, 2000, the Company incurred cial relationships are similar to professional fees to its auditors in ize their rules in due course. BDO those proposed. They narrow signif- the amount of $500,000, of which will continue to adhere to the exist- icantly, from previous rules, the $300,000 related to auditing ser- ing, more stringent rules in this vices, $20,000 related to informa- circle of a firm’s professionals and area until those bodies formally tion technology services and family members whose invest- change their rules. $180,0002 related to all other ser- ments could cause independence vices. Approximately 52% of the problems. Employment relationships total hours spent on the engage- Under the new rules, for the Adopted substantially as proposed, ment to audit our financial state- most part, financial interests in the new employment relationship ments for the year ended December 31, 2000 related to persons other clients impair independence only if rules greatly narrow the circle of fam- than the auditors’ full-time, perma- they are financial interests of the ily members of firm personnel whose nent employees. audit firm, “covered persons” in the employment with a client impairs The Company’s audit commit- firm (as defined below) or “immedi- the firm’s independence. Specifically, tee has considered whether the ate family members” of covered the new rules apply to “close family non-audit services provided by the persons (i.e., spouses, spousal Company’s auditors in connection members” of a covered person (i.e., with the year ended December 31, equivalents and dependents). “immediate family members” of 2000 were compatible with the However, in no event may a covered covered persons, as discussed pre- auditors’ independence. person or immediate family mem- viously, plus parents, nondepen- 2 A company may, if it wishes, provide a further breakdown of fees related to “all other services,” as long as the total of fees related to “all other services” is clearly stated. Additionally, a company may, if it wishes, provide commentary with its disclosure. For example, where a substantial portion of fees for “all other services” consists of traditional audit-related services, the company might add to its disclosure: “A substantial portion of the fees in this category relates to services traditionally provided by auditors, including work performed in connection with registration statements, due diligence procedures performed in connection with mergers and acquisitions, and income tax services.” 4 COPYRIGHT 2001, BDO SEIDMAN, LLP
  5. 5. dent children and siblings) who response to concerns from com- tionship with an auditing firm, may work for a particular client in an menters about such a low thresh- be attributed to the firm for inde- accounting role or financial report- old, the SEC reverted to its previous pendence purposes. ing oversight role, including indi- guidance. As a result, the new rules contin- viduals who: The following are examples of non- ue to permit cooperative networks • Influence the preparers or the permissible business relationships: between accounting firms and contents of the financial state- • Covered person owns a signifi- strategic alliances established ments of the client (e.g., a mem- cant interest in a small business under existing standards that effec- ber of the client’s board of direc- investment company that has tively would have been eliminated tors; chief executive; financial, made a loan to a client; under the proposal. operating or accounting officer; • A client is the general partner general counsel; controller; Contingent Fee and 10% owner in a real estate director of internal audit or limited partnership in which the Arrangements and financial reporting; treasurer; firm holds a 5% limited partner- Commissions vice president of marketing; or ship interest; The new rules bring forward the any equivalent position); or • Audit firm rents, as its offices, accounting profession’s current ban • Prepare or have more than mini- 25% of a building owned by a on an accountant performing any mal influence over the contents client. The remaining 75% is service for an audit client under a of the accounting records. This owner-occupied; and contingent fee arrangement. Also, category may include certain • Covered person acts as executor consistent with existing AICPA individuals, such as an accounts under the will of a client’s princi- rules, the new SEC rules prohibit receivable supervisor or manag- pal officer in which the estate’s auditors from providing any service er, who are relied on by man- principal asset is voting stock of or product to a client for a commis- agement to calculate amounts sion or from receiving a commission the client. that are placed directly into the from a client. company's financial statements. Affiliates Contingent fee arrangements There are also specified employ- Affiliate of audit client are those in which no fee is charged ment restrictions that apply to cer- Independence rules apply to SEC unless a specified result is attained, tain former employees of the firm clients and their affiliates. However, or the amount of the fee otherwise who become employed by a client, the definition of affiliate was depends on the auditors’ findings or and to certain former employees of unclear under the old rules. Under the results of the auditors’ services. a client who become employed by the new rules, an "affiliate of an Exceptions to the contingent fee the firm. audit client" is defined as any entity: ban are fees fixed by a court or other • That has control over the client, public authority, or, in tax matters, Business Relationships or can be controlled by the fees based on the results of judicial Consistent with previous rules, client, or is under common con- proceedings or the findings of gov- independence is impaired if a cov- trol with the client, including the ernmental agencies. ered person has a direct or a mater- client's parent and subsidiaries; ial indirect business relationship Effective Date and with the client or any person asso- • Over which the client has signifi- ciated with the audit client in a cant influence, unless the entity Transition decision-making capacity, such as is not material to the client; or The new rules generally took effect the client's officers, directors or • That has significant influence on February 5, 2001. Companies “substantial stockholders.” However, over the audit client, unless the must comply immediately with the such relationships do not include client is not material to the entity. new proxy disclosure requirements. those in which the auditor provides Affiliate of audit firm Transition periods beyond the effec- professional services to an audit The SEC omitted from the final tive date, ranging from 3 to 18 client or associated individuals or is rules a proposed expansive defini- months, are provided for certain a consumer in the ordinary course tion of an “affiliate” of an audit firm relationships and services. In partic- of business. (to which independence restrictions ular, the existence of specified In the proposed rules, the SEC also would have extended) and, financial interests and employment sought to replace the term “sub- instead, reverted to existing practice relationships do not impair inde- stantial stockholders” with “benefi- in identifying, on a “facts and cir- pendence until May 7, 2001, provid- cial owners of more than 5% of a cumstances” basis, entities whose ed they do not impair indepen- client’s equity securities.” In activities, by reason of their rela- dence under pre-existing indepen- BDO SEIDMAN, LLP, FINANCIAL REPORTING 5
  6. 6. dence standards. Also, auditors may Quality Controls ed entities located outside of the continue providing, until August 5, The final rules provide a safe harbor U.S.” BDO has in place such a quali- 2002, newly restricted appraisal, val- for inadvertent loss of indepen- ty control system. uation services and internal audit dence by a covered person unaware services, if permitted under pre- of the circumstances causing the Implementation existing standards. Contracts for IT impairment. To qualify, the lack of Guidance services in existence on the effective independence must be corrected as The SEC staff has issued guid- date of the rules also are grandfa- soon as possible upon discovery, ance, in the form of responses to thered and, therefore, will not and the accounting firm must main- “Frequently Asked Questions,” to impair independence, provided they tain a quality control system that help companies and their auditors satisfy pre-existing independence implement the new rules. Some of provides “reasonable assurance” standards. that guidance has been incorporated that the firm and its personnel do into this newsletter. However, the Furthermore, international ac- not lack independence. complete text of the guidance can be counting firms with more than The rule provision indicates that found on the SEC’s Web site at 500 SEC clients will have until the quality control system must December 31, 2002 to implement encompass “at least all employees Also, the Chief Accountant of the prescribed quality control systems and associated entities of the firm SEC has gone on record as saying in offices located outside the United participating in the engagement, the staff will not grant any waivers States. including employees and associat- from the new rules. Material discussed in this Financial Reporting newsletter is meant to provide general information and should not be acted upon without first obtaining professional advice appropriately tailored to your individual facts and circumstances. 6 COPYRIGHT 2001, BDO SEIDMAN, LLP PERMIT #1 GRAND RAPIDS, MI PAID Grand Rapids, Michigan 49546 U.S. POSTAGE Suite 300 FIRST-CLASS MAIL 770 Kenmoor S.E. PRESORTED BDO Seidman, LLP