Auditor Independence (5510)

Portfolio 5510, Auditor Independence (Accounting Policy and Practice Series), analyzes the rules and regulations governing auditor independence for auditors of issuers.

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Portfolio 5510, Auditor Independence (Accounting Policy and Practice Series), analyzes the rules and regulations governing auditor independence for auditors of issuers. This Portfolio should be partnered with Portfolio 5502, Henkel, Wheeler, and Lane, Sarbanes-Oxley: Auditor Independence.
The Securities Exchange Act of 1934, as originally passed and subsequently amended, requires a comprehensive reporting system by public companies. The 1934 Act requires that public companies file annual reports on Form 10-K, interim reports on Form 10-Q, and current events on Form 8-K for a wide range of events affecting public companies. In many of those reports, federal securities laws in the United States require financial information filed with the Securities and Exchange Commission (SEC or Commission) following varying levels of attestation services required to be performed by independent public accountants. Federal securities laws also grant the SEC the authority to define the term independent.
Auditor Independence rules serve two related public policy goals. First, the rules are intended to minimize the possibility that external factors will influence an auditor's judgments while performing financial statement attest functions. Second, the rules are intended to promote investor confidence in the financial statements of public companies.
This Portfolio discusses auditor independence rules as mandated by the SEC and the Sarbanes-Oxley Act of 2002 (SOX). This includes the rules issued by Public Company Accounting Oversight Board, authorized by Section 103(b) of the Sarbanes-Oxley Act. The Portfolio discusses the nature, significance, and limitations of auditor independence, as well as the prevailing rules.
This Portfolio should be cited as Tax Portfolio 5510, Whisenant and Whisenant, Auditor Independence (Accounting Policy and Practice Series). Within the Accounting Portfolio Series, references to the Portfolios include only the Portfolio numbers and titles.


Scott Whisenant, Ph.D.

Scott Whisenant, Ph.D., University of Oklahoma; M.Acc., University of Oklahoma; M.B.A., University of Texas-Tyler; B.B.A., Texas A&M-Commerce. Dr. Whisenant is an Associate Professor and Bauer Fellow, C.T. Bauer College of Business, University of Houston. Previously he was a member of the faculty of the Sloan School of Business at Massachusetts Institute of Technology and the McDonough School of Business at Georgetown University. He teaches auditing, advanced auditing, and financial statement analysis. He has published articles in professional publications including The Accounting Review, Journal of Accounting Research, Review of Accounting Studies, Auditing: A Journal of Practice and Theory, Accounting Horizons, and Journal of Accounting Auditing & Finance. Dr. Whisenant is a member of Alpha Sigma Nu honor society, American Accounting Association, American Institute of Certified Public Accountants, Institute of Management Accountants, and the Association of Certified Fraud Examiners.

Lori Whisenant, Esq., CPA (Oklahoma)

Lori Whisenant, L.L.M., Georgetown University; J.D., University of Oklahoma; M.Acc., University of Oklahoma; B.A., University of Texas. Ms. Whisenant formerly practiced with Deloitte & Touche LLP, PricewaterhouseCoopers LLP, and Ernst & Young LLP. She is the Director of Business Law and Ethics Studies at the Bauer College of Business, University of Houston. She is a member of the American Institute of Certified Public Accountants and Oklahoma Society of Certified Public Accountants.

Table of Contents

Portfolio Description



Detailed Analysis

I. General Introduction to Auditor Independence

Introductory Material

A. Significant Principles

B. Major Rules and Role of Regulatory Agencies

1. Securities and Exchange Commission (SEC)

2. Sarbanes-Oxley Act of 2002

3. Public Company Accounting Oversight Board (PCAOB)

4. United States Courts

5. American Institute of Certified Public Accountants (AICPA)

6. The General Accountability Office (GAO)

7. Other Rule-Making Bodies (State Boards and Department of Labor)

II. History of Auditor Independence Rules

Introductory Material

A. Developments Prior to Financial Reporting Release No. 56

1. Historical Perspective

2. SEC Rules Enacted During POB Oversight of Industry (1977-2002)

3. Other Events Affecting the Debate Prior to FRR 56

B. Landmark Rules and Law Affecting Auditor Independence

1. SEC Financial Reporting Release No. 56

2. Sarbanes-Oxley Act (2002)

3. SEC Financial Reporting Release No. 68

C. Changes to Legal Framework

III. Framework for Assessing Auditor Independence

A. Background

B. PCAOB Rules on Auditor Independence

1. PCAOB Interim Standards

2. PCAOB Ethics and Independence Rules

C. Foundations of Auditor Independence Rules

1. Period Over Which Auditor Independence Can Be Impaired

2. Covered Persons of Independence Rules

3. The General Standard for Testing Impairment of Auditor Independence

4. Impairment Issues: Substance Over Form

IV. Applications of the Independence Standard Where Independence Is Impaired

A. Relationships With an Audit Client

1. Financial Relationships

a. Direct Investments in an Audit Client

b. Beneficial Ownership or Control of an Audit Client

c. Voting Investment Rights of Entity Holding Securities of Audit Client

d. Material Indirect Investments

e. Debtor-Creditor Relationships With an Audit Client

f. Checking and Savings Accounts With Audit Client

g. Brokerage Account With an Audit Client

h. Account With Futures Commission Merchant

i. Insurance Products Issued by an Audit Client

j. Investments by the Audit Client in the Auditor

k. Underwriting

2. Employment Relationships

a. Employment of Accountant by an Audit Client

b. Employment of Certain Relatives of an Accountant by an Audit Client

c. Employment of Former Employees of Accounting Firm by an Audit Client

d. Employment of Former Employee of Audit Client by an Accounting Firm

e. One-Year Cooling-Off Period

3. Business Relationships

4. Provision of Non-Audit Services

a. Prohibited Non-Audit Services

(1) Bookkeeping or Other Services Related to the Audit Client's Accounting Records

(2) Financial Information Systems Design and Implementation

(3) Appraisal or Valuation Services and Fairness Opinions

(4) Actuarial Services

(5) Internal Audit Services

(6) Management Functions

(7) Human Resources

(8) Broker-Dealer Services

(9) Legal Services

(10) Expert Services Unrelated to Audit

b. Pre-Approval of Audit and Non-Audit Services by Audit Committee

c. Tax Transactions and Tax Services

5. Contingent Fees

B. Exceptions to Specific Applications of the Independence Standard Where Independence Is Impaired

1. Exception: Inheritance or Gift of Financial Interest in Audit Client

2. Exception: Accepting New Audit Clients

3. Exception: Employment Compensation and Benefit Plans of Family Members Employed by Audit Clients

V. Partner Rotation Rules to Maintain Independence

Introductory Material

A. Rotation and "Cooling-off" Rules

1. Level One Partners: Lead and Concurring (Review) Partners

2. Level Two Partners: Other Audit Engagement Team Partners

3. Level Three Partners: Technical or Specialty Partners

a. Example: Private Client Becomes SEC Registrant

b. Example: Do Re-Audit Years Extend Service Years?

c. Example: Audit Partner Moves to New Firm, Client Follows

d. Example: Client Changes Fiscal Year-End Creating a Transition Year

B. Investment Company Complex Rules Affecting Partner Independence

C. Possible Exemptions From Partner Rotation Rules

VI. The Effect of Compensation Within an Accounting Firm on Independence

Introductory Material

A. Compensation That Impairs Independence

1. Application of Compensation Rules Only to "Audit Partners"

2. Effect on Partnership "Units"

3. Can an Audit Partner Share in Profits of the Audit Practice?

B. Exemption to Compensation Rules That Can Impair Independence

VII. Key Differences Between AICPA and PCAOB/SEC Independence Rules

Introductory Material

A. Registered Public Accounting Firms' Independence Criteria

B. Contingent Fees

C. Tax Transactions

D. Covered Persons on Audit Engagement Team

E. Joint Ventures or Joint Closely Held Investments

F. Grandfathered Loans

G. Cooling-off Period

VIII. Disclosure Requirements

Introductory Material

A. Disclosure of Fees

1. Categories of Fees

2. Related Disclosures About Fees

B. Audit Committee Disclosures

1. Required Audit Committee Disclosures

2. "De Minimus" Exception to Audit Committee Approval Requirement

3. Exception for Investment Company

4. Disclosure Requirements

a. Form of Disclosures

b. Disclosure Requirements for Investment Companies

C. Disclosures of Leased Employees

D. Exempted Companies

IX. Quality Control Procedures For Complying With Independence Rules

A. First Line of Defense Against Independence Violations

1. Written Independence Policies and Procedures

2. Automated Systems

3. Timely Information

4. Training

5. Internal Inspection and Testing

6. Notice of Names of Senior Management Responsible for Independence

7. Prompt Reporting of Employment Negotiations

B. Quality Control Provisions: Inadvertent Violations

1. Limited Exception to Independence Violation

X. SEC Administrative Proceedings and Litigation

A. Introduction

1. Rules Used by SEC in Cases Involving Lack of Independence

a. Rule 102(e) of the SEC's Rules of Practice

b. Cease and Desist Authority Under Section 21C of the Exchange Act (Applying Rules 2-01 and 2-02(b)(1) of Regulation S-X)

B. Sarbanes-Oxley Act of 2002

C. Key Accounting and Auditing Enforcement Release Proceedings

1. Actions Involving Financial Interest in an Audit Client

a. Investment in Multiple Audit Clients by Coopers & Lybrand LLP Partners and Managers (Prior to Its Merger With PricewaterhouseCoopers LLP)

b. KPMG LLP's Investment in STIT, a Money Market Fund Within AIM Funds, an Audit Client

2. Actions Involving Independence Violations Other Than Financial Interests

a. Maintenance or Preparation of Accounting Records or Financial Statements of Audit Client

b. Independence Violations Due to Loans to Audit Engagement Team Members

c. Joint Business Relationships

(1) Ernst & Young's Business Relationship With PeopleSoft

(2) KPMG's Business Relationship With Porta Systems Inc.

d. Other Employment Relationships

e. Financial Dependence on an Audit Client

f. Acting as in Legal Capacity for an Audit Client

g. Fees Owed by Audit Client to Auditor

h. Contingent Fee Arrangements With Audit Client (and Audit of Accounts Including Large Amounts of Non-Audit Fees of Accounting Firm)

i. Threat of Litigation Against Auditor by an Audit Client

j. Payment of Audit Fees

D. Legal Environment Surrounding Auditor Independence

1. The Private Securities Litigation Reform Act of 1995 (PSLRA)

2. Supreme Court's Decision in Central Bank of Denver N.A.

3. Securities Litigation Uniform Standards Act of 1998

Working Papers

Working Papers


Worksheet 1 Abbreviations and Definitions

Worksheet 2 Auditor Independence Checklist

Worksheet 3 Chronology of Auditor Independence Rules

Worksheet 4 SEC Filing Sample: Independence Letter

Worksheet 5 SEC Brochure Audit Committees and Auditor Independence



United States Code


Legislative History


Code of Federal Regulations

Securities and Exchange Commission

SEC Administrative Proceedings

SEC Litigation Releases

SEC Financial Reporting Releases

SEC Accounting Series Releases

SEC Releases

SEC Codification of Financial Reporting Policies

SEC Materials

Public Company Accounting Oversight Board


PCAOB Releases

American Institute of Certified Public Accountants

AICPA Statements on Auditing Standards

AICPA Professional Standards

AICPA Practice Alert

AICPA Code of Professional Conduct

Accounting Principles Board Opinion

Public Oversight Board Report

Independence Standards Board Standards

Federal Trade Commission Report

Government Accountability Office Study

Model Act




Books, Articles, and Miscellaneous