September 25, 2000
September 25, 2000
September 25, 2000
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549
Attention: Mr. Jonathan G. Katz, Secretary
Re: Revision of the SEC's Auditor Independence
Requirements, File No. S7-13-00 - Scope of Services
Dear Chairman Levitt and Commissioners:
Deloitte & Touche* submits this letter in response to the Securities and Exchange Commission's request for comments on its proposed rule regarding Revision of the Commission's Auditor Independence Requirements, Securities Act Release No. 7870 (June 30, 2000) (the "Release").** This letter only addresses the proposal as it relates to the scope of services provided by accounting firms to their audit clients.
* As used in this letter, Deloitte & Touche includes Deloitte & Touche LLP and Deloitte Consulting L.P.
** The Release can be found in the Federal Register at 65 Fed. Reg. 43,148.
TABLE OF CONTENTS
I. Introduction And Executive Summary
II. There Is No Need For This Rule
III. The Proposed Rule Will Harm The Public Interest
IV. The Proposed Rule Is Substantively Flawed
I. Introduction And Executive Summary
The Securities and Exchange Commission (the "Commission") and the accounting profession share the fundamental goals of protecting investors and serving the public interest. We commend the Commission for many of its recent efforts in this area, including its efforts to modernize the independence rules in the area of financial and employment relationships. We strongly believe, however, that the proposed restrictions on scope of services are not in the public interest because they are more likely to erode than enhance the quality of audit services to public companies. Although the Release states that the proposed rule will enhance investor protection and foster investor confidence in the integrity of financial statements,1 we believe that the Commission is gravely mistaken. We are also concerned that the process that has been followed is insufficient to permit due consideration of the many unintended adverse consequences that will result from adopting the proposed rule. We respectfully submit that the proposed restrictions on scope of services should not be adopted. Our reasons include:
We are in agreement with the Commission's objective of trying to improve audit quality. Unfortunately, the proposed rule does not achieve that objective, and may in fact undercut it. We believe that the proposals regarding scope of services in the Release are, at best, unworkable and, if adopted, would result in unintended consequences that could materially impede the efficiency of ourpre-eminent system for capital formation, a system that is the envy of the world. Rather than a measured response to independence concerns, the Release vastly understates the consequences to audit quality and investor protection.2 The proposed rule would impose increased and unnecessary costs on issuers and accounting firms, as well as other adverse consequences and regulatory burdens, without providing significant corresponding benefits to investors and the public interest.
Although we were constrained by the limited time frame provided to comment on the proposed rule, our comments and concerns are discussed below.3
II. There Is No Need For This Rule
A. The Facts Do Not Support The Need For The Proposed Rule
Our opposition to the proposed rule begins with a fundamental observation: there is no empirical evidence to support it, and existing evidence goes the other way. In this instance, the Commission concedes the absence of facts to support the issuance of this wide-sweeping regulation.4 Indeed, the Release cites no empirical evidence to support the notion that providing non-audit services to audit clients has had any adverse effect on the quality of audits, and offers at best anecdotal evidence of "economic pressure" resulting from the provision of non-audit services.5 Rather, the Release relies on purported "common sense" to justify the absence of specific and persuasive evidence.6
The lack of a sufficient connection between the provision of non-audit services and audits gone awry should be recognized by the Commission as a significant and telling fact. The hearings in July and September have produced at best isolated, anecdotal examples which do not have a clear relationship to independence and do not demonstrate the systemic failure in independence that would justify significant, and potentially harmful, change to the current system.7
1. Studies Show That The Provision Of Non-Audit Services Does Not Impair Auditor Independence
Existing empirical evidence belies the purported rationale for the proposed rule. Most recently, the Panel on Audit Effectiveness8 conducted an extensive analysis of audit effectiveness, which included for the first time, a detailed examination of actual engagements at each of the major accounting firms involving the provision of non-audit services. Upon completion of its work, the Panel concluded that it was "not aware of any instances of non-audit services having caused or contributed to an audit failure or the actual loss of auditor independence."9 In fact, the Panel's review found that non-audit services had a "positive impact" on audit effectiveness in "about a quarter of the engagements" in which both types of services had been provided to the client.10 Certain members of the Panel noted that "[t]his is not a momentary phenomenon; for about a century, CPAs have been providingvaluable non-audit services. . . . These Panel members are reluctant to change the rules in the absence of any compelling evidence of a problem."11
Other studies concur:
Study groups including the Cohen Commission, the POB, the major accounting firms, the AICPA's Special Committee on Standards of Professional Conduct for Certified Public Accountants. . ., the Treadway Commission and the SEC Staff have examined the potential effect on the auditor-client relationship of accounting firms' performance of non-audit services for audit clients. According to the United States General Accounting Office, "[n]one of these studies reported any conclusive evidence of diminished audit quality or harm to the public interest, or any actual impairment of auditor independence, as a consequence of public accounting firms providing advisory or consulting services to their audit clients."12
As stated by former SEC Commissioner Steven Wallman: "A prohibitive approach focusing on the provision of non-audit services to audit clients . . . appears to be wholly without any empirical support indicating any lack of objectivity in fact resulting from the provision of non-audit services to audit clients."13
In contrast to the Commission's assumptions about investor perception, two recent studies sponsored by the Independence Standards Board ("ISB") corroborate the above conclusions.14 Those studies, which have resulted in two reports, Earnscliffe I and Earnscliffe II, "assess the perceptions of different audiencesaround the question of auditor independence and objectivity."15 Earnscliffe II probed specifically into issues raised by the provision of non-audit services. That report stated that "most people felt that the fact that accounting firms had branched out into other service areas, in addition to auditing, posed no challenge to the objectivity and independence which they brought to auditing."16 As to offering non-audit services to audit clients, Earnscliffe II also noted that "[f]or the most part, people felt that the idea of separate consulting and audit divisions as well as other safeguards would help mitigate any risk [caused by the provision of non-audit services to audit clients.]"17 Importantly, with regard to the investing public's views, Earnscliffe II concluded:
Very few people knew anything about the current safeguards to ensure independence on the part of the auditor, although they assumed that rules, fear of penalties, codes, etc. all formed part of the system. The more people became informed about current safeguards, the more confident they became in the independence of the auditor. They were open to the idea that more safeguards might be needed, but were not agitating for these, nor were they overly interested in being communicated to about these matters in the future.18
The results of Earnscliffe I and II are corroborated by recent studies. For example, a recent academic study sponsored by the North Carolina State University Accounting Department, found that "nonaudit services had an incremental or positive influence on users' perceptions of auditor independence and objectivity. Moreover, the auditor's provision of nonaudit services had a . . . positive influence on participants' willingness to rely on the auditor's opinion."19 A survey conducted by Penn, Schoen & Berland Associates, Inc., found that "[m]ost investors oppose new regulations which would prevent auditors from providing consulting services to their audit clients."20
2. Current Safeguards Assure Auditor Independence
Institutional structures,21 internal constraints and the threat of civil and administrative sanctions provide powerful incentives to assure independence. This system has worked well since the Securities Act was enacted 67 years ago. It will continue to impose effective limits on independence breaches in the future. For example, lack of independence can serve as the basis of, or an element in, an action under federal securities law, state securities law or common law. Further, accountants can be subject to disciplinary action by the state licensing authorities and professional organizations, such as the AICPA.22 In addition, the Commission canbring administrative actions under Rule 102(e), pursuant to which it can impose a censure or deny, temporarily or permanently, the ability to practice before the Commission.23
The Staff recognized the significance of these strictures in its 1994 Report on Auditor Independence:
[T]he extensive systems of independence requirements issued by the Commission and the AICPA, coupled with the Commission's active enforcement program, provide investors reasonable safeguards against loss due to the conduct of audits by accountants that lack independence from their audit clients. The enactment of detailed legislation or the promulgation of additional rules is not necessary.24
The Release discounts or simply disregards the Staff's prior statements and the extensive framework of regulatory safeguards currently in place, instead relying on the faulty premise that auditors will become vulnerable to economic pressures from audit clients as non-audit services provided to these clients increase. Significantly, however, that premise also fails to consider the accounting firms' own interest in protecting their reputational capital. Courts and commentators have long recognized that "[a]n accountant's greatest asset is its reputation for honesty, followed closely byits reputation for careful work."25 The value of an accounting firm's reputational capital is based on, among other things, the firm's ability to maintain the integrity of its audits.26 An accounting firm risks its reputational capital with respect to each and every audit and each and every client.27 There is no one client, no one audit fee, and no one non-audit engagement worth compromising the quality of the audit. If the firm compromises its objectivity or integrity with respect to any one client, it runs the risk that its reputation may be impugned and its relationships with other current and future clients will suffer. Thus, the accounting firm's paramount interest inprotecting its reputational capital belies the premise that "economic pressures" from providing non-audit services will impair independence.
While clients almost always want to "do the right thing," every auditor eventually comes under client pressure while trying to "do the right thing." The pressure exists whether or not the firm performs non-audit services. Dealing with that pressure is fundamental to what it means to be an auditor and is at the very core of our responsibilities to investors. Our clients pay us and they can hire and fire us -- as consultants and as auditors. While an audit partner does not want to see consulting relationships lost, his or her real concern is with the audit relationship. There are hundreds of situations every year where auditors say "no" to aggressive accounting treatments or the audit uncovers adjustments that are required to make the financial reporting conform with GAAP. Although the Commission may not see these situations because the client complies, they nonetheless occur. Sometimes we lose clients or resign over these matters.
We take our public interest responsibility very seriously and consciously design and operate our audit practice to make sure that our auditors resist any pressure and get to the right answer. We have extensive consultation networks, second partner reviews, and other resources to provide support for the audit partnerdealing with difficult issues so that he or she knows that the firm backs them.28 These safeguards have been and will continue to be effective in ensuring independence.
3. A Broad Range Of Services And A Broad Base Of Clients Helps Assure Auditor Independence
In publishing the proposed rule, the Commission has not given adequate consideration to the advantages to investors provided by accounting firms with a broad range of services and a broad base of clients. First, a broad range of services and a broad base of clients helps an auditor to say "no" when "no" is the right answer on the audit. Not only does providing multiple services to audit clients enable their accounting firms, as well as the individuals working on the audit, to understand their clients better, but it also enables firms and individuals to better withstand pressure from any one client during the course of an audit.29
Second, a broad range of services and a broad base of clients results in larger accounting firms with broader capital bases and stronger balance sheets. Being larger, stronger, more diverse and financially secure, the accounting firms arebetter able to withstand the loss of an individual client, thus enhancing the auditors' ability to exercise independent judgment.
Third, since effective audits depend on specialists, a broad range of services means the needed competencies will be available within the firm on a real time basis, worldwide, to assist the auditor. Access to these competencies enables the auditor to reach informed professional judgments rather than being dependent on the client for information. It also obviates the need to engage outside specialists, who would not be subject to our quality controls and would not be subject to the firm's independence requirements.
From better withstanding pressure, to a stronger capital base, to having specialists available to assist the audit process, a broad range of services and a broad base of clients promotes confidence, investor protection and the public interest. These advantages should not be discarded because of the perception (or misperception) of some. This conclusion is underscored by the lack of empirical evidence cited in the Release that ties the provision of a broad range of services to a lack of independence.30
B. Recent Initiatives Should Be Given Time To Work
Several important initiatives have been undertaken recently in the auditor independence arena. Each of these actions has been undertaken at the urging of, or under the leadership of, the Commission. These developments are consistent with the Commission's longstanding policy that private sector efforts improve investor protection and are the best form of regulation.31 These initiatives are very recent and have not been given time to prove their worth. We believe the current rulemaking is both premature and counterproductive because it will prevent the Commission, the marketplace and the investing public from assessing the results of, or fully realizing the benefits from, these recent initiatives.
1. The Independence Standards Board
The ISB was formed in 1997 as the result of cooperative action of the Commission, the AICPA and the major accounting firms. It was officially authorized by the Commission in 1998.32 The purpose of the ISB is to establish principle-based auditor independence standards.33 In FRR 50, the Commission expressed its intention to give the ISB the leading role in developing independence standards:
After careful consideration, and without abdicating its statutory responsibilities, the Commission intends to look to a standard-setting body designated by the accounting profession--known as the Independence Standards Board ("ISB")--to provide leadership not only in improving current auditor independence requirements, but also in establishing and maintaining a body of independence standards applicable to the auditors of all Commission registrants.34
This statement plainly indicates that as of two years ago, the Commission intended to utilize the ISB as the leader in establishing auditor-independence standards.
Composed of experts in law, business and accounting, the ISB has been working since its inception on a dual track to develop a conceptual framework for independence and to issue independence standards, as needed, while the concep tual framework is being completed.35 Thus far, the ISB has major projects underway directly addressing virtually the same independence issues that the Commission now attempts to address through this fast-paced rulemaking.36 For instance, ISB Standard No. 1 requires discussions between independent auditors and audit committees on all relationships that are reasonably thought to bear on independence.37 This standard enables an audit committee to weigh, under the actual circumstances presented, the benefits of fully-integrated services against potential conflicts, rather than denying the management and directors of an audit client the opportunity to make an informed judgment to use services that they believe will benefit their company and its shareholders.
This ISB standard has not been in effect long enough to be studied, much less to determine whether it needs to be improved. As Dan L. Goldwasser testified on July 26, the Commission's current actions render it impossible to evaluatethe results of the ISB's work, and also "project a lack of confidence in the ISB."38 He noted:
From my perspective, the ISB has approached its task in a thoughtful and methodical manner. It is hard to judge the outcome of this process at this time as the ISB has only issued one substantive standard. . . . Nevertheless, the level of thought reflected in its various discussion memoranda provides confidence that its end-products will be well reasoned.39
Adoption of the proposed rule would create the anomaly of the Commission determining independence standards before the ISB has completed the conceptual framework. The Commission should not only provide an opportunity for individual ISB standards to be tested, but should also lend its full support to the ISB as the central body which the Commission itself charged with addressing independence issues. Indeed, even the Institute of Internal Auditors, which agrees with certain aspects of the proposed rule, "believe[s] that the Independence Standards Board should have primary responsibility for establishing criteria for permissible and non-permissible extended services."40 Numerous other witnesses expressed similarviews.41 Until such time (if any) as the ISB's efficacy is proven inadequate, Commission rulemaking that ignores the work of the ISB signals a no-confidence vote for that body.42 Even if any changes to the ISB's composition or procedures are found to be warranted, we still support the model that recognizes the private sector, in this case the ISB, as the primary independence standards setter.
2. New Audit Committee Rules
The Commission, the New York Stock Exchange, the National Association of Securities Dealers, Inc. and the American Stock Exchange have all adopted rules within the past year intended to improve audit committees' performance and effectiveness.43 The rules are largely based on recommendations made bythe Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees,44 a committee itself formed at the urging of the Commission. These rules require that proxy statements relating to the election of directors contain an audit committee report. In its report, the audit committee, which is required under new self-regulatory organization rules to be composed of independent and financially literate members,45 must disclose, among other things, whether the audit committee has received from the auditors disclosures regarding the auditors' independence (as required by ISB Standard No. 1).46 As ISB Chairman Allen noted in his testimony before the Commission, disclosure is consistent with the philosophy of securities regulation.47 Furthermore, such disclosure not only focuses management and audit committees upon the important aspects of auditor independence, it can provide further assurance to investors of the audit committees' oversight of auditor independence.
Not even one proxy season has gone by which would permit the performance of these new rules to be evaluated. Before taking any action, theCommission should monitor public response to this new disclosure and the efficacy of audit committee oversight of auditor independence.48
3. Public Oversight Board
The Public Oversight Board ("POB") has proposed revisions to its charter. These revisions were driven largely by Chairman Levitt and are supported both by the Commission and the Panel on Audit Effectiveness. The revisions will result in a new framework for public oversight of standard-setting activities for the accounting profession. Under drafts currently being discussed, the POB will have oversight responsibilities for both the ISB and the Auditing Standards Board("ASB"), resulting in consolidation of the oversight of the standards setting that most affect corporate audits.49 The expanded POB oversight responsibilities for standard-setting should be given time to work.
4. Report Of The Panel On Audit Effectiveness
The Panel on Audit Effectiveness (the "Panel") has just completed what we consider the most rigorous investigation of the effectiveness of independent audits. The Panel's report, dated August 31, 2000, contains over 250 recommendations for improvements. Yet before this report was even issued, the Commission chose to propose a prohibitions-based independence rule with respect to the scope of non-audit services. The accounting profession has supported the Panel's work and stands ready to implement the vast majority of the recommended changes.
The Panel's findings in the area of scope of services do not support the need for the proposed rule. Not only did the Panel find no indication that a broad scope of services impaired the quality of the audits examined, it found that non-audit services enhanced audit quality in about one out of every four cases where the audit client received both audit and non-audit services.50 Although the Panel was divided on the appropriateness of an exclusionary ban on non-audit services, a majority ofthe Panel believes that a ban is not a good idea. The Report states that those Panel members opposing a ban believe that:
audit firms can provide both audit and non-audit services to the same public audit client, and with the proper safeguards and disclosures, can maintain independence and objectivity. They believe that nothing in the long history of the profession's providing non-audit services has indicated otherwise. They believe it is incorrect to suggest that the interests of management must be at variance with those of the audit committee and the shareholders, or that the interests of management must be inimical to good financial reporting. The company and shareholders are the primary beneficiaries of consulting services that "benefit management." Thus, in the absence of compelling evidence of a problem, these members believe that such an extreme measure is unwarranted and could well have a negative effect on audit effectiveness.51
The profession, as it has many times in the last several decades, should be given the chance to implement the Panel's recommendations before the Commission determines to issue final rules on auditor independence. Some of these recommendations include suggestions for improvements in the independence area. Since the Panel's recommendations have only recently become final, the Commission should allow this private sector initiative to build on the very model the Commissionhas established under its new audit committee rules before taking any action on the proposed rule.52
5. Voluntary Restructuring By Accounting Firms
Portions of the accounting profession are undergoing a restructuring. Several major accounting firms have announced, or have begun implementing, plans to voluntarily sell or spin off a significant portion of their consulting capabilities. The effect of this change upon those firms' services and clients has yet to be seen. Nor has adequate time passed for any thoughtful analysis of the relative advantages of divided versus full-service firms.53 Having two models, the divided and the full-service firm, operating at the same time, provides the Commission with an opportunity. Without adversely affecting investor protection, the Commission can study the firms' respective experiences and, based on a real-life experiment, assessthe effectiveness of both models. As the AICPA President and CEO stated in his testimony:
[T]hese market-driven business changes taking place at major firms should cause the Commission to pause and consider. Let's see how all of this shakes out before adding new rules - which will affect the work of hundreds of thousands of professionals, disrupt thousands of clients and could potentially ruin a crown jewel of the American economy-its public accounting profession.54
* * *
There are many recent initiatives underway that bear directly on auditor independence.55 The Commission should provide each of the private sector initiatives, most of which were implemented at the Commission's urging, an opportunity to demonstrate their utility. Importantly, the adverse consequences of adopting the proposed rule at this time would be irreversible. By contrast, allowing further reflection and study will enable the Commission to assess whether rulemaking concerning independence is needed at all, and, if so, what approach to take, in light of the information then available.
C. The Proposed Rule Will Limit The Ability Of Accounting Firms To Adapt To Rapid Technological Changes In The New Economy
The new economy requires that accounting firms be able to adapt to rapid changes in this new, globally integrated and technology-driven world. As the AICPA noted:
The demands on the auditor of tomorrow will also require an increasingly robust knowledge base. Traditional audit skills must be supplemented by technological and business knowledge that includes the multi-disciplinary tools necessary for the identification and assessment of business and audit risk in a fast changing world. In addition, the auditor must remain current on the global economy's adaptive behavior in order to make informed judgments about the recoverability of a client's assets and the viability of its full business operation over the foreseeable future. These same forces are intensifying the demand for professional service firms to provide a range of increasingly sophisticated informational services to their clients. All businesses, both large and small, confront a myriad of information technology problems on a daily basis. The accounting profession may be among the best situated to help businesses address these problems and assure the highest value application of technology and knowledge.56
The performance of a range of non-audit services provides a significant benefit to the audit function in this environment by increasing access to technical, industry and general business skills, and enhancing the overall sophistication of the accountingfirm. Accounting firms must be able to grow and enhance their expertise in order to perform quality assurance services in the future.57
The proposed rule would erect a regulatory roadblock to accounting firms' ability to adapt in the new economy. In the future, auditors will have increasing responsibility for providing assurance on the quality and integrity of financial information in a networked business environment.58 As one commentator stated: "Ironically, at precisely the moment when we need to be developing specialized competencies and new ways to systematically account for emerging sources of valuein a rapidly changing world, this proposal would, if adopted, prevent us from doing just that."59
The Release states that accounting firms need not lose the expertise provided by non-audit functions, and that the effect of the proposed rule will be "merely to redistribute the provision of non-audit services among the public accounting firms" because each firm will be able to provide those services to non-audit clients.60 As discussed in Section III below, however, the adverse consequences of the proposed rule cannot be dismissed so simplistically. Contrary to statements made in the Release, the proposed rule will have profound implications for the profession and clients.
Any radical restructuring resulting from the proposed rule would have severe consequences. It is impractical to require public issuers to turn elsewhere in this marketplace to obtain up-to-the-minute advice on technological and financial matters. For example, public companies are now required to conduct timely SAS 71 quarterly reviews.61 In a situation where an accountant is unable to answer a technical question involving the valuation of a derivative while she is completing a SAS 71 review, and the earnings press release is delayed because the technical questionrequires a specialized competency -- a specialty the auditor would be barred from providing or that was spun off because of the separation of audit from non-audit services. Disclosure would be delayed; investors and the public interest could be harmed. In addition, the proposed rule may impede the real-time response which will be required by companies and their advisers, including both audit and non-audit competencies, in order to comply with new Regulation FD, which goes into effect on October 23, 2000.
It is also becoming more common for issuers to seek advice and consultation from accounting firms on leading edge technological and financial reporting issues (e.g., how can we provide real time access of our inventory information to certain constituencies?). In this dynamic environment, the proposed rule does not provide accounting firms with the flexibility needed to adapt to clients' ever-changing needs. The bifurcation of audit and non-audit services will certainly hinder issuers and accounting firms in adapting to the new economy on a real time, global basis.
D. The Proposed Rule Does Not Address The Issues At Which It Is Directed
The Release is premised on the proposition that radical revisions to auditor independence requirements are needed to maintain investor confidence in thereliability and integrity of issuers' financial statements.62 While we share the Commission's goals of maintaining and enhancing investor confidence in the integrity of issuers' financial statements and in reducing the risk of audit failures, we do not believe the Commission will advance these goals through the proposed rule. As set forth in detail above, there is no evidence to support the position that providing audit and non-audit services to the same public audit client compromises independence, objectivity or integrity. Indeed, even if there were instances of such a compromise of independence, they would be no more than isolated examples. Investor confidence in financial statements is extremely high,63 and the Release does not discuss a pattern or practice of audit failures resulting, or appearing to result, from impaired independence. Thus, the proposed rule will not advance the reliability of financial audits and is unlikely to increase investor confidence.
Recent studies confirm that the proposed rule is unlikely to improve investor confidence. For example, the PSB Survey found that ninety percent of investors surveyed believe that annual financial statements are credible.64 The PSB Survey also found that by a three-to-one margin, investors believe that regulatorsshould not play a bigger role than they do now in regulating what services accounting firms provide.65
The Panel on Audit Effectiveness addressed some of these issues. The Panel's report reaffirmed the lack of any specific link between audit failures and non-audit services.66 The Panel's Quasi-Peer Reviews67 "did not identify any instances in which providing non-audit services had a negative effect on audit effectiveness."68 These conclusions are corroborated by insurance industry informa tion, which shows no correlation between non-audit services provided to audit clients and increased risk of audit failure.69 As the AICPA noted in its 1997 report:
Neither insurance brokers nor insurance companies --entities with particular interest in potential liability issues -- associate increased liability risk with accounting firms that perform non-audit services for audit clients. . . . Data on insurance claims made by the six largest U.S. accounting firms confirm the absence of any increased liability exposure associated with the provision of non-audit services to audit clients.70
Simply put, the causes of audit failures have not been due to, nor are they derived from, the provision of non-audit services to audit clients. Recent studies indicate other possible causes, such as issuers' inadequate internal control environments and weak audit committees.71 The Panel on Audit Effectiveness has proposed enhanced audit procedures and standards which, if adopted, would address certain of these issues.72 The new rules on audit committees are designed to enhancethe effectiveness of audit committees.73 The proposed rule neither addresses nor resolves the issues with which the Commission is concerned.74
III. The Proposed Rule Will Harm The Public Interest
A. The Proposed Rule Will Reduce Investor Confidence
Although we strongly agree with the Commission's goal of promoting investor confidence in our markets, we believe the proposed rule fails to account for a point in the Release: "[i]nvestors are more likely to invest, and pricing is more likely to be efficient, the greater the assurance that the financial information dis closed is reliable."75 In fact, the proposed rule has the potential to make financial statement information less reliable. The proposed rule has the potential to cause a restructuring of our audit system, which has developed in response to marketplace demands to provide the highest quality audits and the retention of the highest quality audit teams and associated professionals. Integrated services are a key part of the current audit system. We believe the proposal to ban the provision of non-audit services to audit clients would have a detrimental impact on the ability of firms to provide audits of the same quality as those being performed today. Ultimately, the risks of this experiment in rulemaking will be borne by the investor.76
1. The Proposed Rule Is An Improper Attempt To Force An Involuntary Restructuring Of The Accounting Profession
The proposed rule would compel accounting firms to consider restructuring their business to comply with the new regime. The Release downplays this issue by repeatedly asserting that the proposed rule only bars accounting firms from providing non-audit services to audit clients and does not extend to services provided to non-audit clients.77 According to the Release, accounting firms will stillbe able to provide consulting and other non-audit services to non-audit clients. Contrary to this supposedly "measured approach,"78 however, the proposed rule represents an improper attempt to cause accounting firms to restructure.
The proposed rule relies on incomplete statistics to assert that "because only about 25% of these firms' SEC audit clients buy non-audit services from their auditors, the proposal will only impose costs with respect to, at most, 25% of these firms' client relationships."79 The Release states that "[t]he fact that many issuers currently purchase non-audit services from firms other than their auditor suggests that there is a competitive market for non-audit services. Therefore, issuers who are precluded by the proposals from purchasing such services from their auditor likely will be able to purchase these services from other vendors."80
Measuring the use of non-audit services by audit clients is not as simple as the Release portrays. It involves a complex business analysis that is not static. We believe that the proposed rule will affect significantly more issuers and accounting firms than anticipated by the Release. Our reasons include the following:
First, the Release's use of the 25% figure is misleading. Not all companies engage consultants, and even those that do engage consultants do not engage consultants every year. Non-audit services include a broad range of services that are not needed by companies every year. Certain non-audit services, such as outsourcing the internal audit function, are utilized every year while others, such as litigation support or distribution system consulting, are sporadic and do not have any type of schedule. Companies may be on a 5-7 year cycle for one non-audit service, such as a new IT system, and may be on a 3-4 year cycle for another service, such as litigation support services. By analogy, if regulations were passed that outlawed the sale of new cars, the new regulation would only affect x% of the population in any one year, because that is the percentage that buys new cars in any single year. Since a very high percentage of people will buy a new car in the next several years, the new regulation will affect almost 100% of the new car buying population within a short period of time. Unlike attest services, where each of approximately 15,000 public companies needs an audit every year, non-audit services are used by a differing population of companies every year. Rather than only 25% of the 15,000 public companies being affected, in reality most public companies will be affected by the proposed rule over several years.
Second, although we do not provide non-audit services to all of our audit clients every year, we rely on non-audit competencies for almost all of ouraudit clients. The integration of services model allows firms, such as ours, to develop the breadth and depth of specialized expertise that assures the highest quality audit for our clients. In today's complex market, the ready availability of these professionals is a necessity. Yet, the proposed rule will adversely affect our ability to utilize these professionals and, thereby, affect the quality of audits. While we provide non-audit services to a minority of our audit clients in any one year, we use these non-audit competencies to help us do a quality audit on almost all of our audit clients each year.
Third, we believe that the proposed rule would decrease competition in the market for audit and non-audit services because there will be fewer service providers bidding on the work. The Release asserts incorrectly that "the overall impact of the proposed restrictions may be merely to redistribute certain non-audit services among public accounting firms."81 Under the proposed rule, the auditing side of a firm will only be able to compete for the fraction of the market in which the non-auditing side of the firm is not involved. Thus, the proposed rule would bar at least one firm from bidding on a given non-audit service (i.e., the firm that provides audit services), making the bidding process less competitive. To the extent that another accounting firm is attempting to provide audit services to that particularcompany or an affiliate of that company (and, thus, would be barred from performing non-audit services for that company), an additional firm would be removed from the bidding process. In addition, firms may forgo bidding for the provision of audit services to a prospective client where they have an opportunity to provide significant non-audit services to that client. Ultimately, this would result in far less competition in the bidding for audit and non-audit services, thereby placing firms that choose to split off a portion of their non-audit competencies at a competitive advantage to those firms that choose to stay together. This effect will pressure firms to consider splitting off portions of their non-audit competencies in order for the split-off practice to remain competitive in the marketplace. Conversely, audit choices may also be limited as firms that provide non-audit services to a company may elect not to bid on an audit opportunity because of a desire to retain the non-audit work, leaving the company with a less than acceptable level of choice for their audit firm.
Fourth, the proposed rule would limit the ability of companies to choose the firm they want to provide non-audit services, which would have an adverse public impact. For example, when our audit clients retain us to perform non-audit services for a particular project, they do so because they believe we are the firm best suited to handle that project. In other words, issuers do not select firms to perform non-audit services out of convenience (i.e., merely because such firms already audit the issuers' financial statements), or because of a belief that non-auditservices are fungible. Rather, they consider, on a project-by-project basis, which firm is best for the job.82 The Release incorrectly presumes that all other firms are as qualified and can do as good a job on any given project. Not only does the Release not provide any support for this position, we submit that it is not the case. The proposed rule would in many cases prevent issuers from retaining the firm they believe is most capable of handling a given project, and would force issuers to settle for a second or third choice, or simply perform certain functions in-house, without the benefit of outside expertise.83 Examples of such "adverse selection" include the following:
In each case, an issuer would not receive the services of the best available accounting firm for its audit as a result of the proposed rule.84
Fifth, even assuming that the 25% figure is correct for non-audit services provided by accounting firms for audit clients, the percentage is significantly understated if the definitions of "affiliate of the audit client" and "affiliate of the accounting firm," were adopted, given the broad reach of these definitions when applied together.85
Sixth, the Release improperly relies on the fact that two of the Big Five accounting firms already have split off portions of their consulting practices.86 The ongoing business decisions by some accounting firms to restructure is not a reason to adopt rulemaking that can result in all other accounting firms involuntarily doing so. Quite the contrary, it is too early to know whether, and to what degree, the loss of certain non-audit functions of those firms will harm the quality and/or efficiency of audits.87
2. Non-Audit Competencies Actually Improve Audit Quality and Are Essential to Completing An Audit
Audits in today's complex and increasingly international marketplace require a level of expertise and sophistication unimaginable when the Securities Act was enacted 67 years ago. Today's audits are extremely complex and require carefulanalysis of large amounts of specialized information in short periods of time. To effectively manage these complexities, many accounting firms rely on a wide array of audit and non-audit resources in conducting audits. Non-audit competencies are needed to produce a quality audit for corporations with complex financial structures. As the Panel on Audit Effectiveness recognized:
Today, effective audits depend more than ever on specialists. For example, specialists used in audits include:
Non-audit competencies often are necessary to complete an audit. Indeed, the higher the risk that the audit poses for the accounting firm, the higher the likelihood that non-audit competencies will be necessary to complete the audit. Inour practice, there are numerous examples of how these multi-disciplined audit teams promote reliability. As examples, non-audit competencies are required to: (1) assess going concern determinations that are dependent on executing complex design, engineering, manufacturing, and assembly business plans; (2) test the reliability of ERP system controls89 in a web-enabled, multi-national, 365x24 manufacturer; (3) understand the substance of multi-level changes to the benefit structure in a complex retirement plan; (4) understand complex financial instruments, such as derivatives; and (5) understand and discuss with client advisors complex and ever-evolving tax and business structures of M&A transactions and the accounting implications thereof. As the Panel on Audit Effectiveness Report noted:
[A] company may seek the assistance of its auditors to correct control weaknesses identified during the audit. The public interest is served by the controls (and the company's financial reporting process) having been strengthened through the auditors' knowledge of the company and its operations, and audit effectiveness is enhanced through the auditors' increased understanding of the client's systems. Similarly, a pre-acquisition review of a potential target company by the acquirer's auditors provides timely identification of accounting and operations issues to the acquirer, facilitates the combining of two previously unrelated accounting and financial reporting systems, and enables the auditors toplan a more effective audit of the newly-combined enterprise.90
These non-audit services provide a greater understanding of the client's business operation and transactions, allowing audit risks to be identified more effectively and the requisite audit procedures to be performed using these specialists. Without the ready access to the depth of knowledge and expertise that comes from those who provide non-auditing services, the audit itself could be compromised.
Studies consistently confirm this position. The PSB Survey reported that investors believe that prohibiting consulting services to audit clients will make the accounting firms less knowledgeable about the companies they audit and consequently, the quality of the audits may suffer.91 As early as 1978, the Cohen Commission noted that:
An audit requires considerable knowledge about a company, its operations and its industry. Providing management advisory services for an audit client may increase the auditor's understanding and knowledge and prove advantageous in conducting the audit.92
Twenty-one years ago, the Commission recognized the benefits of certain non-audit services performed by independent accountants, finding that
[t]he broader base of knowledge about, and a greater understanding of, the [client's] business, which often results from the performance of non-audit services may improve the efficiency and the thoroughness of the audit. This broader perspective on the audit is healthy and desirable.93
The Release itself recognizes that "the provision of non-audit services may enhance an auditor's expertise and thereby improve the efficiency or effectiveness of the audit."94
It is short-sighted and dangerous for the Commission to cause accounting firms to narrow their fields of expertise at the very time when broad-based skills and competencies are critical to effectively complete audits in a rapidly changing economy. As the AICPA stated, "[d]ramatic changes in the world economy, in combination with astonishing breakthroughs in information technology, are redefining the audit function, placing new demands on auditors and permanently altering the relationships between accounting firms and their clients."95 Accounting firms should be moving forward to meet the challenges of the 21st century, rather than going backward to a bygone era.
3. The Proposed Rule Will Adversely Impact Accounting Firms' Ability To Recruit And Retain The Highest Quality Personnel
If the proposed rule is adopted and accounting firms restructure by breaking off from their non-audit services, there is a grave and legitimate concern that accounting firms would be unable to recruit and retain highly skilled and motivated professionals who are able to deal effectively with complex business and financial issues.96 As the Release states, "[a] complete prohibition on accounting firms' providing any non-audit services could impose other, different costs on public accounting firms, such as depriving accounting firms of expertise they could have obtained from consulting activities that can be employed in audit engagements, preventing 'synergies' from a better understanding of the client, and harming accounting firms' ability to recruit and retain employees."97 We believe these results are equally likely under the proposed rule.
In today's economy, sophisticated professionals have a wide range of career options available. Accounting firms have worked hard to remain competitive in this environment, and have struggled to attract and retain highly qualified individ uals, by offering a diverse practice within multi-line professional firms.98 Recruiting and retaining the best talent available is essential to maintaining the high level of audit quality provided today. As described more fully above, the proposed rule could lead many firms to split off portions of their non-audit practices. By essentially limiting the practice of accounting firms primarily to audit work, the proposed rule would adversely affect recruiting and thereby potentially harm the quality of audits.
The proposed rule would likely force accounting firms to gain certain expertise by relying on outside providers. Such reliance will subject investors and audit clients to inconsistency, less effective work, increased costs, greater likelihood of breaches of client confidentiality and less assurance of independence. Moreover, it would lead to uncertainties. For example, are the outside providers subject to the same restrictions as the auditor? If so, at what times? Only when a project ison-going, or when the provider is aware of the possibility of a project? Ultimately, the loss of important non-audit resources by accounting firms will have a detrimental impact on investor confidence in the system.99
B. The Proposed Rule Would Adversely Affect United States Capital Markets In The Global Economy
The proposed rule would have substantial negative global implications, the most significant of which is that it would undermine the Commission'sstated policy of facilitating cross-border capital flows. By creating a standard for the "appearance" of independence that fails to recognize legitimate cross-cultural perceptions and traditions of auditor independence, and which in many cases would directly conflict with accounting firms' statutory obligations in other countries, the proposed rule would significantly increase the barriers to cross-border capital formation. In this era of increased emphasis on reducing trade barriers, the proposed rule would have the opposite effect -- undermining global efforts to harmonize accounting and financial reporting standards.
From the Release, it appears that the Staff has not considered in any meaningful way the proposed rule's effect on cross-border capital flows. Nor does the Release appear to reflect consultations by the Commission with its regulatory colleagues in other nations, including those within the International Organization of Securities Commissions ("IOSCO"), on the consequences to issuers or accounting firms in other nations if compelled to adhere to the proposed rule in order to comply with U.S. regulations. This approach contradicts the Commission's previously stated position that it would work to harmonize, not fragment, policies that might adversely affect cross-border capital flow.100
1. The Proposed Rule Fails to Recognize the Differences in Perception of Auditor Independence.
The proposed rule would require an auditor to be independent in fact and in appearance. However, as has been widely recognized and discussed,101 the appearance of auditor independence varies from country to country. An activity that may appear to impair an auditor's independence or present an issue in one country may be perfectly acceptable, or required, in another country. Consequently, applying rules that are designed for one legal and cultural environment to a different legal and cultural environment can cause unintended results.
The appearance of independence is dependent on many factors, including a country's culture, economic environment, business traditions, regulatory structure and legal environment. The Commission has acknowledged that theperception of independence is dependent on these factors. In its 1994 report on auditor independence, the Commission stated:
One of the more controversial issues facing the Commission today is the extent that the Commission, when making independence determinations, should take into account the customs, laws, and culture of the nation in which the audit is conducted.102
One example of differences in perception relates to the notion of "advocacy". The proposed rule would prohibit an auditor from acting as an "advocate" for its audit client. Depending on the culture, business traditions and regulatory and legal environments, the term "advocacy" may be perceived very differently. In many European countries, auditors perform services that may be viewed as "advocacy" under the proposed rule.103 In addition, the professional guidance in the United Kingdom distinguishes between "advocacy" in a general sense and "advocacy" in the context of supporting a client in an adversarial sense. It is this latter type of "advo cacy" that may lead to an "appearance" issue in the U.K. context. The U.K. legal environment is such that when certain expert services are performed, for example, representing a client before a court or similar body, the expert has an overriding obligation to the court, administrative body or other authority, not the client. It follows then, that in such circumstances the expert is neither acting as an advocate for his client nor appearing to act as one, at least from the U.K. perspective. Therefore, without a common understanding of what is meant by "advocacy", the rule becomes unworkable, particularly in a global environment.
Another example where differences in perception exist relates to valuation services. In many countries, administrative bodies or other authorities often look to the accounting firm to perform certain valuation services. For example, under U.K. corporate law, an accounting firm is permitted to perform both statutory valuations and legal valuations.104 These valuations may arise in the context of a merger transaction involving a share exchange or a share repurchase. In these situations, U.K. corporate law, as well as the European Council Directives,105require that an expert be engaged to issue a report on the value of the shares exchanged or issued. The expert is either appointed or approved by a court, administrative body or other authority. The business tradition in the U.K. is such that the accounting firm is in the most suitable position to perform these services. Indeed, the presumption is that it is in the public interest in the U.K. that the accounting firm perform such work.
It appears that the Commission has not given any recognition to the above factors in developing its proposal. Instead, the proposed rule seems to be premised on the erroneous notion that the "appearance of independence" is the same throughout the world, a universal truth that the Commission can impose on the rest of the world. Given the global nature of today's accounting firms and the markets in which they operate, any approach adopted by the Commission must be workable in international environment. Such an approach should be less influenced by circumstances in any one environment, yet provide the flexibility to be workable in multiple environments, as well as to be able to respond to the rapidly changing global economy.
In addition, the proposed rule does not adequately recognize that there may be factors that mitigate the perception that an auditor may not be independent ofits client. These factors include an obligation to operate under a professional code of ethics and an organizational structure that provides safeguards against an auditor being influenced. The assessment of whether an auditor is perceived to be independent should be based on all the relevant facts and circumstances and not on the vagaries of perception, which vary from country to country. This approach is consistent with independence rules in other countries as well as the recent proposal by the International Federation of Accountants ("IFAC").106 For example, the IFAC definition of independence incorporates the notion of mitigating factors when assessing appearance of independence. IFAC defines the independence of a reporting accountant as:
(a) the state of mind that permits the provision of an opinion without being affected by influences that impair professional judgment (sometimes referred to as independence of mind), and
(b) the ability to demonstrate that risks to independence of mind have been eliminated or limited to such clearly insignificant matters that an informed third party would not reasonably question the reporting accountant's objectivity (sometimes referred to as independence of appearance).107
By its own terms, the touchstone of the Commission's proposal is to provide a high level of assurance to investors that audited financial statements fully and fairly reflect companies' financial positions.108 However, as the Federation des Experts Comptables Europeens ("FEE") has noted:
FEE also considers that the role of the statutory auditor is substantially equivalent from one Member State to another within the European Union. Equivalence does not mean that the role is the same. Rather it means that there is enough common ground for statutory audits to give comparable levels of assurance.109
If, as the FEE recognizes, auditors operating under substantially different statutory schemes can provide common levels of assurance, then the Commission likewise should recognize that it is acceptable to have varying perceptions of appearance of independence, so long as actual independence is not compromised.
2. The Proposed Rule Will Conflict with Accounting Firms' Statutory Obligations in Other Countries
The proposed rule would create direct conflicts with auditors' statutory obligations in certain countries.110 Where such conflicts exist, it would beimpossible for an auditor to fulfill his or her statutory obligations under his or her home country law and at the same time be considered independent under the proposed rule.
This would impact situations involving a domestic U.S. issuer with a foreign subsidiary and a foreign issuer who either is registered or listed in the U.S. or is contemplating being so. In the former situation, the accounting firm may receive assistance from its foreign practice111 in the audit of the foreign subsidiary. In addition, the foreign subsidiary may be subject to statutory reporting requirements. Under the proposed rule, neither the accounting firm nor its foreign practice would be able to provide the prohibited non-audit services to the foreign subsidiary. Consequently, in cases where national law requires such services to be performed by the statutory auditor (i.e., the accounting firm or its foreign practice), the accounting firm would not be independent in the context of the audit of the domestic U.S. issuer. As a result, the financial statements of the domestic U.S. issuer would not be in compliance with Commission regulations.
In the case of the foreign issuer, the foreign issuer will likely be subject to statutory reporting requirements. In this situation, the foreign issuer may be audited by either a foreign audit firm or an accounting firm with a foreign practice. Again, under the proposed rule, the accounting firm, whether a foreign audit firm or an accounting firm with a foreign practice, would not be able to provide the prohibited non-audit services to the foreign issuer. Consequently, in cases where national law requires such services to be performed by the statutory auditor (i.e., the foreign audit firm or the accounting firm or its foreign practice), that auditor would not be independent in the context of the audit of the financial statements of the foreign issuer that would be filed in the United States. As a result, the financial statements would not be in compliance with Commission regulations.
Each of these situations would have tremendous implications for the accounting firm, but even more so for the issuer and the public both in the U.S. andin foreign countries. Presumably, the accounting firm would be subject to sanction or liability in its home country if it did not fulfill its obligations under its national law. At the same time, the issuer would not be able to file audited financial statements in the United States because the auditor would not be considered independent. Consequently, the issuer would be required to have a separate audit by another firm. This would subject the issuer, at a minimum, to the time, effort and expense of retaining another firm to conduct an audit for U.S. filing purposes. In addition, any new auditor retained for a "U.S. audit" would most likely not be nearly as familiar with the company, including its systems and controls, as the statutory auditor. Thus, the investing public would potentially be deprived of an audit of the highest possible quality. In the case of a foreign issuer, this would likely result in either a significant and potentially costly delay in completing a filing in the U.S. or a decision to forgo raising capital in the U.S. marketplace, thereby potentially inhibiting investment opportunities and the flow of capital across borders.112
3. The Proposed Rule Directly Conflicts With Global Efforts To Harmonize Independence Rules
As noted above, the Commission has long supported efforts to harmonize accounting and financial reporting standards, including independencestandards. Indeed, in 1988, the Commission indicated in its policy statement on the regulation of international securities markets that "[t]he ultimate goal should be the development of an integrated international disclosure system."113 Since this statement, the Commission has continued its efforts to reduce the barriers to cross-border capital flows. For example, in its proposing release adopting the IOSCO International Disclosure Standards, the Commission noted:
It is becoming more common for companies to increase their global presence and lower their cost of capital by listing on foreign securities markets and raising capital outside their home country. When companies offer or list their securities outside their home market, however, they often face a variety of different, and sometimes conflicting, regulatory systems. The Commission has recognized this problem, and many of our initiatives for foreign issuers have had the goal of reducing barriers to cross-border offerings and listings in the United States.114
This policy was confirmed in February 2000, when the Commission published its concept release, International Accounting Standards, in which it stated:
We recognize that different listings and reporting requirements may increase the cost of accessing multiple capital markets and create inefficiencies in cross-border capital flows. Therefore, we are working withother securities regulators around the world to reduce these differences.115
In contrast with decades of Commission policy, the Release does not appear to reflect any consultation with, much less harmonization with, the work of other securities regulators or international professional associations. For example, the proposed rule takes a completely divergent approach from independence rules in other countries, including the recent IFAC Proposal. The IFAC Proposal, which is consistent with the independence rules in many other countries,116 is based on a framework which sets out general ethical principles, a reasoned analysis of the possible threats to those principles and linked guidance on the safeguards which may be necessary to mitigate those threats. Under this approach, the onus is placed on the auditor to actively consider independence issues and demonstrate that a reasonable and supportable conclusion has been reached. Because this approach is based on an underlying framework, it allows for flexibility in circumstances that may not be contemplated and can be adapted to the ever-changing business and audit environments. Besides the differences in the general approach to independence, there areother differences between the Release and the IFAC Proposal. These differences range from terminology and definitions117 to the scope of the rules.118
Given the global nature in which accounting firms and their clients operate and the globalization of the capital markets, including the significant increase in cross-border activity over the last few years, the global implications of the proposed rule should be evaluated before any action is taken. Given decades of Commission policy, there is no reason why the harmonization of independence standards is not possible. And it is clear that such harmonization, rather than a patchwork of conflicting independence standards, would better serve the investing public. By rejecting its previously stated policy of working towards common ground and harmonization with other nations, the Commission, through the proposed rule, will increase the cost of capital, create inefficiencies in capital formation, and reduceinvestors' investment alternatives. None of this promotes investor confidence or is in the public interest.
IV. The Proposed Rule Is Substantively Flawed
As discussed above, we believe that the proposed rule is ill-conceived and contrary to the public interest. Due to the fundamentally flawed premise of the proposed rule, we urge the Commission to reject the rule as proposed. Our concerns with the proposed rule are as follows.
First, while intended to create "the basic test of an auditor's independence," the proposed rule lacks a definition of "independence." Perhaps more significantly, the four "principles" and ten prohibited "non-audit services," set forth in the proposed rule are vague, overbroad and often conflicting.
Our concerns with the proposed rule are exacerbated by the expansive definition of "affiliate" proposed in the Release. By including affiliates that may have only a nominal or insignificant relationship with the firm, the prohibitions of the proposed rule and its negative consequences are greatly expanded. Similarly, entities will be deemed affiliates of audit clients in cases where those entities have only a minimal relationship with the audit clients, thereby vastly and unnecessarily expanding the universe of businesses which will be adversely affected by the prohibitions of the proposed rule.
In addition to these structural deficiencies, we believe the proposed rule is fundamentally inconsistent with recent regulatory steps taken by the Commission and others in this area.119 Rather than relying upon a "risk-based" model for determining independence, the proposed rule uses a "prohibition-based" model, which is out of step with current standards as well as efforts being made by the ISB in the standards it has issued thus far (and in the ISB's Conceptual Framework project which is underway), as well as other global auditor independence initiatives by IFAC and by the European Commission. For example, we note in particular that for each of the ten proscribed services, the proposed rule indicates that such services would impair an accountant's independence "even if the client accepts ultimate responsibility for the work that is performed or decisions that are made."120 By contrast, under current and international rules, the assumption of responsibility for management judgments, by knowledgeable client personnel, provides an appropriate structure and safeguards such that auditor independence is not impaired by the performance of non-audit services. Section 101-3 of the AICPA's Code of Professional Conduct states that before performing non-audit services for an audit client:
the member should be satisfied that the client is in a position to have an informed judgment on the results of the other services and that the client understands its responsibility to-
- Designate a management-level individual or individuals to be responsible for overseeing the services being provided.
- . Evaluate the adequacy of the services performed and any findings that result.
- Make management decisions, including accepting responsibility for the results of the other services.
- Establish and maintain internal controls, including monitoring ongoing activities.121
We believe that these safeguards are and have been effective. Non-audit services (such as financial information systems design and implementation, internal audit outsourcing and certain other non-audit services the proposed rule would proscribe) do not impair independence if knowledgeable management accept responsibility for management decisions and the accountant does not assume management responsibilities.
Our concerns with the provisions of the proposed rule are set forth below.
A. The Four Principles Are Unworkable
The Release proposes four "governing principles for determining when an auditor is not independent."122 These "principles" individually and in the aggregate are too vague and overbroad to serve as rules.123 Our concerns are illustrated by the list of ten prohibited services that apparently violate one or more of the four principles.124
1. Having A "Mutual Or Conflicting Interest With The Audit Client"
The first principle states the accounting firm may not have a "mutual or conflicting interest with the audit client."125 This principle is too broad to serve as a predicate for a rule, or even to provide conceptual guidance to interpret a rule. If this principle were adopted, the future of management letters (in which auditors make observations and provide recommendations to their clients concerning internal controls and other matters) would be in doubt since they could be viewed as creating both a conflicting and a mutual interest with the client.
Auditors and clients will always have certain mutual interests that have no impact on issues of independence. For example, the auditor and its client will always have a mutual interest in ferreting out fraud and producing and reporting accurate financial information.126 Moreover, mutuality of interests occurs in numerous external areas, including legislative activities, industry associations, civic organizations and politics, without having any bearing whatsoever on auditor independence.127
This first principle also bars an auditor from having a conflicting interest with a client, yet provides no guidance or context for the meaning of conflict. An independent outside auditor will always maintain a healthy skepticism that will inevitably lead to conflict on occasion. This principle is so broad, it is unclear if there would be a conflict in the following three situations: (1) if an issuer's interest is in meeting analysts' earnings estimates for the quarter, but the accounting firm questions or criticizes senior management for the accounting on a certain item which, if represented the way the auditor suggests, would cause the issuer to miss estimates; or (2) if an auditor's primary interest is in conducting a reliable audit but the client's goal is to have a trouble-free and inexpensive audit; or (3) if the auditor raises its audit fee for a client for whom it already conducts audits, but the client wants the fee lowered. None of these situations raises independence issues. The broad assertion, therefore, that an auditor and his or her client cannot have a mutual or conflicting interest without raising independence concerns is incorrect, overbroad, and unworkable.
2. Auditing "The Accountant's Own Work"
The second principle states that the accounting firm may not audit its own work.128 As a general matter, we agree that auditing one's own work can create an independence problem. However, because of the extensive area that this principle potentially covers, it too provides no guidance and appears to prohibit activities which are fundamental to completing reliable audits.
For example, issuers routinely record adjusting journal entries or adjust financial information in response to audit procedures and review by the auditors. Thereafter, auditors must sign off on the revised information -- action that may be interpreted as the auditor "auditing its own work." In practice, this is reconciled by "management taking responsibility" for such adjustments. Such a routine function may be interpreted as impairing independence under the proposed rule. But, given the Commission's apparent unwillingness to embrace this concept in the prohibited services area, we presume this would be the result under the proposed rule. Furthermore, in many instances, auditors are the professionals most skilled to draft language, or assist in gathering data, for certain disclosures or to recommend certain accounting practices or principles. Companies and their investors who relyon financial statements benefit, and independence is promoted, when auditors use their skills to assist in these ways as part of the audit.
The proposed rule would call into question procedures that are known to the Staff and accepted by the profession and business community. These procedures have been used without question for decades, enhance the quality of audits, which improves financial reporting to investors, and do not impair auditor independence. Additionally, as increasingly complex standards are issued by standard-setters, or interpreted by regulators (e.g., Statement of Financial Accounting Standards No. 133) the auditors are typically the source for education and advice. Assuming a client follows advice from its auditors on the appropriate application of new standards, does the audit firm effectively audit its own work when it tests the client's application of a new accounting standard?
3. Functioning "As Management Or An Employee Of The Audit Client"
The third principle states that the accounting firm may not function as management or an employee of the audit client.129 The term "function" in this principle provides no guidance to accountants. For example, auditors routinely conduct administrative tasks during an audit which are indistinguishable from tasks conducted by employees of the client. It is unclear whether an auditor who performssuch tasks would be treated as "[functioning as] an employee of the audit client." While no one would dispute that an auditor should not have managerial roles in audit clients, the rule creates uncertainty by stating that "[e]ven if the audit client accepts ultimate responsibility for the work that is performed or decisions that are made, an accountant is not independent under the standard of paragraph (b)."130 Thus, even if an auditor's advice or recommendation is embraced by management -- and the audit client accepts ultimate responsibility for the results -- it appears that the auditor could be deemed to have violated the proposed rule.
4. Acting "As An Advocate For The Audit Client"
The fourth principle prohibits an accounting firm from acting as an advocate of the client. Audit firms, however, routinely advocate tax and other issues for their clients. As Ray J. Groves, former Chairman of Ernst & Young, testified:
Throughout my 40-year career, and for many years before that, it has been accepted practice for auditors to be advocates for their clients in tax matters. The AICPA Code of Professional Conduct and its predecessors have long acknowledged tax advocacy. A professional cannot provide tax services without being an advocate, nor would a company want to engage a professional to perform tax services who could not act in this capacity . . . . As an independent director of SEC registrants, I believe the registrant and its shareholders are well served by auditor involvement in tax matters. But if the auditor could not act as an advocatein tax matters, my assurance level would be substantially diminished.131
Although the Release states that the proposed rule "would not affect tax-related services provided by auditors to their audit clients," there is nothing in the text of the proposed rule which exempts tax-related services.132
Furthermore, auditors perform numerous non-tax advocacy functions that are important and valuable to issuers and investors. For example, auditors may advocate the propriety of the issuer's audited financial statements if they are called into question; an auditor may advocate legislation which is consistent with the interest of a client; and an auditor may advocate a certain accounting practice consistent with the interest of a client before the Staff.133 Nothing about these activities calls an auditor's independence into question. Since investors rely on the very services auditors provide, a blanket ban on advocacy is unnecessary and unworkable.
* * *
These four "principles," while fruitful areas for doctrinal debate, are inappropriate as rules. They are so expansive and subject to such varying interpreta tions that they will create quagmires for auditors and audit committees. Moreover, they will circumscribe auditor functions that not only do not impair independence, but in many situations promote independence and are in the public interest. Thus, the principles should not be adopted. Instead, we urge the Commission to allow the ISB to complete the work it has already undertaken in its Conceptual Framework Project.
B. The Affiliate Definitions Are Overbroad
The impact of the proposed rule's broad regulatory bans regarding specific non-audit services is compounded by the proposal's expanded definitions of "affiliate." Under the proposal, an accountant will be deemed to lack independence if the accountant (which as defined includes the accounting firm, or an affiliate thereof) provides one of the prohibited non-audit services to an audit client or any affiliate thereof. While we have included a more complete discussion of the proposed definitions of "affiliate" in our comment letter on the proposal relating to financial interests and employment relationships, the following summarizes our concerns with the definitions as they relate to the scope of services proposals.
"Affiliate of the accounting firm" is defined so broadly that it extends well beyond entities over which the accounting firm has control or "significant influence," and thus, is simply unnecessary and unworkable. The definition would include a host of individuals and entities, such as any joint venture, partnership, oralliance or other undertaking in which the accounting firm participates in any form of shared benefits.
In addition, the definition of affiliate of the accounting firm does not take into account consideration structural and other safeguards within an accounting firm that are designed and implemented to separate its audit and non-audit businesses into separate autonomous units. Such a separation can be an effective "firewall" between the units. Indeed, the Staff evaluated the relationship between Arthur Andersen & Co. and Andersen Consulting in its 1990 no-action letter.134 For ten years, Andersen Consulting has not been constrained by all of the independence requirements that would have been applicable if they were considered part of and the same as Arthur Andersen. The factors evaluated by the Staff in 1990 may serve as a useful starting point in a current analysis of the elements of an effective firewall. Characteristics of an effective structure, or firewall, include: the inability of one unit to control the other; separate management and corporate governance for each of the units; and limitations on the sharing of profits or revenues between the units. We firmly believe that the policies and procedures of an effective firewall act as a safeguard. Any attempt to define an "affiliate of the accounting firm" should includeexclusions for situations in which policies and procedures for an appropriate firewall have been established and is in operation.
The following hypothetical situations illustrate the sweeping nature of the proposed definition of an "affiliate of the accounting firm":
A reasonable person would not conclude that any of these examples pose an independence issue. Nonetheless, the proposed rule would deem independence impaired in each. The scope of the definition of an "affiliate of the accounting firm" is so broad as to make it unworkable and a draconian limitation on the investing and business relationships of an accounting firm.
The proposed definition of "affiliate of an audit client" also is overbroad: it is more expansive than existing guidance and it fails to consider the significance of the relationship. The definition would encompass any entity that has "significant influence" over the audit client, or over which the audit client has "significant influence." "Significant influence" is in turn defined to include representation on the board of directors, material inter-company transactions or interchange of personnel.
In addition, there is no reason why certain non-audit services would be proscribed for upstream affiliates of an attest client. For example, if X were a 25% shareholder in A, an attest client of the accounting firm, how would a financial information systems implementation project at X affect the audit of A? For each of the proscribed services a similar analogy can be made; the Release does not state thebasis for the position that non-audit services provided to such affiliates would impair an auditor's independence.
Each of the proposed definitions, "affiliate of the accounting firm" and "affiliate of an audit client," is individually overbroad. But the proposed rule envisions the two definitions applying together to determine whether independence is impaired. Together, the proposed definitions synergistically expand the scope of persons and entities that would become subject to regulation. For example, a travel agent could have a business relationship with an accounting firm and also with a joint venture partner of an audit client. This could cause the travel agent to be subject to the independence rules, could be deemed to impair the auditor's independence, and could put the audit client at risk of having to reaudit its financial statements. This cannot be an intended result of the proposed rule.
C. The List Of Prohibited Non-Audit Services Is Overbroad And Unworkable
Although the Release states that most of the ten prohibited services are already prohibited, this is not the case. The existing codification of the Commission's views and interpretations relating to financial reporting are contained in the Financial Reporting Releases, Section 600, as well as the Code of Professional Conduct adopted by the AICPA, which contain guidance on the types of non-audit services that impair an auditors' independence. The proposed rule significantlyexpands the scope, nature and extent of prohibited services. The proposed prohibitions use language that is far-reaching and unclear and would proscribe non-audit services that are and have been accepted in practice for years and which enhance financial reporting. We believe that even if one accepts the perception-based premises set out in the Release, the proposed rule would prohibit far more services than necessary to achieve the Commission's stated objectives, would lead to confusion and would be incapable of application or predictability. We believe any changes in this area should emanate from the results of the ISB's conceptual framework project.
1. Bookkeeping Services
For decades, auditors have assisted clients in generating complex information regarding income taxes, pensions, leases and other similarly detailed financial statement disclosures that do not rise to the level of "keeping the books." These services have been widely recognized as permissible under existing independence standards.135 The SEC's rules have permitted auditors, in limited circumstances, to provide bookkeeping services to foreign subsidiaries in situations where it is impractical for the registrant to make other arrangements. Such services have longbeen provided in situations where through necessity or emergency the client may have no other practical choice but to use the auditor. Yet, this harmless and long-standing practice would be prohibited under the proposed rule.
The proposed rule expands the scope of existing bookkeeping restrictions to include "generating financial information to be disclosed by the audit client to the public."136 This unclear wording restricts activities currently permitted under existing law and practice.
The proposed rule also prohibits "other services" relating to an audit client's accounting records or financial statements.137 This prohibition creates another broad and unworkable standard. For example, the external auditor works closely with the issuer to compile footnotes to the financial statements. Also, the auditor often makes proposed adjustments to the financial statements where the client accepts ultimate responsibility for the financial statements. All of these activities are accepted by the client. The proposed rule provides no guidance on the outer limits of the services the term "other services related to the . . . financial statements" would prohibit.138
Moreover, the blanket prohibition on other services is likely to lead to many adverse consequences for a client. For example, assume an audit client has a foreign subsidiary with a December 31 fiscal year-end. The subsidiary is trying to close its books in the early part of January. On January 15, the subsidiary's CFO becomes incapacitated due to illness. Under the proposed rule, the accounting firm would not be able to help the subsidiary close its books and records for the year, despite the emergency circumstances and regardless of the materiality of the subsidiary in question.
2. Financial Information Systems Design And Implementation
Current standards allow firms to provide financial information systems design and implementation services, as long as the client makes all management decisions regarding the project.139 The proposed rule contains a regulatory ban, which is totally inconsistent with existing SEC and AICPA guidelines and would have significant adverse ramifications for clients in need of cost-effective assistance with new systems. Audit firms have provided such services to audit clients for decades.
A company's independent auditors often are best suited to help design and implement financial information systems or improvements to existing systems. They are often more knowledgeable about a company's financial systems, internal controls and business operations than anyone else both from the standpoint of experience with a number of companies in the industry as well as with the audit client in particular. This experience yields state of the art knowledge about the client, its systems and its needs, that is more efficiently transferred to other individuals within the same accounting firm, than to third parties with no previous exposure to the companies' business. Thus, allowing independent auditors to perform these services benefits the clients and their shareholders.
As a practical matter, the Commission's attempt to separate a company's (1) financial accounting systems, from its (2) internal accounting controls, and (3) risk management controls, may not be feasible with leading-edge systems and applications. The Release seems to assume that these three functions are separable and operate independent of one another. However, it is not uncommon for a company to have fully integrated computer systems in which all three of these functions are closely related. Accordingly, by prohibiting firms from designing or implementing financial accounting systems, the proposed rule could effectively prohibit firms from designing or implementing internal accounting controls and risk management controls for many companies. This would result in other firms designing and implementing systems for all three areas even though many such firms may lack the expertise in financial accounting, internal accounting controls and risk managementcontrols areas. This result would be detrimental to companies and their shareholders as well as other investors who rely at least indirectly on the integrity of these functions.
As discussed in more detail above, the prohibition on financial information systems design and implementation may cause accounting firms to consider giving up, or otherwise losing, their competencies in these areas, which could have an adverse effect on the quality of audits. For example, it appears that the proposed rule would prohibit an accounting firm from providing tax software to a client to assist management in their analysis of tax provisions.
The proposed rule could also result in more accounting failures as auditors, who have knowledge of a company's financial information systems, would be prevented from assisting a client in fixing unexpected system problems. The inability of a company to obtain immediate assistance in these situations could impair the ability of a company to timely report financial information or result in a limitation on the scope of the external audit. In addition, if management is aware that the Company's external auditor is precluded from assisting the Company in repairing system problems, management would be less likely to discuss system problems with its auditor, which could diminish the effectiveness of the audit.
The proposed rule also fails to contemplate financial systems used by multiple entities, such as outsourced payroll processing, use of an ASP, or othercommon systems, which are being utilized by more companies in today's technology environment. In such circumstances, the proposed rule could prevent the auditor of all companies, which will use the common system, from assisting in the system design or implementation. We do not believe that such a ban would further the interests of investors.
Prohibiting these services is imprudent for an even more fundamental reason. Financial frauds do not result from systems design and implementation problems, but typically result from system over-rides committed by one or more malfeasant employees. Accordingly, prohibiting independent auditors from designing and implementing financial information systems is not likely to reduce the incidence of undetected frauds, or have any beneficial impact on independence. It is actually better from the standpoint of investor protection to have accounting firms knowledgeable about the client's business involved in designing financial accounting systems. Such firms are in a better position to design an effective system and are more likely, in the course of an audit, to discover instances of system overrides or "parallel" systems because of the knowledge gained while helping to build and maintain the system.
3. Appraisal Or Valuation Services
The proposed rule would prohibit any appraisal or valuation service for an audit client (or affiliate of the audit client) where it is "reasonably likely that. . . the results will be audited by the accountant."140 This prohibition is far broader than the current rule.141
As proposed, there is no exception for valuations or appraisals involving amounts or matters which do not affect the issuer's financial statements (either because such valuations or appraisals do not become part of the issuer's books and records or are insignificant to the issuer's financial statements). The proposed rule also does not contain exceptions for purchase price allocations or valuation work done for non-financial (e.g., tax or benefit plan) purposes.142
The Release does not provide a rationale for this outright ban on all valuation and appraisal services -- services which in some forms have historically been provided by accounting firms to their audit clients. As with other aspects of the broadly drawn prohibitions of the proposed rule, the nature and significance of the services being prohibited are simply not taken into account. Valuations or appraisals should not be prohibited where the assets or liabilities under consideration are insignificant or will not became part of the financial statements. Since independence is not implicated in such cases, the proposed rule is not justified in extending to those services.
In some European countries, auditors are required by law to perform certain appraisal and valuation services.143 The proposed rule would prevent an accounting firm from complying with its statutory obligations in those jurisdictions while remaining independent under the proposed rule. Failure to consider these issues will adversely affect comity between the United States and foreign countries.
4. Actuarial Services
Current rules contain restrictions on actuarial services for insurance company clients.144 The proposed rule would expand the existing restrictions onactuarial services for insurance company clients to any advisory services involving the determination of "policy reserves" and related accounts for any public company, even if the actuarial services are immaterial to the company's financial reporting.145
Moreover, the proposed rule does not define "policy reserves." While it may be clear that the term covers insurance policy reserves of insurance companies, it is not clear whether this prohibition is intended to affect other actuarial determined liabilities, such as pension plans or other post-employment benefits, or self-insurance reserves (e.g., workers' compensation, employee health insurance, liability insurance). In addition, the proposed rule would appear to also extend to advisory services involving the determination of policy reserves and related accounts for any public company, even if the actuarial reserves were immaterial to the company's financial reporting.
5. Internal Audit Outsourcing
The proposed rule would impose an outright ban on providing "internal audit services" to an audit client, with limited exceptions, e.g., for "operational internal audits unrelated to the internal accounting controls, financial systems,or financial statements." As such, the proposed rule is not merely a codification of existing guidelines but a complex and sweeping proposal that would ban many currently permitted services. It would impose new restrictions on providing internal audit and extended audit services beyond the interpretive guidance issued by the profession in 1996.146
With the exception of certain industries that operate within specific regulatory environments, e.g., banking, there is no requirement that issuers have an internal audit function. Maintaining or implementing an effective internal audit program, however, is integral to investor protection.147 Accordingly, independent auditors should not be prohibited from helping companies with their internal audit function. Companies should be able to select which firm they want to help them with this function since they bear responsibility for the financial statements.148 Given that internal audit functions are not required, companies could simply dissolve thefunction and expand the scope of the external audit and achieve the same result. Thus, the proposed prohibition on internal audit outsourcing would neither improve audit quality nor further investor protection.149
The proposed rule presumes a sharper distinction between external and internal audit functions than may in fact exist. The distinction between the two functions is often blurred. External auditors often are asked to extend their audit procedures by management of the audit committee. This rule potentially forecloses the auditor from extending the procedures to the extent that it may result in performing what may be characterized as internal audit services.
The proposed rule also presumes that there is a detriment to having an external audit firm provide personnel for the internal audit functions. As an initial point, we note that any purported appearance issue is obviated by the use of separate internal and external audit teams, which is our standard practice. Moreover, having both functions conducted by the same firm may have a substantive benefit: it would deter any attempt by management to override or limit the internal auditor's role. If management would attempt to do so, the internal auditor is certain to report the attempt to the external audit team when he or she is part of the same accounting firm. This benefit may be less certain when the functions are the responsibility of separatefirms. Internal and external audit functions conducted by the same accounting firm also compliment each other where the corporate governance structure of the audit client requires the internal auditor to report directly to the audit committee. Thus, rather than cause an independence issue as the proposed rule suggests, having the same firm conduct both the internal and external audits can and does result in complimentary functions.
Moreover, this prohibition will be costly for small companies. Many small companies do not have an internal audit department. Therefore, if these companies choose to conduct internal audit activities - - which of course, would be in the best interests of investors - - they need to rely on outsourcing at least a portion of, if not all of, these services. It would be unduly burdensome to require all small businesses to hire a separate firm to do this.
With the increasing globalization of businesses, companies of all sizes increasingly need multilingual staff with an understanding of business operations around the world, as well as staff with highly specialized skills in areas such as Information Technology. It may be costly and difficult, if not impossible, for many companies to hire such employees in-house. Accordingly, companies would and do benefit from having globally connected firms that are capable of assisting with these services on a global basis.
6. Management Functions
We have no disagreement with the proposition that an accounting firm cannot perform management functions for an audit client without impairing independence. There are, however, potential problems with the proposed rule's prohibition on the performance of management functions. Once again, the language is vague and overbroad. For example, the proposed rule bars the accountant from "performing any decision-making . . . function[s] for the audit client or affiliate of the audit client."150 The proposed rule, however, provides no guidance on what is meant by a "decision-making" function. Does the decision-making authority have to relate to the audit? Or does it even have to relate to the client's business in order for it to be prohibited? It is common for an accounting firm doing an audit to observe or monitor the effectiveness of the accounting function, and in connection with that to recommend personnel changes (e.g., hire a new Controller or Chief Financial Officer), recommend that new positions be created (e.g., Accounting Manager), or recommend a restructuring of the accounting function. Each of these recommendations are made to improve the accounting and financial reporting process, a goal at the very heart of investor protection and public confidence. Indeed, many clients actually look to the auditor for just such recommendations because the auditor knowsthe company and its business. Accordingly, many such recommendations become the basis for the company's "decision-making." Disallowing these functions and other functions that may be swept into this prohibition may harm the accounting and disclosure process by preventing prompt, effective remedial action where an audit reveals the need for such action.
7. Human Resources
Current guidance adopted voluntarily decades ago by the SEC Practice Section ("SECPS") prohibits accounting firms that are members of the SECPS from providing executive recruiting services to audit clients.151 The proposed rule, however, would expand the ban to include a number of other services, such as: designing compensation packages; advising clients about management or organizational structures; and developing employee evaluation or satisfaction programs. The proposed rule goes well beyond the current rules to prohibit common human resources advice provided to many audit clients that do not impair independence.
This prohibition is also vague and confusing. For example, while it prohibits an auditor from "designing" compensation packages, it also prohibits an auditor from "developing" employee evaluation programs, and prohibits an auditorfrom "advising" about an audit client's "management or organizational structure."152 The use of these different terms leads to confusion about what services are prohibited. Moreover, it is unclear what the prohibition on advising about the audit client's "management or organizational structure" means. For example, the proposed rule does not state whether this prohibition applies only to management level personnel or all employees. Does the proposed rule prohibit providing advice to a client regarding its business process re-engineering activities? Does it prohibit advising about the structure of the client's human resources department? While the Commission has indicated that tax services should not be affected by the proposed rule, the proposed rule could be interpreted as banning tax advice on employee benefits or executive compensation, which are often designed to achieve certain tax objectives. Such a proscription would limit the ability of a company to obtain tax advice on these often complicated matters, while providing no apparent enhancement of investors' interests.
8. Broker-Dealer, Investment Adviser Or Investment Banking Services
Although existing guidelines prohibit firms from acting as a broker-dealer, promoter or underwriter for an audit client,153 the proposed rule goes even
further. The proposed rule bans providing advice on the design of the client's compliance systems, a service provided to many audit clients for many years that plainly benefits investors. The proposal also uses the term "securities professional" in a manner to prohibit additional non-audit services provided under the current standards, such as personal financial planning services provided to audit clients. The proposed rule may prevent accounting firms from providing information as straightforward as the direction of interest rates, or other basic securities related information the provision of which would not impair independence.
The prohibition on broker-dealer, investment adviser, or investment banking services is also vague. First, it is unclear what constitutes "designing" a "system" to comply with broker-dealer or investment adviser regulations. Second, the Commission should encourage auditors and their regulatory specialists154 to makerecommendations to their clients regarding improvements to the clients' regulatory compliance controls. Such recommendations benefit the audit clients and the investors who use those clients' services. Compliance controls help to protect the broker-dealer or investment adviser from reputational, legal and compliance risk. Effective compliance controls protect investors and are an integral part of the system used by broker-dealers and investment advisers to comply with complex and changing regulations. A company's auditor is often uniquely suited to providing those services relating to compliance controls. The proposed rule could have the effect of discouraging broker-dealers and investment advisers from engaging their accountants to assist them in assessing and improving compliance controls, and discouraging auditors from making suggestions for improvement. Both unintended consequences are directly at odds with investor protection.
As the Commission has repeatedly stated, the financial responsibility rules are the cornerstone for protecting investors' funds and securities. Rule 17a-5 under the Securities Exchange Act of 1934 recognizes the value of having a third party reviewing regulatory compliance. While Rule 17a-5 requires independent accounting firms to communicate material weaknesses in regulatory compliance tomanagement and others, the proposed rule could prohibit the independent accountant from communicating recommendations on how those weaknesses can be cured. The words "designing" a "system" in the proposed rule could be read to prohibit accountants from communicating recommended improvements to management, because the accounting firm will be held not to be independent by virtue of the words "even if the audit client accepts ultimate responsibility . . . ."155 Being required to communicate weaknesses but being prohibited from recommending improvements is illogical; communicating a weakness and recommending an improvement are often inextricably intertwined. Moreover, investors and the public are well-served by such recommendations and the assistance of the auditor in terms of advice and implementation. The broad prohibition on broker-dealer, investment adviser or investment banking services is not in the public interest.
9. Legal Services
Although current regulations recognize the possible incompatibility of the provision of legal services and auditor independence,156 the definition of legal services in the proposed rule is so broad that it would ban many services provided to audit clients under existing guidelines, particularly services to foreign clients. Theproposed rule's blanket prohibition is without a conceptual foundation. Certain services which may fall within the domain of "legal services" may be entirely appropriate for an accounting firm or an affiliate thereof to provide to its audit clients without implicating independence. The nature and materiality of the service provided must be examined in any given case. The proposed rule forgoes this approach by imposing a complete ban. The Release does not consider initiatives of other bodies, such as the Multi-Jurisdictional Practice Project of the American Bar Association. Nor does the proposal consider the alternatives being considered by the ISB in its Conceptual Framework project. These alternatives include those which address the degree of advocacy involved as well as structural alternatives, such as separating the legal practice from the audit function. Moreover, the proposal does not recognize possible strategic alliances between law and accounting firms where there is no shared equity, no profit or fee sharing but merely cooperation in the market place between separate entities.
We believe the approach of the proposal is wrongheaded. Most "legal" services consist of advisory services similar to consulting services. Accounting firms and their affiliates historically have provided such consulting work in areas such as tax and real estate, and the Release offers no basis for the assumption that such services give rise to independence concerns. Moreover, providing immaterial or ministerial legal services does not implicate independence issues.
Here, as elsewhere, the proposed rule fails to take into account the global nature of the accounting profession, providing no exception for legal services routinely provided in foreign countries. The proposal would ban all legal services, including insignificant legal services that accounting firms have long provided to audit clients and their affiliates outside the United States.157 The proposal would ban tax services provided by accounting firms in those foreign countries that require such services to be rendered by lawyers, despite the fact that those services have been provided by auditors for decades around the world. For example, an accountant-provided tax service that is permissible in the United States may not be permissible under the proposal in several European countries that require the same service to be performed by tax lawyers.
Domestically, the prohibition would ban legal services which are more akin to consulting than to practicing law as well as legal services which because of their nature or amount are insignificant to the financial statements. For example, should a client be prohibited from calling an accounting firm and asking how Item 303 of Regulation S-K works? Should a lawyer working for an accountingfirm be prohibited from handling a real estate transfer or other insignificant legal matter for a client? Because independence would not be impaired in these cases, we strongly believe the proposed rule casts too wide a net in its outright ban on all legal services.
10. Expert Services
The proposed rule would prohibit an accounting firm or affiliate thereof from rendering or "supporting expert opinion. . .in legal, administrative or regulatory filings or proceeding"158 in circumstances which are currently permitted. For example, the proposal would prohibit currently permissible testimony in domestic utility rate-making proceedings where an accounting firm's accounting, audit, tax, and industry knowledge and expertise is valuable from a public interest perspective. The proposal could also ban similar services in foreign jurisdictions that require accounting firms to act as experts in regulatory proceedings. For example, the U.K. legal environment is such that when certain expert services are performed, for example, representing a client before a court or similar body, the expert has an overriding obligation to the court or regulatory body, not the client. It follows then, that in such circumstances, the expert is neither acting as an advocate for his client nor appearing to act as one, at least from the U.K. perspective. Finally, the proposedrule could prohibit accounting firms from rendering tax opinions for audit clients, performing litigation support activities, which often consist of gathering and analyzing large volumes of data unrelated to the preparation of financial statements, and similar services that are currently permitted.
The proposed rule is contrary to the current AICPA position on expert witness services. The AICPA's Profession Ethics Executive Committee, has stated in a ruling:
101. Client Advocacy and Expert Witness Services
.202 Question-Would the performance of expert witness services be considered as acting as an advocate for a client as discussed in interpretation 102-6 [ET section 102.07]?
.203 Answer-No. A member serving as an expert witness does not serve as an advocate but as someone with specialized knowledge, training, and experience in a particular area who should arrive at and present positions objectively."159
Performing expert services on this basis would not appear to impair an auditor's independence. Taken to its logical conclusion, the proposed rule, could prohibit an accounting firm from being named as an expert in a registration statement for a public offering under the Securities Act of 1933 ("Securities Act") because their work would be expertised in the "Experts" section of the registration statement (aregulatory filing). The same expertise that would disable the auditor from testifying in front of a court, tribunal or state or federal agency, would impair independence because of the expertise an accountant admits to under Item 509 of Regulation S-K.
11. The Catch-All Clause
The proposed rule also contains a provision that acts as a "catch-all" or "rubber clause." The proposed rule provides that
An accountant is not independent under the standard of paragraph (b) of this section [the four principles] if, during the audit and professional engagement period, the accountant has any of the financial, employment or business relationships with, provides any of the non-audit services to, or receives a contingent fee from, the accountant's audit client or an affiliate of the audit client . . . or otherwise does not comply with the standard of paragraph (b) of this section.160
This provision makes clear that the list of prohibited services is not intended to be exclusive. Moreover, if the "catch-all" provision is part of the rule, then there is no need to have the list of ten prohibited services. This catch-all further expands the scope of the proposed rule and adds even more uncertainty to precisely what the rule prohibits. As Philip Laskawy, Chairman of Ernst & Young noted, "[a]udit clients would also be affected - they would have to be very careful about hiring their auditor for any non-audit services, because any such service might be second-guessed and are-audit of the financial statements by a new auditor could be required. Even short of a re-audit, the ambiguities in this area might well slow down financings or merger and acquisition transactions when questions or concerns are raised during SEC review of the company's filings."161
12. The Transition Provision
While the proposed rule is not in the public interest and should not be adopted, if the Commission takes any action concerning non-audit services, a transition provision is necessary. Although the two-year transition period may be adequate in some situations, there are many situations where two years would not be sufficient for a client to make an orderly transition to another provider of the non-audit service that meets the client's requirements. For example, many ERP system implementation projects span a period of more than two years. It is not uncommon for a multinational company to roll out implementation of a system over a three to five year period. It would not be in the interests of investors to cause a company in such a situation to have to change its information systems consultant or its auditor two years after the effective date of the proposed rule when a project may be on-going at that date. If the company were to decide to change its information systems consultant in the middle of an implementation project, the transition to a newconsultant would be, at best, disruptive to the process and could result in system failures or the inability of the company to complete the implementation project.
We also note that there is no transition provision for a non-audit client that becomes an audit client while non-audit services are in the process or have recently been completed. For example, assume we were to be engaged to provide financial systems implementation services to A, a company that is not an audit client of the firm. If one year into the implementation project, A were acquired by B, an attest client of the firm, would the firm have to immediately resign from the audit of B? What if the acquisition of A by B occurred shortly after completion of the systems implementation project, would the fact that the firm performed implementation services on systems that will be utilized by A, which is not an attest client as a result of B's acquisition of A, impair the independence of the firm with respect to B?
These are merely two examples which illustrate the unintended negative consequences to registrants and their shareholders posed by the transition provision. Accordingly, if the Commission takes any action with regard to non-audit services, we believe that the transition provisions should not be adopted as proposed.
D. The Proposed Proxy Disclosure Requirement
The proposed rule also contains a new disclosure requirement for public companies. The proposed rule would require a company to disclose in its annual proxy statement any services received from an independent public or certifiedaccountant, unless the amount of such services was less than the lesser of $50,000 or 10% of the audit fee.
The Release states the Commission's belief that "an investor needs the information to form a judgment about independence."162 While we support the general principle of disclosure of meaningful information that is useful to investors and are continuing to study possible approaches to disclosure in this area, we note the Commission promulgated a similar proxy disclosure rule in 1978. Thereafter, the Commission concluded that the rule did not provide useful information to investors, and thus, was unnecessary. Accordingly, the Commission rescinded the rule in 1982. The disclosure mandated by the proposed rule is far broader than the disclosure required in the earlier rule. As proposed, the rule should not be adopted. Nevertheless, in the interest of promoting meaningful disclosure we are continuing to evaluate disclosure alternatives.
We strongly urge the Commission to withdraw the proposed rule because of the serious, irremediable conceptual and structural flaws described in this letter. The Commission has not clearly articulated the harm to investors, or any public interest to be served by the proposed rule, that would justify the imposition ofthese burdens on, and impediments to, capital formation in the United States. The Release does not present empirical evidence to justify risking a wholesale restructuring of a profession that has served investor protection and the public interest for decades. Nor has the Commission provided empirical studies of the impact of its proposals on competition, efficiency, and capital formation. The anecdotal examples in the Release are not sufficient to support the sweeping changes that are likely to result from adoption of the proposed rule.
As to the rule itself, it will lead to a decline in audit quality and thereby erode rather than enhance investor confidence. It is not a reasoned solution to complex issues being studied domestically and internationally, but rushes such issues to an arbitrary conclusion. In sum, if adopted, the proposed rule could have a material adverse effect on the Commission's and the accounting profession's mutual interest in investor protection and public confidence.
/s/ Deloitte & Touche
cc: The Honorable Arthur Levitt, Chairman
The Honorable Isaac C. Hunt, Jr., Commissioner
The Honorable Paul R. Carey, Commissioner
The Honorable Laura S. Unger, Commissioner
|1||Release, 65 Fed. Reg. at 43,148.|
|2||The Release misleadingly states that only about 25% of audit clients buy non-audit services from their auditors. See Section III.A.1, infra.|
|3||The apparent haste of the Commission in publishing the proposed rule, and the limited time provided for comment, are particularly puzzling in light of the fact that no pressing deadline -- Congressional or otherwise -- requires hasty action. Quite apart from what one may think about the need for the proposed rule, it is not the kind of rule that needs expedited or emergency action. Moreover, the proposed rule is not merely a technical modification of reporting requirements for the accounting profession. Under these circumstances, the 75 days provided for comment was not only insufficient, but unnecessarily abbreviated and ultimately unfair. In addition, the Commission's refusal to extend the comment period was contrary to its established practice with respect to rules of comparable breadth. Given the shortness of the comment period, we reserve the right to submit additional comments as appropriate.|
|4||See Release, 65 Fed. Reg. at 43,154-55.|
|5|| As used in this letter, competencies refers to a broad range of specialized knowledge. Many non-audit competencies are used in an audit engagement. These competencies also provide the accounting firm with the capacity to provide non-audit services to non-audit clients and to audit clients outside the audit engagement.
Non-audit services include both consulting and other non-audit services. Consulting, as used in this letter and as commonly understood, includes services, such as information technology and other traditional management advisory services. Other non-audit services include services such as: actuarial and benefit services, computer controls and security services, merger and acquisition services, tax services and valuation services.
|6||See Release, 65 Fed. Reg. at 43,154-55.|
|7||For example, the CalPERS General Counsel addressed the "lack of empirical data precisely linking each of the independence issues identified in the Proposal with some financial harm to the company and its investors." The only evidence mustered by CalPERS, however, was the statement that "[a]necdotally . . . the poorest performers within our portfolio . . . had problems with the quality of [their] financial statements, and seemingly meek auditors." Written Testimony of Witnesses at SEC Public Hearing on Proposed Rule Amendments Regarding Auditor Independence (Sept. 13, 2000) (hereafter, the "September 13 Hearing") (Testimony of Kayla J. Gillan, General Counsel, California Public Employees Retirement System, at 2). Jay Eisenhofer, a securities litigation lawyer, offered Oxford Health Plans ("Oxford") as a "case in point." Although Eisenhofer claims that Oxford's auditor "fell down on the job," contributing to significant financial problems, he could point to no non-audit service offered by Oxford's auditors and specifically conceded that "this is not a case where the auditor had provided significant computer consulting to Oxford." (September 13 Hearing, Testimony of Jay W. Eisenhofer, at 2-4).|
|8||The Panel on Audit Effectiveness (the "Panel") was created by the Public Oversight Board (the "POB") in 1998 at the request of Chairman Arthur Levitt and was charged with performing a comprehensive review and evaluation of the current audit model and the effect of recent trends in auditing on the public interest.|
|9||See Public Oversight Board, The Panel On Audit Effectiveness: Report and Recommendations (hereafter, "Panel on Audit Effectiveness Report") §5.8, at 110 (August 31, 2000) (emphasis added).|
|10||Id. §5.18, at 113.|
|11||Id. §5.43, at 127.|
|12||American Institute of Certified Public Accountants ("AICPA"), Serving the Public Interest: A New Conceptual Framework for Auditor Independence (Oct. 20, 1997) (hereafter, "AICPA Conceptual Paper on Auditor Independence") at 50; see also Written Testimony of Witnesses at SEC Public Hearing on Proposed Rule Amendments Regarding Auditor Independence (July 26, 2000) (hereafter, the "July 26 Hearing") (Testimony of Ray J. Groves, CPA (Ernst & Young), at 3) ("I have never observed any impairment of independence caused by the performance of non-audit services for an audit client, and those with this concern have never been able to cite an example of impairment of audit independence to me."); July 26 Hearing (Testimony of J. Terry Strange (KPMG LLP), at 1) ("Indeed, decades of studies considering auditor independence have concluded unanimously that there is no evidence that the provision of non-audit services has ever had a negative impact on audit effectiveness").|
|13||Steven M.H. Wallman, The Future of Accounting, Part III: Reliability and Auditor Independence, 10 Acct. Horizons 76, 92 (Dec. 1996); see also July 26 Hearing (Testimony of Robert R. Garland (Deloitte & Touche)), at 1-2 ("Given what is at stake, the lack of any evidence of a problem is a compelling argument against the rulemaking. It is irresponsible to take the risk inherent in the proposal without demonstrating either a compelling need or a major benefit. The proposal does neither.").|
|14||Earnscliffe Research & Communications, Report to the United States Independence Standards Board: Research into Perceptions of Auditor Independence and Objectivity (November 1999) (hereafter "Earnscliffe I"); Earnscliffe Research and Communications, Report to the United States Independence Standards Board: Research into Perceptions of Auditor Independence and Objectivity - Phase II (July 2000) (hereafter "Earnscliffe II"). A total of 131 interviews were conducted in connection with Earnscliffe I. The interviewees consisted of 9 CEO's of SEC registrants, 24 CFO's of SEC registrants, 18 Chairmen of audit committees of SEC registrants, 18 buy side investment analysts, 17 sell side investment analysts, 19 audit partners and 19 regulators. A total of 51 interviews were conducted in connection with Earnscliffe II. The interviewees consisted of 9 CEO's of SEC registrants, 11 CFO's of SEC registrants, 10 Chairmen of audit committees of SEC registrants, 10 buy side investment analysts, and 11 audit partners.|
|15||Earnscliffe I, at 2.|
|16||Earnscliffe II, at 39.|
|18||Id. at 45.|
|19||Krawczyk and Jenkins, Perceptions of the Relationship Between Nonaudit Services and Auditor Independence, North Carolina State University (July 25, 2000) (hereafter, "NCSU Study"), at 11. The NCSU Study consisted of 289 individuals, comprised of people from the general public, non-Big 5 CPA firms, and Big 5 CPA firms.|
|20||Penn, Schoen & Berland Associates, Inc. National Investor Survey (Sept. 12, 2000) (hereafter, "PSB Survey"). The PSB Survey consisted of 600 adult U.S. investors aged 25 or older interviewed from August 30 to September 6, 2000 and was commissioned by the AICPA. The investors' portfolios ranged from less than $50,000 to more than $2 million.|
|21||For many years the accounting profession, as part of its quality control system, has maintained structures and procedures to ensure independence and audit quality and to assist engagement partners in reaching the appropriate conclusions and judgments. These include required concurring partner reviews, assignment of second partners to specific accounts, auditor partner rotation requirements, extensive required consultations, and expansive consultation networks in the field and the National Office of the firm. Additionally, annual practice reviews and triennial peer reviews serve to ensure that these structures are in place and functioning as designed.|
|22||See, e.g., AICPA Code of Professional Conduct, Introduction: "Compliance with the Code of Professional Conduct . . . depends . . . ultimately on disciplinary proceedings, when necessary, against members who fail to comply with the Rules." See also Rule 101: "A member in public practice shall be independent in the performance of professional services as required by standards promulgated by bodies designated by Council," and interpretations thereunder; AICPA Bylaws, Section 7.4.2, providing for disciplinary proceedings and expulsion to address violations of any rule of the Code of Professional Conduct.|
|23||See 17 CFR 201.102(e); Davy v. SEC, 792 F.2d 1418 (9th Cir. 1986).|
|24||Office of the Chief Accountant, SEC, Staff Report on Auditor Independence, (March 1994) (the "1994 Staff Report"), at 55.|
|25||DiLeo v. Ernst & Young, 901 F.2d 624, 629 (7th Cir. 1990). See also Stanley R. Klion, MAS Practice: Are the Critics Justified?, 145 J. Acct. 72 (June 1978) (the CPA's "reputation and livelihood depend on his ability to advise clients in confidence and with competence").|
|26||See AICPA Conceptual Paper on Auditor Independence, supra note 12, at 59-65 (citing Law and Economics Consulting Group, An Economic Analysis of Auditor Independence for a Multi-client, Multi-service Public Accounting Firm (hereafter "An Economic Analysis") at 16) ("[e]ngaging in an institutional-level abrogation of independence would put the firm's entire stream of audit revenues at risk"); D. Jordan Lowe & Kurt Pany, CPA Performance of Consulting Engagements with Audit Clients: Effects on Financial Statement Users' Perceptions and Decisions, 14 Auditing J. Prac. & Theory 35 (Fall 1995) ("[A]uditors, particularly those from large firms (i.e. Big 6 firms), may be constrained not to compromise their independence on a given client so as not to forfeit their quasi-rents from numerous other audit clients.").|
|27||See AICPA Conceptual Paper on Auditor Independence, supra note 12, at 61 (citing An Economic Analysis, Appendix B, at 16) ("[A]n abrogation of independence with one client threatens the revenue stream derived from the entire client pool.").|
|28||See supra footnote 23.|
|29||See NCSU Study, at 11 (concluding that "nonaudit services enhance auditor independence, thus strengthening the auditor's ability to resist management pressures.").|
|30||We note also that there are serious questions concerning the Commission's authority to adopt the proposed rule. The list of purported statutory authorities cited in the Release does not include a single provision authorizing the Commission to regulate the accounting profession. Moreover, the courts have upheld only the Commission's right to adjudicate, on a case-by-casebasis, whether an accountant has been in fact incompetent, unethical, or has acted improperly, and have cast doubt on whether the Commission has authority broadly and directly to regulate the structure of the accounting profession. It is notable also that until recently, the Commission's Office of the General Counsel has likewise expressed doubt as to the Commission's authority to adopt a rule, such as this one, which proposes to directly regulate and re-shape the accounting profession. See Memorandum from Ralph Ferrara, General Counsel of the Commission, to Clarence Sampson, Chief Accountant of the Commission, Oct. 18, 1979.|
|31||See, e.g., Securities Act Rel. No. 6695 [1987 Transfer Binder] Fed. Sec. L. Rep. (CCH) § 84,122, at 88,638 (1987 SEC Lexis 2189) (Apr. 1, 1987) (discussing the value of peer review).|
|32||See Securities Act Release No. 7507, 63 Fed. Reg. 9135 (Feb. 24, 1998).|
|33||See July 26 Hearing (Testimony of William T. Allen, at 1).|
|34||See Securities Act Release No. 7507, supra note 32, at 2.|
|35||See id. at 4.|
|36||See id. at 2. See also "Expected Timetable for Board Projects," www.cpaindependence.org (describing schedule of proposed standard-setting projects in 2000 and 2001).|
|37||See Independence Standards Board Standard No. 1, Independence Discussions with Audit Committees, 1998.|
|38||See July 26 Hearing (Testimony of Dan L. Goldwasser (Vedder, Price, Kaufman & Kammholz), at 2).|
|39||Id. at 2-3.|
|40||September 13 Hearing (Comments of the Institute of Internal Auditors (the "IIA"), at 3) (the IIA also advocates that the ISB reconstitute its membership).|
|41||See September 13 Hearing (Comments of Anne H. Ross, Member and most recent past Chairman of the South Carolina Board of Accountancy at 3) ("I respectfully urge the Commission to let the ISB continue with and complete its work using the deliberative model it has been employing."); see also id. (Comments of Dom Esposito, Chief Executive Officer, Grant Thorton LLP at 2) ("We strongly urge the Commission to maintain public commitment to the Independence Standards Board by allowing the ISB to consider the scope of services issue.").|
|42||See, e.g., Philip A. Laskawy, Chairman, Ernst & Young LLP, "The Global Marketplace, the Connected Economy, and the SEC's Auditor Independence Proposals," address to the American Accounting Association (Aug. 15, 2000) (the "Laskawy Address"), at 15 (noting that the ISB has devoted great effort on a proposed conceptual framework for auditor independence); and September 13 Hearing (Comments of Dennis Paul Spackman, Chairman, National Association of State Boards of Accountancy), at 3.|
|43||See Exchange Act Release No. 42266, 64 Fed. Reg. 73,389 (Jan. 31, 2000).|
|45||See, e.g., New York Stock Exchange Listed Company Manual, Rule 303.01(B)(2).|
|46||Exchange Act Release No. 42266, 64 Fed. Reg. 73,389.|
|47||See July 26 Hearing (Testimony of William T. Allen, at 3).|
|48||See September 20 Hearing (Testimony of BDO Seidman, LLP at 5) ("Because of its enhanced role, the audit committee is in the best position to consider all of the facts relating to possible independence issues, including the existence of appropriate safeguards. The Commission should allow [the recently adopted audit committee rules] to realize their full impact before adopting rules relating to non-audit services."). The Commission has previously expressed its belief in the effectiveness of audit committees and others to deal with independence issues. See, e.g., ASR No. 296, at 62,939: "The Commission believes that audit committees can be effective forces in helping to assure that management advisory services performed by accountants do not impair their independence." See also ASR No. 296, at 62,940: "Accountants and their self-regulatory structure, audit committees, boards of directors and managements are aware of the Commission's views on accountants' independence and should be sensitive to the possible impact on independence of non-audit services performed by accountants. The Commission believes it should be able to rely on these persons to ensure adequate consideration of the impact on accountants' independence of non-audit services because they share the responsibility to assure that the public maintains confidence in the independence of accountants."|
|49||See Laskawy Address, supra note 42, at 8.|
|50||Panel on Audit Effectiveness Report, §5.18, at 113.|
|51||Panel on Audit Effectiveness Report, §5.26, at 116.|
|52||See September 20 Hearing (Testimony of Iowa Accountancy Examining Board at 3) (noting that the Panel on Audit Effectiveness "cleary indicated" that it could find no correlation between audit failures and the performance of non-audit services and concluding: "We would recommend further study prior to changing the rules for independence.").|
|53||As Joseph F. Berardino, Managing Partner, North America Assurance and Business Advisory Practice, Arthur Andersen LLP ("AA") stated at the hearing on September 21, 2000 regarding the separation of audit from non-audit services at AA, "I've seen this movie before." He further stated that after separating the attest function from its consulting practice, AA realized that it needed the same competencies that had just been severed to perform quality audits and therefore redeveloped a consulting practice.|
|54||September 13 Hearing (Testimony of Barry Melancon (President and CEO, AICPA), at 21).|
|55||In fact, recent studies have indicated that investors, by a three to one margin, believe audit committees and boards of directors generally act in the interest of shareholders, and that they should decide what services the accounting firm should provide. See, e.g., PSB Survey, supra note 20, at 8-9.|
|56||AICPA Conceptual Paper on Auditor Independence, supra note 12, at 78-79.|
|57|| As one commenter stated:
Auditors familiar with professional services such as risk assessment, performance measurement design, and various information technology services, are more likely than are auditors whose experiences are limited to historical financial auditing to recognize developing threats to financial reporting (and business viability). Proscribing such services to audit clients would hamper development of the broad perspective auditors need to be able to recognize and protect investors' interests in a period of rapid change and global competition.
September 20 Hearing (Testimony of Professor William R. Kinney, Jr. (McCombs School of Business, University of Texas at Austin), at 1).
|58||September 13 Hearing (Testimony of Stephen G. Butler (Chairman, KPMG LLP), at 1).|
|59||July 26 Hearing (Testimony of Joseph F. Berardino at 2).|
|60||Release, 65 Fed. Reg. at 43,186.|
|61||17 C.F.R. § 210.10-01(d); 17 C.F.R. &sec; 228.310.|
|62||Release, 65 Fed. Reg. at 43,148.|
|63||See Earnscliffe II, at 44; PSB Survey.|
|64||See PSB Survey, at 1.|
|65||Id. at 2.|
|66||Panel on Audit Effectiveness Report, supra note 8, §5.8 at 110.|
|67||The Quasi-Peer Reviews undertaken by the Panel were "in depth reviews of the quality of a significant number of audits of financial statements of public company clients of the eight largest accounting firms." Report at viii. The Report states: "The QPR process was designed to make a comprehensive review of public company audits performed by the eight largest firms, to evaluate the way independent audits are performed and to assess the effects of recent trends in auditing on the public interest." Panel on Audit Effectiveness, App. E at 211. The Panel staff reviewed approximately 20 audit engagements for each of the Big 5 firms, and 10 audit engagements for each of the other three firms. "Overall, the staff selected 130 engagements of which results were tabulated for 126 engagements representing 320,790 audit hours." Id. at 213. 37 of the engagements reviewed included the provision of non-audit services, which represented 29% of the QPR population.|
|68||Id. at 113.|
|69||AICPA Conceptual Paper on Auditor Independence, at 12.|
|70||Id. at 55-56. See also General Accounting Office, The Accounting Profession, Major Issues: Progress and Concerns (Sept. 1996).|
|71||Beasley, Carcello and Hermanson, Fraudulent Financial Reporting: 1987-1997 An Analysis of U.S. Public Companies, The Committee of Sponsoring Organizations of the Treadway Commission (Mar. 1999) (the "COSO Report").|
|72||Panel on Audit Effectiveness Report, supra note 8, at §§ 5.29, 5.30, 5.31.|
|73||See 17 C.F.R. §§ 228.306, 229.306, 240.14a-101.|
|74||Moreover, the federal government itself apparently does not perceive a conflict in providing non-audit services to audit clients when those clients are government agencies. Specifically, the federal government has not restricted the type of non-audit services that accounting firms may provide to a federal agency when they also provide auditing and accounting services to that agency. In fact, it is common for an accounting firm to provide both audit and non-audit services to the same agency. The provision of those services is, of course, subject to the Federal Acquisition Regulation and Government Auditing Standards. That regulation and those standards place no scope-of-services restrictions on a contractor, and the Government Auditing Standards specifically note that "auditors may perform services other than audits." United States General Accounting Office, Government Auditing Standards, 1994 Revision, §2.10 (June 1994). In certain circumstances, a contracting officer in the exercise of his or her duty to determine whether there is an organizational conflict of interest, may require disclosure of certain information by a contractor. This disclosure, made to the contracting officer, is analogous to the information provided to audit committees under ISB 1. There is no basis to hold public issuers to a standard different than that maintained by the government in the audits of its business, where the confidence of all members of the public, not just investors, is at issue.|
|75||65 Fed. Reg. at 43,149.|
|76||See Earnscliffe I, at 6 (finding that, "the mood among most respondents, with the exception of regulators, was that caution was necessary when raising the level of public debate about financial reporting and its reliability.").|
|77||65 Fed. Reg. at 43,155; see also id. at 43,148, 43,149, 43,168, 43,173,43,185.|
|78||Id. at 43,155.|
|79||Id. at 43,185.|
|82||See, e.g., September 13 Hearing (Testimony of Barry Melancon (President and CEO, AICPA), at 17): "all firms are not fungible - particular firms have expertise in particular areas."|
|83||See, September 20 Hearing (Testimony of Frank Tirelli, Chief Operating Officer, myCFO, Inc., at 5) ("The Commission's proposed rule, in precluding me from retaining the company's audit firm for certain non-audit projects, could potentially put me in a position to retain the "second best" firm for these projects").|
|84|| One commenter provided a concrete example of this issue. Axciom Corporation ("Axciom"), based in Little Rock, Arkansas, changed its auditors. Axciom's comment letter stated:
The change of auditors was primarily driven by the fact that our predecessor auditors had elected to close their local office. Being that our company is not headquartered in a large metropolitan city, our remaining choice of local professional service providers was somewhat limited. Fortunately, we were able to find a national firm with a local presence and with the appropriate skill set to meet our needs. The firm that was selected was chosen based upon their professional reputation, their credentials and our prior experience with them.Comment Letter of Caroline Rook, Financial Operations Leader, Axciom Corporation, Sept. 5, 2000 (emphasis in original).
|85||See Section IV.B, infra.|
|86||See Release, 65 Fed. Reg. at 43,148, 43,153, 43,185.|
|87||See Section II.B.5, supra.|
|88||Panel on Audit Effectiveness Report, supra note 8, §5.10 at 111.|
|89||"ERP" stands for "Enterprise Resource Planning," which is a comprehensive computer system that integrates the gamut of activities, such as payroll and shipping, within a given business enterprise.|
|90||Panel on Audit Effectiveness Report, supra note 8, §5.44 at 127-28.|
|91||PSB Survey, supra note 20, at 2.|
|92||AICPA, The Commission on Auditors' Responsibilities: Report, Conclusions and Recommendations, 95 (1978).|
|93||Accounting Series Release No. 264, 7 SEC Docket 877 at 883 (June 14, 1979); see also the 1981 Proposal to Rescind Rule; 46 Fed. Reg. 43,181 at 43,182 & n.7 (citing report to Congress on the Accounting Profession and the Commission's Oversight Role).|
|94||Release, 65 Fed. Reg. at 43,185-86.|
|95||AICPA Conceptual Paper on Auditor Independence, supra note 12, at 1.|
|96||See, e.g., September 13 Hearing (Submitted Testimony of Stephen G. Butler, (Chairman, KPMG) (noting the "war for talent" in which all the accounting firms are engaged)).|
|97||Release, 65 Fed. Reg. at 43,185.|
|98|| As the AICPA noted,
To continue to provide top quality service, accounting firms must attract and retain the most qualified individuals. Relatively few people know what they would like to do with their careers when they are at the entry-level stage. Within a multi-line professional service firm, new recruits enjoy a wide array of career potentials beyond their entry-level positions. Such diversity of practice has proven to be critical in attracting individuals with the breadth of professional and business skills necessary for today's complex audits in an increasingly competitive recruiting environment.
AICPA Conceptual Paper on Auditor Independence, supra note 12, at 81-82.
|99|| Statement on Auditing Standards No. 73, Using the Work of a Specialist ("SAS 73"), provides guidance to an auditor who uses the work of a specialist in performing an audit in accordance with auditing standards generally accepted in the United States. The specialists to which SAS 73 applies include, but are not limited to, actuaries, appraisers, engineers, environmental consultants, and geologists. SAS 73 includes guidance on evaluating "the relationship of the specialist to the client," using the findings of the specialist, and the effect of the specialist's work on the auditor's report.
When applying SAS 73, an auditor often will utilize a specialist within his or her firm, with the appropriate non-audit competencies to assist in the audit process by: (i) evaluating the qualifications of a specialist engaged by an attest client; (ii) reviewing the work product of the specialist, including, at times, discussing with the other specialist and reviewing of supporting work papers; and (iii) consulting with other members of the audit team on the appropriateness of the assumptions and methodologies uses by the specialist as well as the results of the specialist's work. The use of an internal specialist enhances the quality of the audit.
We believe that an unintended consequence of the proposed rule would be the loss of internal, non-audit competencies by accounting firms which would, at best, complicate the process of consulting with specialists and would result in diminished use of non-audit competencies in the performance of audits. We believe that such an impact would adversely affect the quality of the audit and therefore harm the interests of investors.
|100|| As was noted by the AICPA:
[T]he existence of detailed independence requirements in the UnitedStates exacerbates the conflicts that exist between [the] U.S. and foreign independence standards, at a time when auditors' reports are increasingly used in cross-border transactions. . . . The SEC has recognized that differing auditor independence standards create an impediment to multi-jurisdictional offerings and international capital formation. . . .
AICPA Conceptual Paper on Auditor Independence, supra note 12, at 41-42.
|101||See, e.g., Falk, Frucot and van Zijl, Auditor Independence: An International Perspective (Oct. 1998), at 11 and 12.|
|102||The 1994 Staff Report, supra note 24, at 46.|
|103||Under the European Council Directives, draft terms of a merger shall be examined by "[o]ne or more experts, acting on behalf of each of the merging companies but independent of them." See Third Council Directive 78/855/EEC,1978 O.J. (L 295); art. 10.1 (Oct. 9, 1978) (based on Article 54(3)(g) of the Treaty concerning mergers of public limited liability companies). As this Directive suggests, it is compatible with the perception of independence for an auditor to be acting "on behalf" of, or as an advocate for, a company -- a concept, which the Commission, in the proposed rule, has concluded, creates an appearance of a lack of independence. See proposed §210.2-01(b)(4) (Release, 65 Fed. Reg. at 43,190-194).|
|104||A statutory valuation is one that is required under U.K. statutory law (see section 103/108 of the U.K. Companies Act). A legal valuation relates to a valuation pursuant to a company's Articles of Association.|
|105||The Second European Council Directive, 77/91/EEC, 1976 O.J. (L 026) (Dec. 13, 1976), requires that an expert be engaged to perform certain services related to the issuance of shares for consideration other than cash. See id.,Art. 10 & 27.|
|106||IFAC Ethics Committee Exposure Draft, Independence: Proposed Changes to the Code of Ethic for Professional Accountants (June 2000) (hereafter, "IFAC Proposal").|
|107||Id. at 5 (quoting code of ethics).|
|108||Release, 65 Fed. Reg. at 43,148.|
|109||FEE, The Role, Position and Liability of the Statutory Auditor in the European Union (January 1996), at 4.|
|110||This would include the performance of expert, appraisal, and valuationservices, as well as the preparation of local statutory accounts. Depending on individual countries' customs and laws, the statutory auditor either typically performs or is required to perform such services. For example, Italian law requires that for a merger involving an exchange of shares, the statutory auditor issue a report on the application of valuation methods adopted to determine the exchange ratio (see Article 2501 of the Italian Civil Code and Article 158 of Legislative Decree No. 58 of 1998). Likewise, in Belgium, certain corporate transactions, such as the creation of a subsidiary with contributions in kind require a valuation report by a Belgian statutory auditor. In other countries, such as Norway, it is customary for public accountants to render advisory services within their field of professional competence, such as taxation, accounting and internal control and reorganization of businesses, to both audit and non-audit clients. Given time constraints on the 75 day comment period, it is not possible to identify all of the ways in which the proposed rule would conflict with auditors' statutory obligations in all of the countries. It does not appear, however, that the Staff has even considered, much less analyzed the manner in which its proposed rule would conflict with the laws of other countries, and thus impede cross-border capital flows.|
|111||As used in this letter, foreign practice means a non-U.S. practice of the international accounting organization of which the accounting firm is a part.|
|112||The proposed rule could also impact U.S. issuers, as other countries could respond by taking similar positions concerning U.S. issuers so that U.S. issuers would have difficulty raising capital overseas.|
|113||Regulation of International Securities Markets, Securities Act Release No. 6807, 1988 SEC LEXIS 2266, *12 (Nov. 14, 1988).|
|114||International Disclosure Standards, Securities Act Release No. 7637 (Feb. 2, 1999).|
|115||International Accounting Standards, Securities Act Release No. 7801 (Feb. 16, 2000).|
|116||These countries include those within the European Union as well as Australia.|
|117||For example, the proposed rule only defines what it means not to be independent, while the IFAC Proposal actually defines independence, taking into consideration factors that may mitigate the appearance of an independence problem.|
|118||For example, the proposed rule would extend to entities of the accounting firm that are controlled, jointly controlled, or under common control, as well as to shareholders that have a 5% or more interest in the accounting firm and to entities where the accounting firm has a 5% or more interest. On the other hand, the IFAC Proposal would extend to entities controlled by the accounting firm that can directly influence the conduct of the audit.|
|119||See Section II.B, supra.|
|120||Release, 65 Fed. Reg. at 43,192.|
|121||AICPA Code of Professional Conduct, § 101-3 (Jan. 1, 1988).|
|122||Release, 65 Fed. Reg. at 43,158.|
|123||See September 13 Hearing (Testimony of the New York State Society of Certified Public Accountants at 9) ("The first overriding concern is the use of the four governing principles: When we have applied these principles, we have found the guidance derived from them is too abstract for any practical usefulness and, therefore, may be counter-productive.")|
|124||As a matter of regulatory construction it is unclear how these principles would be used to analyze auditor independence. For example, proposed Rule 2-01(b) states that an accountant is not independent if during an audit the accountant engages in conduct implicating any of the four principles (e.g., having a "mutual or conflicting interest" with the client). However, proposed Rule 2-01(c) states that an accountant is not independent under paragraph (b) if during the audit the auditor has any of certain enumerated "financial, employment or business" relationships with the client or an affiliate of the client. The interplay between these two paragraphs is not addressed by the proposed rule or the Release. Not only is it unclear whether one section is intended to limit, expand, or define the other, but the Release does not state which section has priority in the event of a conflict.|
|125||Release, 65 Fed. Reg. at 43,190.|
|126||See Laskawy Address, supra note 42, at 14 (noting that "when a company distributes its audited financial statements to shareholders, the company and its auditors have a 'mutual interest' in the integrity of those statements").|
|127||See July 26 Hearing (Testimony of Ray J. Groves, at 1) (describing tortreform efforts that culminated in the Private Securities Litigation Reform Act of 1995; noting that these efforts involved a number of coalitions that included accounting firms and audit clients of some of these firms; and concluding that the "mutual interest" had no bearing on independence).|
|128||Release, 65 Fed. Reg. at 43,190.|
|130||Id. at 43,192.|
|131||July 26 Hearing (Testimony of Ray J. Groves, CPA (Ernst & Young), at 2).|
|132||Release, 65 Fed. Reg. at 43,172.|
|133||See July 26 Hearing (Testimony of Ray J. Groves, CPA (Ernst & Young), at 2).|
|134||Arthur Andersen & Co., 1990 SEC No-Act. LEXIS 943 (July 9, 1990).|
|135||See AICPA Code of Professional Conduct, § 101-3 (independence not impaired by bookkeeping services such as "[p]ropos[ing] standard, adjusting, or correcting journal entries or other changes affecting the financial statements to the client").|
|136||Release, 65 Fed. Reg. at 43,192.|
|139||AICPA Code of Professional Conduct, § 101-3.|
|140||Release, 65 Fed. Reg. at 43,192.|
|141|| For example, the AICPA Code of Conduct states that independence would not be impaired where the auditor provides appraisal or valuation services such as:
AICPA Code of Professional Conduct, § 101-3.
|142||Although the Release states that the proposed rule does not prohibit an accounting firm from providing valuation or appraisal services for non-financial (e.g., tax) purposes, 65 Fed. Reg. at 43,169, the proposed rule is silent on this point.|
|143||See Section III.B.2, supra.|
|144||For example, Section 101-3 of the AICPA Code of Professional Conductnotes that preparing an actuarial report "using assumptions determined by the member and not approved by the client" would impair independence.|
|145||Release, 65 Fed. Reg. at 43,192.|
|146||See AICPA Code of Professional Conduct 101-13; Ethics Ruling 101.206-207.|
|147||See, e.g., COSO Report, supra note 71.|
|148||See September 13 Hearing (Testimony of Thomas C. DeFazio (Executive Vice President and Chief Financial Officer, VirtualCom, Inc.), at 3) ("I believe that corporate executives need the freedom of choice to solicit the type of assistance that is necessary for a given project," and noting instance where as CFO he had "elected to outsource the function to the company's accounting firm. I knew that the accounting firm had the requisite understanding of the company's business to assist me with this important function.")|
|149||See Financial Executives Institute Comment Letter at 4 (Sept. 14, 2000).|
|150||Release, 65 Fed. Reg. at 43,192.|
|151||SECPS §1000.35 (April 2000).|
|152||Release, 65 Fed. Reg. at 43,192.|
|153||See AICPA Code of Professional Conduct 101-3; Financial Reporting Releases - Codification, § 602.02(e), 7 Fed. Sec. L. Rep. (CCH), para;73,267; Regulation S-X, § 2.01(b).|
|154||Like technology consultants, regulatory specialists often assist accountants performing audits of clients in the financial services industries. If the pro posed rule is adopted in its current form, accountants may no longer be able to utilize these specialists' expertise.|
|155||Release, 65 Fed. Reg. at 43,192.|
|156||Financial Reporting Release - Codification, § 602.02.e.ii, 7 Fed. Sec. L. Rep. (CCH) para;73,268.|
|157||We understand that the Staff previously indicated that it would not object to an accounting firm providing certain limited legal services overseas. The Staff's action was a recognition of the longstanding accepted practice in this area. The proposed rule would simply abrogate that understanding without any justification.|
|158||Release, 65 Fed. Reg. at 43,192.|
|159||AICPA Code of Professional Conduct Ethics Ruling 101.202-203.|
|160||Release, 65 Fed. Reg. at 43,190 (emphasis added).|
|161||Laskawy Address, supra note 42 at 14-15.|
|162||Release, 65 Fed. Reg. at 43,176.|