SEC Staff Letter on Contingent Fees and Auditor Independence for SEC Registrants

May 12, 2017

May 21, 2004

Mr. Bruce P. Webb, Chair
Professional Ethics Executive Committee
American Institute of Certified Public Accountants Harborside Financial Center 201 Plaza Three Jersey City, NJ 07311-3881

Dear Bruce:

Thank you for copying me on your April 30th letter to Douglas Carmichael at the Public Company Accounting Oversight Board. In your letter, you discuss the application of the Commission's auditor independence rules to the receipt by an accounting firm of contingent fees for tax services provided to an audit client that is a Commission registrant. This letter is to remove any ambiguity that we understand may exist regarding the Commission staff's position on this issue and related issues.

The Commission's rules state the receipt by an accounting firm of a contingent fee from an audit client impairs the auditor's independence with respect to that client.1 The Commission's rules define "contingent fee" as follows:

Contingent fee means, except as stated in the next sentence, any fee established for the sale of a project or the performance of any service pursuant to an arrangement in which no fee will be charged unless a specified finding or result is attained, or in which the amount of the fee is otherwise dependent upon the finding or result of such product or service. Solely for the purposes of this section, a fee is not a "contingent fee" if it is fixed by courts or other public authorities, or, in tax matters, if determined based on the results of judicial proceedings or the findings of governmental agencies. Fees may vary depending, for example, on the complexity of services rendered.2

In Financial Reporting Release No. 56, which announced the adoption of these rules, the Commission noted that the exception for fees fixed by courts or other public authorities or, in tax matters, for fees determined based on the results of judicial proceedings or findings of governmental agencies, was consistent with the rules of the American Institute of Certified Public Accountants.

Your letter to Doctor Carmichael indicates that because of the consistency in the language in the Commission and AICPA rules, you believe that AICPA Ethics Interpretation 302-1, and the examples under that interpretation, should apply equally to the Commission's rules. Your letter quotes Interpretation 302-1 as follows:

A fee is considered determined based on the findings of government agencies if the member can demonstrate a reasonable expectation, at the time of a fee arrangement, of substantive consideration of an agency with respect to the member's client.

Neither the Commission's rule nor the Commission's release refers to this interpretation. The Commission release, in fact, indicates that the Commission had in mind a much different test for the application of this exception. The release states:

We have added the AICPA's exception for fees, in tax matters, determined based on the results of judicial proceedings or the findings of government agencies. This exception is based, in part, on the position that when the fee is determined not by the parties but by courts or government agencies acting in the public interest, it is less likely that such fees will be used to create a mutual financial interest between the auditor and audit client. (Emphasis added.)

As stated in the release, the exception in the Commission's rule is not based on whether the accountant reasonably expects a government agency would consider issues with respect to its audit client. The release makes clear that the exception would apply only when the determination of the fee is taken out of the hands of the accounting firm and its audit client and is made by a body that will act in the public interest, with the result that the accounting firm and client are less likely to share a mutual financial interest in the outcome of the firm's advice or service.

For example, if an accounting firm and audit client were to agree that the firm would receive 30% of any tax savings to the client resulting from tax advice provided by the firm, the fee would be a contingent fee and impair the auditor's independence notwithstanding an expectation that a government agency would consider issues related to the client's taxes. In this case, the firm and client, not a court or government agency, would have agreed to the determination of the fee. The fact that a government agency might challenge the amount of the client's tax savings and thereby alter the final amount of the fee paid to the firm heightens, not lessens, the mutuality of interest between the firm and client. Accordingly, such fees impair an auditor's independence.

This position is consistent with the example in the release that clearly states if an accounting firm and audit client were to agree that the firm would receive a fee based in whole or part on the amount of the client's tax credits identified by the firm then the accounting firm's independence would be impaired. The Commission stated:

… For example, as discussed in the Proposing Release, an auditor might undertake a study of certain types of a client's expenditures in order to identify greater amounts of qualifying expenses that would result in greater income tax credits. Fees for such services might be based on a percentage of the tax credits generated, a base fee plus a percentage of tax credits generated over a pre-determined base amount, or a base fee plus a "value added" amount to be added to the base fee. In that case, the accounting firm's economic benefit will be greater if the tax credits are maximized. Because this interest (in the economic benefit) is inconsistent with acting independently in assessing the accuracy of the impact on the income tax accounts and financial statements of the tax credits, those kinds of fee arrangements are prohibited under the final rule. (Emphasis added.)

To clarify its position on whether arrangements for an audit client to pay a "value added" fee in addition to the accounting firm's base fee would impair the auditor's independence, the Commission stated in the release:

In response to comments, we have eliminated from the rule text the language regarding "value added" fees. Some commenters represented that accounting firms sometimes receive fees where the client determines at the end of the engagement whether the services rendered warrant an additional fee, but there is no agreement (written or otherwise) for the audit client to pay the additional fee. In these situations, the client, at its complete discretion, determines at the end of the performance period that the accountant provided services that had greater value than the amount due under the contract. That type of "value added" fee is not within the scope of the prohibition.

On the other hand, the staff will look closely to determine whether a fee labeled a "value added" fee is in fact a contingent fee, such as where there are side letters or other evidence that ties the fee to the success of the services rendered…. (Emphasis added; footnotes omitted.)

In approving any audit or non-audit service, therefore, an audit committee should be aware that any agreement - from a direct contract provision to "a wink and a nod" - that provides for the possible additional payment of a "value added" fee based on the results of an accounting firm's performance of a tax or other service would be viewed as impairing the firm's independence. In addition, an audit committee should consider carefully the impact on an accounting firm's independence of the possibility of even a completely voluntary payment of a "value added" fee by an audit client to the firm. As noted above, to be permitted under the contingent fee rules, the client cannot decide whether to make such a discretionary payment or the amount of the payment prior to the end of the performance period. Both the accounting firm's interest in encouraging a large payment and the leverage provided to the client to withhold or reduce such a payment if it is in any way dissatisfied with the firm could have an adverse affect on a reasonable investor's conclusion that the accounting firm is capable of exercising objective and impartial judgment on all issues encompassed within the audit engagement and, thus, impair the accounting firm's independence under the Commission's auditor independence rules.3 Furthermore, if determination or payment of a discretionary "value added" fee were delayed pending an event or information coming to the attention of the client that would indicate, directly or indirectly, the success of the advice or service provided by the accounting firm, then the fee would be a prohibited contingent fee.

As you know, the Sarbanes-Oxley Act of 2002, and the Commission rules implementing that Act, directed the national securities exchanges to require that audit committees of listed companies appoint, compensate and oversee the work of registered public accounting firms. The Act also requires that audit committees pre-approve all audit and non-audit services provided by those firms.

I hope that this letter has helped to clarify the staff's position on these issues. If you have any questions, please feel free to contact Robert Burns at (202) 942-4400.

Sincerely,

Donald T. Nicolaisen
Chief Accountant

cc:	Douglas R. Carmichael, PCAOB Susan Coffey, AICPA

Endnotes

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1 17 CFR 210.2-01(c)(5).

2 17 CFR 210.2-01(f)(10).

3 17 CFR 210.2-01(b).

Last Reviewed or Updated: May 21, 2004