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May 15, 2012

As professionals in accounting and finance, we are well aware of the independence requirements set forth by the Sarbanes-Oxley Act of 2002 that govern how accounting firms can, and cannot, interact with their publicly traded clients. Yet 10 years after its enactment, independence is still a dynamic issue. In the first quarter of 2012, we saw a resurfacing of activity around independence, and specifically the prohibited services related to independence. In this issue of A&M Tax Advisor Weekly, we:


  • Review the prohibited services that are held by the Act to compromise independence;
  • Make note of two recent instances where the heightened awareness of these prohibited services has caused a change in the services that audit firms are performing for their publicly traded clients; and
  • Revisit (see ) the concept of mandatory audit firm rotation being considered by the Public Company Accounting Oversight Board (PCAOB).

Prohibited Services

One of the Sarbanes-Oxley Act's primary intentions is to ensure and preserve auditor independence. To that end, Title II of the Act addresses the provision of certain non-audit services by the auditor and specifically provides for the following nine categories of prohibited non-audit services:

  • Bookkeeping or other services related to the accounting records or financial statements of the audit client ---- This includes all bookkeeping services unless it is reasonable to conclude that the results will not be the subject of audit procedures. Further, bookkeeping is considered to include maintaining or preparing the audit client's accounting records, preparing financial statements that are filed with the Securities and Exchange Commission (SEC) or the information that forms the basis of financial statements filed with the SEC, and preparing or originating source data underlying the audit client's financial statements.
  • Financial information systems design and implementation ---- This includes any service related to the audit client's information systems, unless it is reasonable to conclude that the results of these services will not be subject to audit procedures during an audit of the audit client's financial statements. The audit firm is also prohibited from designing or implementing a hardware or software system that aggregates information that is significant to the financial statements taken as a whole.
  • Appraisal or valuation services, fairness opinions, or contribution-in-kind reports ---- Appraisal and valuation services include any process of valuing assets or liabilities. Fairness opinions and contribution-in-kind reports include opinions and reports on which the firm provides its opinion on the adequacy of consideration in a transaction. These services are prohibited except where the audit firm is providing such services for purposes of non-financial reporting, or the audit firm uses its own valuation specialist to review work performed by the audit client or a third-party specialist.
  • Actuarial services ---- This prohibits the audit firm from providing to its audit client any actuarially-oriented advisory service involving the determination of amounts recorded in the financial statements and related accounts for the audit client, unless it is reasonable to conclude that the results of these services will not be subject to audit procedures during an audit of the client's financial statements.
  • Internal audit outsourcing services ---- This includes any internal audit service that has been outsourced by the audit client that relates to the client's internal accounting controls, financial systems or financial statements, unless it is reasonable to conclude that the results of these services will not be subject to audit procedures during an audit of the client's financial statements.
  • Management functions or human resources ---- This prohibits the audit firm from acting temporarily or permanently as a director, officer or employee of an audit client, or performing any decision-making, supervisory or ongoing monitoring function for the client. Further, this includes when the audit firm searches for or seeks out prospective candidates for managerial, executive or director positions; acts as negotiator on the audit client's behalf; or undertakes reference checks of prospective candidates; as well as when the audit firm engages in psychological testing, or other formal testing or evaluation programs, or recommends or advises the audit client to hire a specific candidate for a specific job.
  • Broker or dealer, investment advisor, or investment banking services ---- This includes performing brokerage or investment advising services, serving as an unregistered broker-dealer, serving as a promoter or underwriter, or making investment decisions on behalf of the audit client or otherwise having discretionary authority over an audit client's investments, or executing a transaction to buy or sell an audit client's investment, or having custody of assets of the audit client.
  • Legal services and expert services unrelated to the audit ---- This includes providing to an audit client any service that, under circumstances in which the service is provided, could be provided only by someone licensed, admitted or otherwise qualified to practice law in the jurisdiction in which the service is provided. This also includes providing expert opinions or other services to an audit client, or a legal representative of an audit client, for the purpose of advocating that audit client's interests in litigation or in regulatory or administrative investigations or proceedings.
  • Any other service that the PCAOB determines, by regulation, is impermissible ---- This includes certain tax services. Specifically, audit firms would impair their independence by representing an audit client before a tax court, district court or federal court of claims. Audit committees also should scrutinize carefully the retention of an audit firm in a transaction initially recommended by the audit firm, the sole business purpose of which may be tax avoidance and the tax treatment of which may be not supported in the Internal Revenue Code and related regulations.

Large Public Accounting Firms React

In a recent, and what some may call delayed, change of posture regarding independence with an audit client, a large public accounting firm ceased providing a non-attest service to its Global 100 audit client of more than 100 years. Previously, in addition to auditing the client's financial statements, the audit firm provided loan staff services to the client's tax department.

In January it was reported that these loan staff services were no longer being provided to the client. There is some speculation that the change was brought about by regulators, namely the SEC and the PCAOB; however, neither party has commented to date.

Another large public accounting firm just announced that it will no longer perform lobbying services for three of its audit clients. All three of these situations involved lobbying efforts around tax-related issues. Carl Levin and Jack Reed, both Democratic senators, asked the SEC to look into the issue when the relationships and the lobbying work were disclosed in a news story in March. The SEC has refused to comment because its investigations are not public. Whether it was forced into making this change or it wanted to end any potential conflict before it was required to do so, the accounting firm filed paperwork in April showing that the firm will no longer be doing lobbying work for the three companies.These actions allude to a stricter interpretation of the independent relationship required between an audit firm and its audit clients, as well as companies behaving more conservatively when deciding how to use their audit firm.

Mandatory Audit Firm Rotation 

Last year, the PCAOB introduced an idea that, if adopted, has the potential to add further complexity to the independence terms of the Act. The idea is mandatory audit firm rotation, which would serve to limit the number of consecutive years a public accounting firm could serve as the auditor of a public company. In March (2012), the PCAOB held a public meeting to discuss this concept and other measures to improve auditor independence.

During the meeting, the PCAOB heard a variety of perspectives on the issue. Certain parties opposed to the idea stated that regardless of what rules are imposed, the SEC and PCAOB simply cannot prevent fraud in financial statements. Others in favor of the idea expressed concern for long-term audit engagements and the impact these long-term relationships might have on investors' ability to rely on audited financial statements. Concerns over increased audit costs and the risks associated with the steep learning curve that the new audit firm would face were also discussed.

While some have advocated that a pilot program be tested with some of the largest audit engagements, it is looking like the PCAOB might shift its focus more toward strengthening the role of the audit committee instead. This shift is likely driven in part by the House Financial Services Committee's threat of legislation to bar auditor rotation. In an interview in mid-April, Jeanette Franzel, the PCAOB's newest member, stated, "Some of the themes that are coming through are the need to look at strengthening the role of the audit committee and audit committee performance, perhaps looking at some of the types of disclosures, perhaps about audit firm tenure." The board is also considering "things like the retendering of audits periodically without a mandatory audit firm rotation requirement. Everybody is acknowledging there's an inherent conflict of interest in the client payer model, so we're looking very broadly at how to mitigate the risks associated with that."

All in all, adoption of an audit firm rotation system remains unclear. The concept was proposed during 2011 and although it has not been adopted and formalized, it is far from being a dead issue. The introduction of this concept and the more recent focus on the role of the audit committee are just further indications of the trend toward stricter independence requirements.

Alvarez & Marsal Taxand Says:

Independence is not a simple "once and done" analysis. When evaluating service providers for non-attest services, consideration must be given to the evolving independence landscape. The recent activity we have seen around this topic demonstrates an elevated posture for regulators, service providers and audit clients alike. Navigating through these issues can be time-consuming and risky. While it remains uncertain whether or not the PCAOB will adopt rules requiring audit firm rotation, the fact remains that companies should be extremely careful and conservative when determining what non-attest services they will use their audit firm to perform. In light of all of these developments, the appeal of an independent multi-disciplinary consulting firm like Alvarez & Marsal, which can perform services without any of the complicated independence issues needing to be considered, has become even more apparent. 

Compliance Week, "Podcast: Q&A With PCAOB Member Jeanette Franzel," Tammy Whitehouse. April 19, 2012. 


Marchall Reiss, Director, contributed to this article.

For more information:

Layne Albert 
Managing Director, New York
+1 214 438 8410

Gregory Gunderson 
Managing Director, Dallas
+1 214 438 8410

Paul Helderman
Managing Director, New York
+1 212 763 9760

Charles Henderson IV
Managing Director, Atlanta
+1 404 720 5226

Sean Menendez 
Managing Director, Miami
+1 305 704 6688

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