The SEC has adopted new rules to enhance the independence of accountants that audit and review financial statements and prepare attestation reports filed with the Commission. As discussed in more detail below, the new rules:

• specify certain non-audit services that, if provided to an audit client, would impair an accounting firm's independence;
• require that an issuer's audit committee pre-approve all audit and non-audit services provided to the issuer;
• prohibit certain partners on the audit engagement team from providing audit services to the issuer for more than five or seven consecutive years, depending on the partner's involvement in the audit;
• prohibit an accounting firm from auditing an issuer's financial statements if certain members of management of that client had been members of the accounting firm's audit engagement team within the one-year period preceding the commencement of audit procedures;
• preclude independence in a situation where an audit partner receives compensation for selling non-audit services to the issuer;
• require that the auditor of an issuer's financial statements report certain matters to the issuer's audit committee, including "critical" accounting policies used by the issuer; and
• require additional disclosure to investors regarding the audit and non-audit services provided by, and fees paid to, the auditor of an issuer's financial statements.

The rules are effective as of May 6, 2003, although transition rules apply to some provisions, as discussed below.

A. Service Outside the Scope of the Practice of Auditors

The new rules provide that it shall be unlawful for a registered public accounting firm that performs an audit of an issuer's financial statements (and any person associated with such a firm) to provide to that issuer, contemporaneously with the audit, any non-audit service, including specified services set forth in the Act. There is an exception, however, for any non-audit service, including tax services, that is not specified as a prohibited service, but only if the service has been pre-approved by the issuer's audit committee. According to the SEC, the rules are based on three basic principles, violations of which would impair the auditor's independence. Under these principles, a company's auditors should not audit their own work, function as part of management or as an employee of their client, or act as an advocate for their client.

The prohibited services contained in these rules only apply to non-audit services provided by independent accountants to their audit clients. These rules do not limit the scope of non-audit services provided by an accounting firm to a non-audit client. Under the Act, the responsibility falls on the audit committee to pre-approve all audit and non-audit services provided by the accountant.

Under the new rules, an auditor's independence is impaired if the auditor provides any of the following services to the issuer:

• bookkeeping or other services related to the audit client's accounting records or financial statements;
• financial information systems design and implementation. Consistent with previous rules, the new rules do not preclude an audit firm from working on hardware or software systems that are unrelated to the audit client's financial statements or accounting records, so long as those services are pre-approved by the audit committee; evaluating the internal controls of a system as it is being designed, implemented or operated as part of an audit or attest service and making recommendations to management; or making recommendations on internal control matters to management or other service providers in conjunction with the design and installation of a system by another service provider;
• appraisal or valuation services, fairness opinions, or contribution-in-kind reports;
• actuarial services;
• internal audit outsourcing services;
• management functions;
• human resources;
• broker-dealer, investment adviser, or investment banking services;
• legal services; or
• expert services (for the purpose of advocating that audit client's interests in litigation or regulatory, or administrative investigations or proceedings) unrelated to the audit.

In contrast to the above, tax services are not included among the non-audit services expressly prohibited by the Act. Instead, tax services (and all other non-audit services omitted from the above list) would fall under the category of non-audit services for which audit committee pre-approval is required. An accounting firm may continue to provide tax services such as tax compliance, tax planning and tax advice to audit clients, subject to the normal audit committee pre-approval requirements, without impairing the firm's independence. Additionally, the rules require issuers to disclose the amount of fees paid to the accounting firm for tax services.

The SEC cautioned, however, that merely classifying a service as a "tax service" does not mean that the service may not be within one of the categories of prohibited services or may not result in an impairment of independence under the rules. The accounting firm and the issuer's audit committee should consider, for example, whether the proposed non-audit service is an allowable tax service or constitutes a prohibited legal service or expert service.

Effective Date and Transition. The rules provide that until May 6, 2004 the provision of these non-audit services will not impair an accountant's independence, provided the services are pursuant to contracts in existence on May 6, 2003.

B. Partner Rotation

The new SEC rules require:

• the lead and concurring audit partners to rotate after five years and, upon rotation, be subject to a five-year "time out" period; and
• audit partners, other than the lead and concurring partner, to rotate after no more than seven years, and to be subject to a two-year "time out" period.

For purposes of this rule, the SEC has defined the term "audit partner" to mean the lead and concurring partners, as well as partners on the audit engagement team who have responsibility for decision-making on significant auditing, accounting, and reporting matters that affect the financial statements or who maintain regular contact with management and the audit committee. In particular, in addition to the lead and concurring partners, audit partners would include all partners who serve the client at the issuer or parent level, other than specialty partners; other audit engagement team partners who provide more than ten hours of audit, review or attest services in connection with the preparation of the annual or interim financial statements; and the lead partner on subsidiaries of the issuer whose assets or revenues constitute 20% or more of the client's consolidated assets or revenues. The term audit partner does not include specialty partners or partners assigned to "national office" duties who may be consulted on specific accounting issues related to a client. Accordingly, these individuals are not subject to the rotation requirement.

Effective Date and Transition. In order to allow firms to establish an orderly transition of their audit engagement teams, the SEC has established transition provisions related to the partner rotation requirements, as follows:

• Lead partner - the rotation requirements applicable to the lead partner are effective for the first fiscal year ending after May 6, 2003. In determining when the lead partner must rotate, time served in the capacity of lead partner prior to May 6, 2003 is included in determining the number of years served.
• Concurring partner - in order to facilitate the process of staggering the rotation of the lead and concurring partners, the rotation requirements for the concurring partner are effective as of the end of the second fiscal year after May 6, 2003. Time served in the capacity of concurring partner prior to May 6, 2003 is included in determining the number of years served.
• Other "audit partners" - the rotation requirements are effective as of the beginning of the first fiscal year commencing after May 6, 2003. However, in determining the number of years served, that first fiscal year will constitute the first year of service for these partners.

C. Audit Committee Administration of the Engagement

The rules require that the audit committee pre-approve all permissible non-audit services and all audit, review or attestation engagements required under the securities laws. The rules require that before the accountant is engaged by the audit client to render the service, the engagement must be approved by the audit client's audit committee or entered into pursuant to pre-approval policies and procedures established by the audit committee, provided the policies and procedures are detailed as to the particular service, the audit committee is informed of each service, and the policies and procedures do not include delegation of the audit committee's responsibilities to management.

The rules recognize audit services to be broader than those services required to perform an audit pursuant to Generally Accepted Auditing Standards ("GAAS"). The rules identify various other types of services as audit services, including services performed to fulfill the accountant's responsibility under GAAS and review of complex accounting issues through consultation with national office or other technical reviewers to reach an audit judgment. The rules require that the audit committee pre-approve all of these services. The audit committee has the sole authority to pre-approve the engagement of the issuer's independent accountant to perform all services. The audit committee can establish policies and procedure for pre-approval, provided they are detailed as to the particular service and designed to safeguard the continued independence of the auditor. One or more audit committee members are permitted to pre-approve the service. Decisions made by the designated audit committee members must be reported to the full audit committee at each of its scheduled meetings.

The rules also include a de minimis exception solely related to the provision of non-audit services for an issuer. This exception waives the pre-approval requirements for non-audit services provided that all such services do not aggregate to more than five percent of total revenues paid by the audit client to its accountant in the fiscal year when services are provided and were not recognized as non-audit services at the time of the engagement. Such services must be brought to the attention of the audit committee and approved by the audit committee or one or more designated representatives prior to the completion of the audit.

Finally, the audit committee's policies for pre-approvals of services must be disclosed by issuers in their annual reports and proxy statements.

Effective Date and Transition. These rules apply to all audit, review, and attest services and non-audit services that are entered into after May 6, 2003. For arrangements for non-audit services entered into prior to that date, regardless of whether or not they were pre-approved by the audit committee, the accounting firm will have until May 6, 2004 to complete these services.

D. Conflicts Of Interest Resulting From Employment Relationships

Under the SEC's current rules, an accounting firm is not deemed to be independent with respect to an audit client if a former partner, principal, shareholder, or professional employee of the accounting firm accepts employment with the client and continues to have a financial interest in the accounting firm. This requirement remains unchanged.

The new rules also impose a "cooling off" period that provides that when any member of the audit engagement team accepts a position with the issuer in a "financial reporting oversight role" within the one year period preceding the commencement of the current audit engagement, the accounting firm is not independent with respect to that issuer. The rule applies to employment relationships entered into between members of the audit engagement team and the issuer. Members of the engagement team are considered to be the lead partner and the concurring partner, regardless of the amount of hours spent on the audit engagement, as well as all other members who provided more than ten hours of service to the issuer.

The rules specify that the cooling off period will extend for one year. For purposes of the rules, audit procedures are deemed to have commenced for the current audit engagement period the day after the prior year's periodic annual report (e.g., Form 10-K or 10-KSB) is filed with the SEC. The audit engagement period for the current year is deemed to conclude the day the current year's periodic annual report is filed with the SEC. Therefore, under the new rules, an accounting firm would not be considered independent until the completion of one full annual audit cycle subsequent to the individual's participation on the audit engagement team.

The rules define "financial reporting oversight role" as a role in which an individual has direct responsibility or oversight of those who prepare the issuer's financial statements and related information (e.g., MD&A), which will be included in an issuer's report filed with the SEC.

Effective Date and Transition. The "cooling off" period rules are effective for employment relationships with issuers that commences after May 6, 2003.

E. Compensation

The rules provide that an accountant is not independent of an audit client if, at any point during the audit engagement period, any audit partner, other than specialty partners, earns or receives compensation based on the audit partner procuring engagements with that audit client to provide any services other than audit, review, or attest services. Audit partners include the lead and concurring partners and other partners on the audit engagement team who have responsibility for decision-making on significant auditing, accounting and reporting matters that affect the financial statements or who maintain regular contact with management or the audit committee.

Effective Date and Transition. The compensation rules will be effective beginning in the first fiscal period of the accounting firm that commence after May 6, 2003.

F. Communication with Audit Committees

The new rules require the accounting firm to report to the issuer's audit committee, prior to the filing of that period's financial statements with the SEC:

• all critical accounting policies and practices used by the issuer;
• all alternative accounting treatments of financial information within GAAP related to material items that have been discussed with management, including the ramifications of the use of such alternative treatments and disclosures and the treatment preferred by the accounting firm; and
• any other material written communications between the accounting firm and management of the issuer.

Please note that these communications are not required to be in writing, but the SEC indicated that it expects these communications would be documented by the auditor and the audit committee.

The SEC has defined "critical" accounting policies as those that are both most important to the portrayal of the company's financial condition and results and that require management's most difficult, subjective or complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain.

The discussion of general accounting policies should include the range of alternatives available under GAAP that were discussed by management and the auditors along with the reasons for selecting the chosen policy. If an existing accounting policy is being modified, then the reasons for the change should also be communicated. If the accounting policy selected is not the auditor's preferred policy, then the SEC expects the discussions to include the reasons why the auditor considered one policy to be preferred but that policy was not selected by management.

The rules specify that the communications between the auditor and the audit committee must occur prior to the filing of the audit report with the SEC pursuant to applicable securities laws. As a result, these discussions will occur, at a minimum, during the annual audit, but could occur as frequently as quarterly or more often on a real-time basis.

G. Expanded Disclosure

The new rules address expanded disclosure for accountants' fees as well as audit committee policies and procedures.

Under the new rules, the disclosure of professional fees paid for audit and non-audit services must be broken into the following categories:

• Audit fees, which include fees paid to the principal accountant for services necessary to perform an audit or review in accordance with GAAS, and may also include services that generally only the independent accountant can reasonably provide, such as comfort letters, statutory audits, attestation services, consents and assistance with and review of documents filed with the SEC. Also included are fees for services that normally would be provided by the accountant in connection with statutory and regulatory filings or engagements. The adopting release specified that all services performed to comply with GAAS should be classified as audit services. This could include services such as tax services and accounting consultations, to the extent that these services are necessary to comply with GAAS.
• Audit-related fees, which include assurance and related services that are traditionally performed by the independent accountant, such as employee benefit plan audits, due diligence related to mergers and acquisitions, accounting consultations and audits in connection with acquisitions, internal control reviews and attest services that are not required by statute or regulation and consultation concerning financial accounting and reporting standards.
• Tax fees, which include all services performed by professional staff in the independent accountant's tax division, except those related to the audit and included in audit fees. Tax fees would include fees for tax compliance, tax planning and tax advice.
• All other fees, which include fees for financial information systems implementation and design.

The rules require disclosure of these fees for each of the two most recent fiscal years, rather than just the most recent fiscal year as previously required, so that investors have comparative information. In addition, other than for audit fees, issuers are required to describe, in qualitative terms, the type of the services provided that are categorized as audit-related fees and all other fees. The rules also include disclosure requirements related to audit committee pre-approval policies and procedures for audit and non-audit services provided by an independent public accountant, as well as the percentage of fees that were approved pursuant to the de minimis exception. This information must be provided by category.

The requirement to disclose the percentage of audit services that are not provided by permanent, full-time employees of the independent public accounting firm, if more than 50%, remains unchanged from existing rules.

The rules also require that issuers filing proxy statements disclose any policies and procedures developed by the audit committee concerning pre-approval of the independent accountant to perform both audit and non-audit services.

The disclosure should set out in detail the audit committee's policies and procedures for engaging the independent accountant to perform services other than audit, review and attestation services. The SEC stated that it expects issuers to provide clear, concise and understandable descriptions of the policies and procedures. Alternatively, a copy of those policies and procedures can be included with the proxy statement delivered to investors and filed with the SEC. Either method should allow shareholders to obtain a complete and accurate understanding of the audit committee's policies and procedures.

Under the rules, the new disclosure will be required to be included in a company's annual report, as well as in a company's proxy statement on Schedule 14A or information statement on Schedule 14C. Because the information is to be included in Part III of annual reports on Forms 10-K and 10-KSB, companies will be able to incorporate the required disclosures from the proxy or information statement into the annual report. Issuers that do not issue proxy statements are required to include appropriate disclosures in their annual filing included in Form 10-K or Form 10-KSB.

Effective Date and Transition. The disclosure provisions are effective for periodic annual filings for the first fiscal year ending after December 15, 2003. However, the SEC encouraged issuers that have not previously issued their periodic annual filings to adopt these disclosure provisions earlier.

The foregoing is meant to be a summary only. As with any discussion of the law, certain exceptions may apply to specific situations. Please call Ted Tashlik or Martin Goldwyn to discuss any specific matters.