The SEC is proposing to modernize auditor independence rules in response to drastic changes in the accounting profession in recent years. The new rules primarily address the conflicts of interest raised by financial investment and employment relationships as well as the scope of services provided by audit firms to their audit clients.

With regard to financial investment relationships, the proposed rules would narrow the circle of people whose investments trigger independence concerns. Under the rules, restrictions from investments would be limited primarily to those who work on the audit or can influence the audit. Currently, many partners in firms that do not work on the audit of a client, as well as their spouses and families, are restricted from investments in a firm's audit clients.

Similarly, the rules would reduce the pool of people within audit firms whose families would be affected by the employment restrictions necessary to maintain independence. The rules also would provide that if "close family members" hold positions that allow them to influence the audit client's financial records, the employment relationship would impair an auditor's independence.

The rules also identify specific non-audit services that are inconsistent with independence. These services include, among other things, bookkeeping services, financial information systems design and implementation, appraisal or valuation services, and actuarial services.

The rules provide a limited exception from independence violations for firms with adequate quality controls in place that provide reasonable assurance that the firm and its employees maintain their independence. The basic controls must include written independence policies and procedures, automated systems to identify financial relationships that may impair independence, training, internal inspection and testing, and a disciplinary mechanism for enforcement.

The industry is particularly concerned with the scope of services section of the proposed rules. SEC Chief Accountant Lynn Turner said at an open SEC meeting that two of the Big 5 accounting firms support the rules. However, four industry leaders—including the three remaining Big 5 firms and the AICPA—argued against some of the proposed provisions in a teleconference call later that day.

Jeff Peck, managing director of the office of government affairs at Arthur Andersen, was disappointed that the Commission decided to "shackle" the financial investment and employment relationship rules to the scope of services rules. He said that the industry is in complete consensus that the financial investment and employment relationship rules need to be modernized as soon as possible. However, linking these rules to the highly controversial scope of services rules may delay long overdue changes, Peck said.

At the open meeting, Turner said it would be "awkward" to divide the proposed rule into two pieces—one regarding conflicts of interest and one regarding scope of services. He added that the public will be best served by having clear guidelines regarding both issues as soon as possible.

Bill Ezzell, a partner with Deloitte & Touche, was concerned with some of the activities that fall under the restricted scope of services. For instance, he noted that Deloitte & Touche has been involved in financial information systems design and implementation for years, yet this activity would compromise auditor independence under the proposed rule. Ezzell added that there have been no indications that this type of service needs to be restricted.

Stephen Allis, a partner at KPMG, said that auditors should never engage in certain activities, such as acting as management or auditing their own numbers. However, he believes that restricting the scope of services as drastically as the proposed rules do will drive talent away and ultimately hurt the audit process.

Turner noted at the open meeting that, under the proposed rules, non-audit services may jeopardize an auditor's independence, but they are not outright banned.

The comment period for the rules is 75 days and will include public hearings, which are expected to take place in early fall. The rules would have a two-year transition period in order for consultants to bring existing efforts to a conclusion.

Commissioner Isaac Hunt said that the comment period should be extended to 120 days. Peck agreed, and noted his concern that the Commission is in a "rush to regulate," and may be pushing to adopt a final rule before Congress goes out of session and the Administration changes hands.

SEC Chairman Arthur Levitt, however, said that he believes the comment period is adequate given that the issue, which has been considered by the last five commissions, has been in the forefront for quite some time. The rules have not been updated in about 30 years.