RESPONSE TO REQUEST FOR COMMENTS IN

SECTIONS V., VI., VII. AND VIII.

This Appendix responds to the Commission's request for comments in Sections V., VI., VII. and VIII. of the Release.

V. Cost-Benefit Analysis

While the Release contains a discussion of the costs and benefits of the proposed rule, the Commission has not conducted an economic study, nor has it considered the costs and benefits of other available alternatives, including not acting in this area. Given the importance of an economic study to the proposed rule, we believe that the Commission should have conducted a cost-benefit economic study before publishing the proposed rule for comment and that such an economic study is necessary for the public interest and the protection of investors before any final rulemaking action is taken.

A. Benefits Of The Proposed Rule

The Release states that the benefits of the scope of services proposals include: (1) the elimination of "certain uncertainties" as to when a company's auditor will not be recognized as independent; (2) increased investor confidence in financial reporting; (3) increased utility of annual audits by indirectly requiring a "second opinion" of some non-audit services; (4) increased revenue for consulting firms that, but for the proposed rule, would not have been hired; and (5) increased competition in the market for the provision of non-audit services by public accounting firms. TheRelease requests comments on all aspects of the identified benefits. We address each identified benefit separately.

Elimination of "certain uncertainties." As discussed in Section IV. of our scope of services letter,¹ we believe that the proposed rule, specifically with respect to the use of an appearance standard, the four general principles and the ten non-audit services, is too general to work as a rule. We believe the proposed rule will confuse, not clarify, auditor independence at all levels - firm administration, self-regulatory bodies and investors. We consider the added uncertainty and confusion in the auditor independence area to be a cost of the proposed rule, not a benefit.

Increased investor confidence. A goal of the proposed rule is to increase investor confidence in financial statements and the audit process. However, the Release does not cite any study or body of evidence that correlates investor confidence with the proposed rule or the type of regulation the proposed rule represents. We do not believe that the proposed rule will increase investor confidence. Indeed, the proposed rule may ultimately decrease investor confidence. Penn, Schoen & Berland Associates conducted a survey regarding investor confi dence in financial statements and audits.² The PSB Survey found that a majority of investors believe that the proposed rule may decrease the quality of audits because accounting firms will know less about the companies they audit.³

We believe that there are alternatives to the proposed rule that could achieve the Release's goal of increased investor confidence without imposing the costs of the proposed rule. The alternatives should be included in the above-mentioned economic study to determine their respective costs and benefits. A simple example of an alternative would be for the Commission to increase its review of and comment on financial statements by its Division of Corporation Finance. In 1995, the Commission Staff reviewed and commented on 5,080 filings.⁴ In 1999, that number decreased to 4,240, despite an increase in the number of reporting companies during that period.⁵ If the Commission would increase the number of reviews it performs annually back to or above its 1995 level, investor confidence in financial statements and audits may increase.

Increased utility of annual audits. The Release states that the proposed rule may increase the utility of annual audits by indirectly requiring a "second opinion" of some non-audit services. We do not believe that this would be a new benefit of the proposed rule. Rather, this is already a function of the audit process that is required to be performed by individuals other than those who provided the non-audit services. Generally accepted auditing standards require an accounting firm to obtain an understanding of internal controls sufficient to plan an audit by performing procedures to understand the design of controls relevant to an audit by financial statements⁶ and also require the performance of procedures to determine whether reliance on a specialist's work is appropriate.⁷ Therefore, the proposed rule would not result in an additional benefit.

Increased revenue for consulting firms. The Release states that the proposed rule may benefit other consulting firms that, but for the proposed rule, would not have been selected to perform services. Although the proposed rule would result in companies not selecting their accounting firm to perform certain non-audit services, this change could have the adverse effect of causing companies to use less efficient competitors as a result of a regulatory action. Companies would be denied access to the full range of firms providing high-quality, non-audit services. We consider thisartificial effect on the business of non-audit services to be a cost of the proposed rule, rather than a benefit.

Increased competition. The Release states that the proposed rule may increase competition in the market for the provision of non-audit services by accounting firms. As discussed in Section III.A.1. of our scope of services letter, we believe that competition will decrease for both audit and non-audit services if the proposed rule is adopted because there will be fewer service providers bidding for the same work. The proposed rule would bar at least one firm from bidding on the service, making the bidding process less competitive. To the extent that another accounting firm is attempting to become the principal auditor for a particular company or an affiliate of that company, more than one firm could be taken out of the bidding process for non-audit services. This would result in less competition and is a cost of the proposed rule, not a benefit.

Moreover, this benefit appears to be premised on the view that all audit and non-audit competencies of all major accounting firms are fungible in their expertise and ability to provide services. This is not the case in practice. For example, the audit and non-audit services provided by an accounting firm relating to the electric and gas utility industry may be superior and therefore far more sought after than the professional services of other accounting firms. The proposed rule would force a company in this industry to decide whether to hire the superior accounting firm as its auditor or, alternatively, as its non-audit service provider. Disabling one firm from providing its special expertise in this manner may result in companies being unable to obtain the best provider of services to meet its needs.

Finally, as described in Section II.A.1. of our scope of services letter, almost all auditors rely on non-audit competencies to perform a quality audit. The proposed rule would affect the manner in which these professionals are utilized within an accounting firm, thereby possibly decreasing their skills and negatively affecting the quality of the audit.

B. Costs Of The Proposed Rule

The Release states that the costs of the proposed rule are expected to be relatively minor. As described below, we believe that the Commission has not considered all of the costs or the effects of these costs. We believe that the costs of the proposed rule clearly outweigh any benefits that they may provide.

More companies and accounting firms affected by proposed rule. As described in Section III.A.1. of our scope of services letter, we believe that the proposed rule will significantly affect more companies and accounting firms than described in the Release, thereby increasing the estimated costs. We believe that the assumption in Section V. of the Release that only 25% of public companies engage their accounting firms to perform non-audit services is skewed. The Commission did not consider several factors that would substantially increase the cited percentage of companies who engage their accounting firms for non-audit services. First, the data only includes management advisory services, rather than all non-audit services thataccounting firms perform. Therefore, companies that engaged their accounting firms for litigation services, for example, were not taken into account in computing the percentage. Second, the data includes mutual fund companies, which generally do not require consulting services and constitute a large number of "companies" in the calculation. Third, the 25% calculation only covers one year. Even assuming arguendo that the percentage of companies purchasing non-audit services from their accounting firm remains static from year to year, the companies that purchase such services change from year to year. For example, company A may need a computer system in year 1, while company B may need that computer system in year 2. The proposed rule would bar both company A and company B from engaging their accounting firms for non-audit services, without increasing the 25% total in any one year. Based on these three factors alone, we believe that the percentage of companies affected by the proposed rule is significantly higher than the purported 25%.

Additionally, the proposed rule affects every accounting firm that provides audit and non-audit services to reporting clients, not just members of the Big 5. The proposed rule could impute to any accounting firm the activities of virtually any entity with which the firm has a business relationship by viewing such an entity as an "affiliate of the accounting firm." Each accounting firm would be forced to consider whether or not it could enter into joint ventures or partnerships, since the firm's independence could be impaired as a result of the activities of other parties in which it may have an immaterial investment, or with which it may beassociated in only limited respects, but does not control. Strategic alliances or cooperative arrangement involving an accounting firm could result in requiring each member of the alliance to comply with the proposed rule or for the accounting firm to monitor compliance for each member in order for the accounting firm to be in compliance. Moreover, the restrictions could extend to any alliance or cooperative arrangement with overseas accounting and other firms, such as legal service providers.

More negative effects than assumed. As stated in Section III.A.1. of our scope of services letter, we do not believe that the proposed rule will result in a mere redistribution of non-audit services among accounting firms. Instead, we believe that the proposed rule and the resulting market forces would cause accounting firms to consider restructuring and divesting themselves of portions of their consulting practices.⁸

Negative effect on recruitment and retention. If the proposed rule is adopted, we believe that there may be a negative effect on recruiting and retention of the best talent. The best non-audit professionals may not want to work at a firm where a large percentage of the market is "off-limits," and the same is true for the best audit professionals, whose future career paths would be more limited. Similarly, the best and brightest students may not be drawn to firms which have this type of limit on the opportunities that can be offered. The proposed affiliate definition is sobroad that it makes more entities "off-limits," increasing the negative effect on recruitment and retention. The "audit-only" firms that may result from the adoption of the proposed rule may have difficulty attracting the necessary talent both from accounting programs and from information technology programs. Talent will be drawn toward industries with broader career opportunities.⁹

Decreased competition. As discussed in Section V.A. of this Appendix, the proposed rule unnecessarily restricts reporting companies' freedom of choice in selecting providers of audit and non-audit services. We believe the proposed rule will result in decreased competition because it is likely that there will be fewer service providers bidding on the work. Decreased competition is a cost of the proposed rule, not a benefit.

Decrease in audit quality. As we described in Section V.A. of this Appendix, the proposed rule could require a company to decide whether to hire the superior accounting firm in its industry as its auditor or as its non-audit service provider. In the likely scenario in which a company selects the leading service provider in its industry to perform non-audit services, the company is forced to select another service provider to perform its audit. Because the service provider selected as the auditor does not have the industry expertise that the service provider selected as the consultant has, the quality of its audit may be compromised.

The proposed restrictions on non-audit services will also likely produce unintended consequences, such as undermining auditor independence by making accounting firms overly or exclusively dependent on auditing fees. Therefore, each audit client becomes that much more important to the firm as a source of revenue. In this scenario, auditors could, depending on their circumstances, attempt to keep clients in situations where they should not. This result is contrary to the public interest.

As noted above, such restrictions may also harm accounting firms in their recruitment and retention of the most qualified personnel, including non-audit professionals, thereby potentially harming the quality of audits.

Regulatory Uncertainty. As described on pages in Section IV. of our scope of services letter, the appearance standard, the four general principles and the ten prohibited services are vague, overbroad and will result in confusion and uncer tainty with respect to auditor independence. Regulatory uncertainty is a cost of the rule because of the time, effort and expense that will be needed by companies, audit committees and accounting firms, as well as the Commission itself, to interpret and resolve the uncertainties.

Costs of the Proxy Disclosure Rules. The Release estimates that the total annual costs of the proposed proxy disclosure requirements will be $272,260. We estimate that the actual cost of the proxy disclosure requirements to be at least 30 times as much as the amount in the Release. First, as discussed in Section VII. of this Appendix, we estimate that the average annual burden hours of the proposed requirements to be 50 to 100 hours for large companies and three to six hours for all other companies.¹⁰ Second, we question the Commission's estimate that 75% of the burden hours will be expended by internal company staff and the remaining 25% by outside professional assistance. The time-intensive burden of the proposed rule requires the gathering of information regarding audit fees, non-audit fees and composition of audit personnel.¹¹ It is just as reasonable to assume that the company will ask the auditor to provide some or all of this information. However, in calculating our estimate of the costs, we used the Commission's assumed 75%-25% split between a company's personnel and outside professional assistance. We also usedthe Commission's estimate of cost per hour of company personnel and outside personnel of $85 and $175, respectively, although we believe that these costs may be higher. Using these assumptions, we estimate that the total annual costs will be between $5 million and $10 million for large companies and between $3 million and $6 million for all other companies.¹² Therefore, we estimate that the total annual costs per year of the proposal proxy disclosure requirements will be between $8 million and $16 million.¹³

VI. Summary of Initial Regulatory Flexibility Analysis

The Regulatory Flexibility Act requires the Commission to prepare an Initial Regulatory Flexibility Analysis regarding the proposed amendments to Rule 2-01 of Regulation S-X and Item 9 of Schedule 14A. The Release states that the Commission does not believe that the proposed amendments regarding consulting and non-audit services or the proposed proxy disclosure requirements would have asignificant impact on a substantial number of "small entities," also referred to as "small businesses." Our comments are directed at this determination.

The Release states that the impact of the proposed proxy disclosure requirements on small businesses is not considered substantial because the requested proxy information should be readily available to companies under ISB Standard No. 1.¹⁴ In fact, ISB Standard No. 1 requires significantly less information than the proposed rule would require. ISB Standard No. 1 requires an accounting firm to annually:

• disclose to the audit committee (or board of directors if there is no audit committee) in writing all relationships between the accounting firm and its related entities and the company and its related entities that in the accounting firm's professional judgment may reasonably be thought to bear on independence;

• confirm in writing that, in its professional judgment, it is independent of the company; and

• discuss the accounting firm's independence with the audit committee.

In contrast to the information ISB Standard No. 1 requires, proposed Item 9(e) of Schedule 14A would require the following information:

• a description of each professional service provided by the principal accountant for which the fee was, is, or will be the lesser of $50,000 or 10% of the fee for the audit of the company's annual financial statements;

• disclosure of whether, before each professional service was rendered, the audit committee (or the board of directors if there is no auditcommittee) approved the service and considered the possible effect of the service on the principal accountant's independence;

• disclosure of the fee for each professional service;

• disclose the aggregate fee for the audit of the company's financial statements for the fiscal year most recently completed and for the reviews of the financial statements included in the company's Form 10-Q or 10-QSB for that fiscal year; and

• if greater than 50 percent, disclosure of the percentage of the hours expended on the principal auditor's engagement to audit the company's financial statements for the most recent fiscal year that were attributed to work performed by persons other than the principal accountant's full-time, permanent employees.

Proposed Item 9(e)'s disclosure requirements are above and beyond the aggregate information required to be collected or communicated to the audit committee by ISB Standard No. 1, Statement on Auditing Standards No. 61¹⁵ and the membership requirements of the SEC Practice Section of the AICPA.¹⁶ Due to the time, effort and expense required to collect and analyze the information, we believe that the additional information to be required by proposed Item 9(e) could have a significantadverse impact on a substantial number of both small businesses¹⁷ and small accounting firms.

In addition, we do not believe that the de minimis exception, as proposed, is meaningful to small businesses. It would except from disclosure those services that are less than the lesser of $50,000 or ten percent of the audit fee. For small businesses with relatively small audit fees, the exception would be hard to use. For example, a company with an annual audit fee of $100,000 would need to disclose any non-audit services over $10,000. Not only is the de minimis exception illusory for small businesses, but the proposed rule would require compliance by every small business that is subject to Section 12 of the Securities Exchange Act of 1934 ("Exchange Act"), not just the 25% of small businesses that the Release assumes.¹⁸ The proposed rule would also affect every small accounting firm that performs audits for reporting companies.

Without endorsing any one approach, we believe that there are other alternatives to the proposed rule that the Commission should have considered that are both consistent with the proposed rule's stated objectives and have the potential to minimize the significant adverse impact of the rule on small entities. For example, in 1977 the Commission proposed,¹⁹ but did not adopt a proxy disclosure requirement that would have required the disclosure of the fee for each non-audit professional service.²⁰ Commenters on the 1977 proposal believed that this disclosure would be particularly detrimental to small businesses and small accounting firms. The commenters believed the disclosure requirement would pressure small businesses to reduce or eliminate non-audit services, when those same companies had limited internal expertise and were often the most in need of using a wide range of non-audit services. Instead of adopting the specific dollar amounts in the 1977 proposal, the Commission's final rule in 1978 required disclosure of "percentage relationships" of non-audit fees to audit fees. The Release does not discuss the need for the disclosure of dollar figures, rather than percentages, nor does it discuss the adverse effect that specific dollar amount disclosure could have on small businesses. Without such an explanation, the Commission should not impose a greater burden on small businessesthan the previous rule that was in place to collect the same information for the same purpose, especially when a similar proposal was considered and not adopted.

VII. Paperwork Reduction Act

On August 22, 2000, we submitted a comment letter, together with Arthur Andersen LLP, KPMG LLP and the AICPA, to the Office of Management and Budget commenting on the proposed rule.²¹ We commented on the following aspects:

• the proposed rule lacks practical utility for investors;

• the Commission underestimated the burden of the proposed collection of information; and

• the rule proposal constitutes a major rule.

Specifically, we have the following comments on the necessity of the rules for the proper performance of the Commission's function; the accuracy of the estimated number of burden hours; ways to enhance the clarity of the proposed rule; and ways to minimize the burden on the collection of information.

A. Necessary For The Proper Performance Of The Functions Of The Agency, Including Whether The Information Will Have Practical Utility

We do not believe that the proposed collection of information has practical utility. The proposed rule relates to the disclosure of non-audit services, many of which the Release proposes to ban.²² We question the necessity of the proposed rule in the scheme of the Release. Further, the Release states that the proposed proxy disclosure "may be material to an investor's decision to vote on the selection or ratification of the auditor."²³ This statement seems to proceed from a faulty assumption. Neither the federal securities laws nor most state corporation laws, including the Delaware General Corporation Law, require stockholders to approve or ratify the company's outside auditor. The certification under the Paperwork Reduction Act does not demonstrate how, in the absence of a stockholder vote, the disclosure of this information has practical utility. Moreover, the PSB Survey shows that investors believe, by a three to one margin, that audit committees and boards of directors are best positioned to decide whether or not it is appropriate for the accounting firm to provide non-audit services to the company.

B. Accuracy Of The Average Number Of Burden Hours

The Release states that the proposed collection of information will add one hour to the burden hours of Schedule 14A for only 25% of reporting companies. We believe this estimate is significantly understated.

The proposed collection of information will add burden hours for 100% of the companies subject to Section 14 of the Securities Exchange Act of 1934, not just 25%. This is because the proposed rule requires 100% of the companies subject to Section 14 to disclose the aggregate fee for the audit of the company's financial statements for the fiscal year and each fiscal quarter.²⁴ The proposed rule also requires 100% of the companies subject to Section 14 to review their records to determine whether they must comply with the other sections of the proposed rule.²⁵ As a corollary, the proposed rule will require 100% of accounting firms with reporting clients to collect and review personnel information for every reporting client.

The Release states that the information required to be disclosed is readily available to companies because of the requirements of ISB Standard No.1.²⁶ In our experience, this information frequently is not readily available and in anyevent may not be current at the date of the proxy statement is mailed. As we discussed in Section VI. of this Appendix, the proposed rule requires more information to be collected and disclosed than is readily available or required today. The collection and disclosure of this additional information will require time, effort and expense for every reporting company and accounting firm.

The amount of time required to collect this additional information will vary from company to company, based on many different factors. Factors that would affect the amount of time required by a company include: the size of the company, the corporate structure, the number of reporting locations within the company, whether the financial reporting system is centralized or decentralized, and the difficulty experienced in obtaining information from foreign locations, if applicable.²⁷

While it is difficult to estimate the average hours without an empirical study, we believe, based on our experience, that companies with basic reporting systems would require an average of approximately three to six hours to collect and produce the proposed information. We believe that large companies with complex reporting systems would require an average of approximately 50 to 100 hours to collect and produce the proposed information. These estimates are significantly higher than the Commission's estimates.

C. Ways To Enhance The Clarity Of Information To Be Collected

We believe that the text of the proposed rule is confusing. The proposed rule would require companies to "describe each professional service provided during the most recent fiscal year by the independent public or certified public accountant that is the company's principal accountant."²⁸ While there is no definition of "professional service" in the proposed rule, the Release states that companies will "include in their proxy statements certain disclosures about non-audit services provided by their auditors during the last fiscal year."²⁹

D. Ways To Minimize The Burden Of Proposed Collection Of Information

The proposed rule requires companies to disclose the aggregate fee for the audit of the company's financial statements and for the review of the quarterly reports.³⁰ We do not believe that this information is necessary for the proper performance of the functions of the Commission and we note that this approach was considered and rejected by the Commission in 1978.³¹ At that time, commenters believed disclosure would result in an inappropriate comparison of audit fees for different companies. The reasons given by commenters as to why the amounts werenot comparable included the use of different accounting systems and the number of locations of accounting records and assets. Another criticism was that the disclosure of audit fees may create pressure to reduce those fees and that such pressure may ultimately result in lower quality audits. The Commission addressed these concerns by requiring disclosure of percentage relationships of non-audit fees to audit fees, rather than dollar amounts. Without an explanation for the need for greater disclosure than was previously required, the Commission should not increase the disclosure burden on companies.

The proposed rule also requires a description of each professional service, unless that service's fee was, is or will be less than the lesser of $50,000 or 10% of the fee for the audit of the company's annual financial statements.³² As adopted in 1978, these disclosure requirements provided an exception for any non-audit service that was less than 3% of the audit fees.³³ We believe that for many companies in today's market, $50,000 will be the practical threshold, rather than the 10%, or even the 3% of audit fees. We believe that the low threshold will result in the disclosure of insignificant expenditures by hundreds, if not thousands, of companies. Collection and evaluation of fee and service information would also be burdensome and time consuming on all reporting companies. These burdens wouldbe incurred even if the company ultimately determined that no disclosure regarding non-audit services is required.

We believe that the Commission may also minimize the burden of the proposed rule by requiring the disclosure only when the stockholders vote on the approval or ratification of the company's accounting firm.

VIII. Consideration Of Impact On The Economy, Burden On Competition, And Promotion Of Efficiency, Competition, And Capital Formation

A. Section 23(a)(2) Of The Exchange Act

Section 23(a)(2) of the Exchange Act requires the Commission to consider the anti-competitive effects of any rule it proposes for adoption under the Exchange Act. In the Release, the Commission states that the proposed rule will increase competition by removing the accounting firm's competitive advantage in bidding on or otherwise obtaining non-audit work required by audit clients. For the reasons described in Section V.A. of this Appendix, we believe that the proposed rule will actually decrease competition in the selection of audit and non-audit services. Thus, Section 23(a)(2) requires further consideration by the Commission.

B. Section 3(f) Of The Exchange Act

Section 3(f) of the Exchange Act requires the Commission to consider or determine whether an action is necessary or appropriate in the public interest and to consider whether the action will promote efficiency, competition, and capital formation. The Release states that the proposed rule will increase investor confi dence in the integrity of the audit process and in the audited financial information, and that this increased sense of confidence should promote market efficiency and capital formation. We disagree with the premise of this position. We do not believe that the proposed rule will increase investor confidence in the audit process or the audited financial statements. The Release provides no evidence that there is a correlation between non-audit services and investor confidence. In contrast to the Commission's concerns, the PSB Survey shows that 91% of individual investors say that they have confidence in the annual audits of companies they invest in. While we support the Commission's goal of increasing investor confidence, we believe that the Commission should study this premise before proceeding with this rulemaking.

We also believe that there are alternatives to the proposed rule which should be studied since they could increase investor confidence in the audit process and audited financial statements without the negative consequences of the proposed rule. For example, we believe that the Commission could increase investor confidence with less cost if it increased its review and comment process of financial statements. This could include an increase in the number of reporting company reviews the Staff performs every year. As described in Section V. of this Appendix, the Commission's review of filings decreased by 16% from 1995 to 1999 while the number of companies reporting under the Exchange Act increased.

We believe that the proposed rule may also create inefficiencies in the selection of providers of non-audit services and may decrease the amount of competi tion for non-audit services. We question whether adopting the proposed rule, and thereby removing any "competitive advantage" that exists for accounting firms in providing non-audit services, may inadvertently result in a more costly, less efficient marketplace. It is an axiom of state corporation law that the members of boards of directors have a fiduciary duty to act in the best interest of stockholders. An accounting firm may be selected to perform non-audit services, rather than other firms, because the non-audit work requires intimate knowledge of the company. The accounting firm may be in the best position to provide work in an efficient manner because it would take a period of time and expense for another firm to obtain similar knowledge about the company. Stated another way, selecting an accounting firm to perform non-audit work may often be the most efficient decision for a company and the one that is in the best interests of its stockholders. We believe that the proposed rule will create inefficiencies in this process that will result in increased costs which will not benefit stockholders or the investing public. Even the Release implicitly acknowledges these increased inefficiencies. The Release considers the fact that consulting firms that would not have otherwise been selected to perform services may be selected because of the prohibitions contained in the proposed rule.³⁴

Finally, the Release requests that we provide empirical data to support our views. We strongly agree that empirical data is necessary for an appropriateanalysis of the effects of the proposed rule on the economy, competition, efficiency and capital formation. However, the abbreviated comment period permitted by the Commission has limited our ability to provide as fulsome of an analysis as would otherwise be performed.

Footnotes