SEC Independence Rules: Auditor Independence for the CPA Exam

SEC Independence Framework

The SEC independence rules, codified primarily in Regulation S-X Rule 2-01 and supplemented by the Sarbanes-Oxley Act of 2002, establish strict independence requirements for auditors of public companies (issuers). These rules are more restrictive than the AICPA Code of Professional Conduct and are enforced by the SEC and PCAOB. For the CPA AUD exam, candidates must understand the key differences between SEC and AICPA independence requirements and be able to apply both sets of rules.

Prohibited Non-Audit Services

Services That Impair Independence

Section 201 of the Sarbanes-Oxley Act identifies nine categories of services that, if provided to an audit client that is a public company, impair the auditor's independence: bookkeeping or other services related to the accounting records or financial statements, financial information systems design and implementation, appraisal or valuation services or fairness opinions, actuarial services, internal audit outsourcing services, management functions or human resources, broker-dealer or investment adviser or investment banking services, legal services and expert services unrelated to the audit, and any other service that the PCAOB determines by regulation is impermissible.

Permitted Services

Non-audit services not specifically prohibited may be provided to audit clients if they are pre-approved by the audit committee. Tax services are generally permitted, subject to specific restrictions and audit committee approval, but certain aggressive tax strategies and contingent fee arrangements for tax services are prohibited.

Partner Rotation Requirements

Mandatory Rotation

The Sarbanes-Oxley Act requires that the lead engagement partner and the concurring review partner on audits of public companies rotate off the engagement after five consecutive years. After rotation, these partners must observe a five-year cooling-off period before they can return to the engagement in the same capacity. Other audit partners who serve in a significant role on the engagement must rotate after seven consecutive years and observe a two-year cooling-off period.

Rationale

Partner rotation is designed to prevent excessive familiarity between the auditor and the client, which can compromise the auditor's objectivity and professional skepticism over time. By requiring fresh perspectives on the engagement, rotation helps maintain the quality and independence of the audit.

Audit Committee Pre-Approval

All audit and non-audit services provided by the auditor to the public company client must be pre-approved by the audit committee. The audit committee may establish general pre-approval policies for certain types and levels of services, but the committee must be informed of each service and no pre-approval delegation to management is permitted. A de minimis exception exists for non-audit services that were not recognized as such at the time of the engagement, provided the total does not exceed five percent of total fees paid to the auditor, the services are promptly brought to the audit committee's attention, and the audit committee approves them before the audit is completed.

Employment Relationships and Cooling-Off Periods

Independence is impaired when a former partner, principal, shareholder, or professional employee of the audit firm is employed by the audit client in an accounting or financial oversight role unless that individual has been disassociated from the firm for at least one year (the one-year cooling-off period). This means that a former engagement team member cannot immediately accept a position as controller, CFO, or other financial reporting role at the client.

Financial Relationships

The SEC rules prohibit certain financial relationships between the auditor and the audit client, including direct investments, material indirect investments through intermediaries, savings or checking accounts exceeding FDIC insurance limits at a bank audit client, and insurance policies with insurance company audit clients. The SEC also restricts business relationships and lending relationships between the auditor and audit client that could impair independence.

CPA Exam Tips

• Know the nine categories of prohibited non-audit services under Sarbanes-Oxley. Expect questions that ask whether a specific service impairs independence.
• Lead and concurring review partners must rotate after five years with a five-year cooling-off period. Other significant partners rotate after seven years with a two-year cooling-off period.
• All services must be pre-approved by the audit committee. The de minimis exception requires that total unapproved services not exceed five percent of total fees.
• A one-year cooling-off period applies before a former engagement team member can accept a financial reporting oversight role at the audit client.
• SEC independence rules apply only to audits of public companies (issuers). Nonissuers follow AICPA independence rules unless otherwise required.