Comment Letter of Deloitte & Touche on the Proposed Revision
of the SEC's Auditor Independence Requirements
Regarding Financial and Employment Relationships
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 IndependenceRequirements, File No. S7-13-00 - Financial and Employment Relationships
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 addresses all aspects of the proposed rule except those relating to scope of services, which are addressed in a separate comment letter.
___________________________
* 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
Page
I. Introduction And Executive Summary
III. The Proposed Rule Regarding Investments In Audit Clients
IV. The Proposed Rule Should Provide Certain ExceptionsFor Employer-Sponsored Benefit Plans
V. The Proposed Rule Regarding "Other Financial Interests" Should Be Modified
A. Applicability In Foreign Countries
C. Savings And Checking Accounts
VI. The Proposed Exceptions Would Provide More Meaningful Protection With Certain Modifications
VIII. The Proposed Business Relationship Rule
IX. The Quality Controls Provisions Should Be Modified
I. Introduction And Executive Summary
The Securities and Exchange Commission's (the "Commission") proposed rule governing financial and employment relationships between auditors and their family members and audit clients represents a significant step towards modernizing the independence rules. The Commission has recognized that changes in the existing rules are necessary due to "significant demographic changes, changes in the accounting profession, and changes in the business environment that have affected firms."1 Indeed, the increase in dual-career families, the increased mobility of professionals, and the broadening international presence of audit firms and their clients have altered the landscape in which the accounting profession operates.2 The financial interests and employment relationship rules are in need of updating and we support efforts to realize this goal.3
We believe, however, that it would be preferable for the Independence Standards Board ("ISB") to develop standards in this area, and we believe that the Commission should defer to the ISB as the appropriate private sector body for that purpose.4 Indeed, the ISB already has several projects underway or completed in this area. In fact, the Commission's proposed rule regarding financial interests and employment relationships appears to be directionally consistent with the ISB's work.5
While we believe the Commission should defer to the ISB, the proposed rule, if adopted, would lead to unintended consequences, raising a number of concerns, including the following:
II. The Proposed Definitions Of "Affiliate Of The Accounting Firm," "Affiliate Of The Audit Client" And "Covered Persons In The Firm" Are Flawed And Should Be Modified
A. The Definition Of An "Affiliate Of The Accounting Firm" Should Be Limited To Those Third Parties That Warrant Being Treated Like The Accounting Firm For Independence Purposes
The proposed definition of "affiliate of the accounting firm" would broadly encompass, among other things, any joint venture or partnership or other undertaking in which the accounting firm participates and in which the parties agree to any form of shared benefits, including any form of shared revenue, income or equity appreciation.6 The consequences of being deemed an "affiliate of the account ing firm" are profound, in that any entity that is deemed an "affiliate of the accounting firm" would be subject to all of the independence requirements to which the accounting firm is subject.7
Deloitte & Touche, like other major accounting firms, has a number of relationships with other companies that provide the firm with access to diverse skills, tools and technologies that enhance audit quality. These relationships are beneficial to investors, audit clients and the public. They allow us to better understand the businesses and dynamics of audit clients. They also allow us to work closely with other companies to provide better and more affordable products and services. The proposed rule could result in the loss of these relationships. For example:
The proposed definition of an "affiliate of the accounting firm" would stymie these relationships by broadly including in its definition relationships that are neither found in, nor contemplated by, the current definition of an "affiliate" in Regulation S-X.8 The Release provides no adequate basis or explanation for extending the definition of "affiliate" beyond that found in Regulation S-X, much less creating multiple definitions of the same term.9 In short, the proposed definition would make it virtually impossible for accounting firms to maintain relationships with third parties, including relationships with non-audit clients that have helped to enhance audit quality. Under the proposed definition, even when a relationship doesnot impair independence and is beneficial to investors, audit clients and the public, the relationship might nonetheless cause an entity to be deemed an affiliate of the accounting firm, subject to all of the prohibitions placed on the accounting firm. Accordingly, third parties willing to enter into such a relationship with an accounting firm would incur the costs and burden required to monitor their compliance with the independence requirements of the accounting firm. Requiring third parties to comply with the independence rules applicable to accounting firms would be impractical. This problem will be exacerbated where third parties have relationships with more than one major accounting firm, requiring the third party to comply with the independence requirements applicable to each of those accounting firms. As a practical matter, third parties will likely sever or avoid these relationships, rather than comply with the independence rules. Clearly, this outcome is not in the public interest.
Relationships with third parties would be further hampered under the prohibition on investments by audit clients or affiliates of audit clients in the affiliates of accounting firms.10 In the IBM example above, our more than 2,000 SEC audit clients and presumably their pension plans would be unable to invest in IBM. Many companies will likely be unwilling to forfeit the investment opportunities potentially available to them from an accounting firm's numerous audit clients andaffiliates of those audit clients. Additionally, it would be difficult and expensive for an accounting firm to assure that none of its audit clients or their affiliates have a direct investment in third parties with which the accounting firm either has a relationship or is considering a relationship. As a result, business relationships that would have otherwise been undertaken with accounting firms will be unlikely to occur.
In light of these very serious concerns, the rationale for the proposed definition is sorely deficient. The Release states that the portion of the definition relating to joint ventures and partnerships is based upon the governing principle that such relationships create a "mutuality of interest between the auditor and its partner or shareholder because the revenue or profits accruing to each party depend, to some degree, on the efforts of each."11 The Release does not explain how such a mutual interest could impair an auditor's independence, particularly if the revenue derived from the relationship is not significant to the firm. Such a construction ignores the fact that the parties also have a mutual interest in providing to their clients the best products or services possible, including those that would improve audit quality.
Additionally, the Release states that entities that provide non-audit services to one or more of the accounting firm's audit clients, and in which the accounting firm has any equity interest, has loaned funds to, shares revenue with, orwith which the accounting firm or any covered persons has any direct business relationship, should be considered an "affiliate of the accounting firm" because "the actions and investments of the consulting entity are fairly attributed to the accounting firm because the accounting firm's interest in the consulting entity creates a mutuality of interest in the promotion and success of the entity's consulting projects."12 The proposed definition's use of "any direct business relationship" and "any equity interest" is overbroad and would capture relationships that would not create a mutuality of interest, such as the relationship with the payroll service provider described above.
B. The Prohibitions Against Certain Relationships With An "Affiliate Of The Audit Client" Should Be Limited To Those Affiliates That Are Material To The Audit Client
The proposed rule defines an "affiliate of the audit client" as an entity that has significant influence over the audit client, or an entity over which the audit client has significant influence.13 This proposed definition of an "affiliate of theaudit client" is overbroad, unnecessary and unworkable in today's global economy in which companies are highly diversified and evolve rapidly. Considering the large market capitalization of many of today's public companies, a modest investment would often place such a company in a position to exercise significant influence, even though the investment is not material to the investor. In other words, the proposed rule would require the auditor of Company A to be independent of Company B, a non-client, if Company A has an investment in Company B, which makes Company B an affiliate of Company A, even though the investment is immaterial to Company A. In other words, Company A's investment in Company B could be .001% of Company A's total assets, but Company A's auditors would have to be independent of Company B.
The consequences of adopting this broad definition of an "affiliate of the audit client" are severe. In the example above, independence may be impaired if covered persons of the accounting firm conducting the audit of Company A havecertain relationships with Company B including: (1) investments;14 (2) loans; (3) savings or checking accounts; (4) brokerage accounts; (5) credit card balances; (6) individual insurance policies or professional liability policies;15 (7) business relationships;16 and (8) certain employment relationships.17 Yet there is no evidence that these relationships with an "affiliate of the audit client," as defined, impair independence when the affiliate is immaterial to the audit client. The consequences of adopting this broad definition of an "affiliate of the audit client" would be exacerbated by the extensive financial and employment relationship restrictions between audit clients or affiliates of audit clients and the affiliates of accounting firms.
The application of the proposed rule to certain relationships between auditors and affiliates of audit clients should be limited to only those affiliates that are material to the audit client.18 This modification is more likely to identify thoserelationships that may impair an auditor's independence and would avoid undue hardships to registrants and accounting firms in situations where registrants have numerous affiliates that are immaterial to them. For example, the proposed rule would unnecessarily require the spouse of a covered person to transfer assets out of his or her brokerage account held at an immaterial affiliate of an audit client to the extent the value of such assets exceed the Securities Investor Protection Corporation ("SIPC") coverage.19 There is no threat to an accounting firm's independence where the affiliate is not material to the audit client, and the accounting firm does not audit the affiliate.
C. The Definition Of "Covered Persons In The Firm" Should Include Only Those Who Have The Ability To Influence The Audit
The proposed rule defines the professional personnel in the accounting firm to whom the independence rules apply through its definition of "covered persons" and includes four categories of persons: (1) the audit engagement team; (2) those in the "chain of command"; (3) any other employee of the accounting firm whois "involved in providing any professional service to the audit client or an affiliate of the audit client"; and (4) partners, shareholders and principals in any "office" of the accounting firm that participates in a significant portion of the audit.20 We agree that those who are in a position to influence an audit should be included in the definition of "covered persons" under the proposed rule. Thus, for instance, the audit engagement team should always be prohibited from entering into certain relationships with audit clients.
However, in other respects the definition is both overbroad and under inclusive. First, the proposed definition of "chain of command" includes all individuals who have any type of responsibility over members of the audit engagement team even though many of these individuals will have no influence over the audit. Second, the proposed definition uses an overbroad and unworkable definition of the term "office" that would include as covered persons partners who have absolutely no involvement with the audit and therefore no ability to influence the audit; indeed, with a more focused definition of "chain of command," the "office" concept becomes unnecessary. Third, the proposed definition unnecessarily includes all professionals providing non-audit services to an audit client. Fourth, the definition should include leased personnel who are on the audit engagement team.
1. A Modified "Chain Of Command" Concept Makes The "Office" Concept Unnecessary
The proposed rule defines "chain of command" to include, among others, "all persons having any supervisory, management, quality control, compensation, or other oversight responsibility over either any member of the audit engagement team or over the conduct of the audit."21 While we support the use of a "chain of command" model, the proposed definition of "chain of command" is overbroad in its inclusion of all individuals who have any type of responsibility over any member of the audit engagement team, regardless of whether such responsibility has any bearing on the audit. The Release states that the "chain of command" is "defined broadly to refer to the group of people in the accounting firm who, while not directly on the audit engagement team, are capable of influencing the audit process either through their oversight of the audit itself or through their influence over any member of the audit engagement team."22
The proposed definition of the "chain of command" would unnecessarily include many individuals who have no direct or indirect responsibility or influence over the audit and who would not be in a position to influence members of the audit engagement team. Simply having any supervisory, management, qualitycontrol, compensation, or other oversight responsibility over members of the audit engagement would not necessarily place an individual in a position to influence either the audit or a member of the audit engagement team. Consider the following examples applicable to us:
In defining the "chain of command," the proposed rule should focus upon who has the ability to influence the conduct of the audit, particularly the audit conclusions to be reached in forming an opinion on the financial statements. Forexample, we believe the following "chain of command" model based on our organizational structure provides a meaningful, yet flexible, framework that would encompass all individuals with the ability to influence the audit.
This model includes all individuals having any supervisory responsibility, or other control, over the conduct of an audit, review or attestation engagement. It also recognizes that certain individuals are in a position to influence the audit because of their positions in the firm and others who are brought in to the chain of command because they are consulted with respect to a specific accounting or auditing matter.
Consistent with our view that those who are capable of influencing the audit process should be independent of the audit client, we believe that the term "position to influence" would be a more appropriate descriptor than "chain of command." As discussed below, we believe that this modified "chain of command" or "position to influence" concept makes the inclusion of an "office" concept unnecessary.
2. The Use Of The "Office" Concept Does Not Provide A Useful Framework For Determining Who ShouldBe A "Covered Person"
The proposed rule also defines a covered person to include any other partner, principal, or shareholder from an "office" of the accounting firm that participates in a significant portion of the audit.24 As discussed above, we believe the "chain of command" concept, as modified by our comments, captures all individualsoutside the audit engagement team that could possibly influence an audit and obviates any need to include within the definition of covered persons an "office" concept. Also, due to growth in the accounting profession and technological innovations, the traditional "office" has become an unusable, archaic term.
The Release states that the definition of covered persons includes partners from an "office" that participate in a significant portion of an audit because:
They are the ones most likely to interact with the audit engagement team on substantive matters and to exert influence over the audit engagement team by virtue of their physical proximity to, or relatively frequent contact with, the audit engagement team.25
We disagree with this reasoning. First, professional personnel, regardless of their "office," who are consulted on substantive matters, even sporadically, by the audit engagement team would be included in our modified definition of "chain of command." Given the way in which business is conducted and people communicate today, the "physical proximity" denoted by the address on one's business card does not necessarily equate to "frequent contact" with others sharing that address.
The use of an "office" concept, delineated along geographical or practice lines may result in unintended consequences. For example, there could be two partners who are assigned to the same office: Partner A is a mutual fundspecialist and Partner B is a healthcare specialist, and both only participate in, and consult on, audits of clients in their industry; yet under the proposed rule, neither partner could have an investment in any of the other partner's clients because they are assigned to the same office.
We also believe the concept of defining an "office" along practice lines is problematic. For example, our personnel who serve public utility clients are organized within a national practice that could under the proposed rule be deemed an "office." In this instance, one should not presume that a public utility partner in Virginia would influence the audit of a California public utility client. Nonetheless, under our proposed modified concept of "chain of command," the Virginia partner would be restricted from investing in the California client if he or she was in fact consulted on the audit of that client.
We believe that if the "chain of command" concept is modified to include all professional personnel who have the ability to influence the conduct of the audit, the "office" concept is unnecessary.
3. The Definition Of "Covered Persons In The Firm"Unnecessarily Includes All Professionals Providing Non-Audit Services
The definition of "covered persons in the firm" is overbroad in its inclusion of all professionals who provide consulting or other non-audit services tothe audit client.26 The Release states that these professionals are included "because the auditing literature, quite appropriately, directs the audit engagement team to discuss certain matters with the firm personnel responsible for providing such services to that client."27 However, the professional personnel in accounting firms who would be responsible for providing consulting and other non-audit services, and who are likely to be consulted by the audit engagement team, would be partners and managerial employees, not all of the professional personnel who provided such services. The proposed rule is thus too broad.
We suggest that the definition be limited to the partners and managerial employees responsible for the consulting and other non-audit services provided to the audit client as they may be in a position to influence the audit, whereas staff level employees are not. There is no need to include all such professional employees as "covered persons" if they in fact are not, and will not be consulted, by the audit engagement team.28
4. The Definition Of "Covered Persons" Should Include Certain Leased Personnel
The definition of "covered persons" should include leased accounting personnel, employed full-time or part-time by an accounting firm, on the audit engagement team. These individuals should be considered to be in the same position as the accounting firm's professionals on the audit engagement team. They will similarly be in a position to influence the quality of the audit, and the accounting firm's independence may be impaired if they have a prohibited financial interest in an audit client.
III. The Proposed Rule Regarding Investments In Audit Clients
A. The Proposed Rule On Indirect Investments In An Audit Client Should Include A Workable Materiality Standard
The proposed rule also prohibits "any material indirect interest in an audit client, including: (1) Ownership of more than five percent of an entity that has an ownership interest in the audit client; or (2) Ownership of more than five percent of an entity of which the audit client has an ownership interest."29 The proposed rule is vague because it does not provide sufficient guidance in applying materiality. Following the text of the proposed rule to its logical conclusion, the investments enumerated in (1) and (2) would be material indirect investments. Such a result would suggest that independence would be impaired if an accounting firm invests an immaterial amount to acquire 5.1% of a company of which the audit client owns one share. There is no sound basis for a restriction on such investments and it does not further the Commission's goals.
The only point in the Release that provides any guidance on how materiality should be applied is found in Footnote 131, which states that "we have used the term 'material' in our proposed rules in the sense that it has been used in ourcurrent independence rules."30 Footnote 131 cites to section 602.02.b.iii. of the Codification, "Interests in Nonclient Affiliates and Investee Companies" and ASR No. 79.31 Section 602.02.b.iii. of the Codification, however, states that:
An immaterial financial interest in a nonclient investee of a client company would not have an adverse effect on the independence of the auditor of the client/investor where the investor's investment in the investee does not exceed five percent of the investor's consolidated total assets and the investor's equity in the investee's income from continuing operations before income taxes does not exceed five percent of the investor's consolidated income from continuing operations before income taxes.32
The materiality standard in section 602.02.b.iii. is not reflected in the text of the proposed rule. Rather, the proposed rule appears to prohibit the covered person from owning more than five percent of any entity in which the audit client has any ownership interest. We believe that the materiality determination should be based upon a comparison of the auditor's or accounting firm's proportionate interestof the investment in the audit client with the net worth of the auditor or the accounting firm at the time of the investment.33
The proposed rule is also both underinclusive and overinclusive because it encompasses financial interests which would not impair independence, while allowing other financial interests that may impair independence. For example, the proposed rule appears to prohibit an accounting firm from owning 5.1% of the shares of a non-client mutual fund that owns only .001% of the outstanding common shares of an audit client. On the other hand, the proposed rule appears to allow an accounting firm to own 4.9% of the shares of a mutual fund having a majority of its assets invested in the equity securities of an audit client. We fail to see why independence could be impaired in the former, but not the latter.
Rather than the proposed rule, we believe the Commission should follow the ISB's proposed approach regarding material indirect interests, which would provide clarity and a more meaningful rule. Indeed, a clear rule that can be applied to the myriad of investment products that may encompass indirect interests through other entities (e.g., mutual funds, unit investment trusts, etc.) is sorely needed. The ISB's proposed approach provides that independence would be impaired if the accounting firm, or any covered person, has a material indirect interestin the audit client.34 Furthermore, the ISB's proposed approach would clearly distinguish between what would constitute an "indirect investment" and a "direct investment." The ISB's proposed approach states that:
[T]he term "indirect investment" means an investment in one or more investees through an intermediary, such as a mutual fund, unless: a. The holder of an interest in the intermediary has control over that entity or its investment activities; or b. The intermediary has an investment in the investee that amounts to 20% or more of its total investments, in which case the investment is considered to be direct.35
Additionally, considering that auditors will have no practical and timely way to determine changes in the amount of a registered investment company's assets that are invested in an audit client, the determination of what percentage of a registered investment company's assets are invested in an audit client should be made at the time of the investment. Such a standard would provide further protection against unavoidable, inadvertent violations of the independence rules and would simplify the independence rules relating to investments in common investment vehicles such as mutual funds and unit investment trusts.
B. The Proposed Five Percent Rule Should Be Modified For Certain Persons To Focus On Significant Influence Or Control
The proposed rule states that an accounting firm will not be independent of an audit client if:
Any partner, principal, shareholder, or professional employee of the accounting firm, any of his or her immediate family members, or any close family member of a covered person in the firm, or any group of the above persons has filed a Schedule 13D or 13G with the Commission indicating beneficial ownership of more than five percent of an audit client's equity securities, or otherwise controls an audit client.36
Although the beneficial ownership of a considerable percentage of an audit client's equity securities might create the perception that an accountant's independence is impaired, the Release provides no explanation for why the ownership of more than five percent of a registrant's equity securities by a professional employee of an accounting firm who is not on the audit engagement team or in the chain of command would impair an accounting firm's independence. A bright-line threshold of five percent applicable to all firm employees and their family members would create an undue burden . For example, under the proposed rule an accounting firm's independence would be impaired if a first year New York office staff accountant with no involvement in the audit has a spouse who beneficially owns 5.1% of theequity securities of a public audit client that is controlled by unrelated third parties and is audited by personnel in the firm's Los Angeles office.
The proposed rule should be modified to provide a more meaningful and workable standard, as follows:
All: |
Cannot Have: |
Covered persons and their immediate family members. |
Any direct or material indirect investment in audit client. |
Partners and their immediate family members. Close family members (other than immediate family members) of the members of the audit engagement team. |
Beneficial ownership (as evidenced by the filing of a Schedule 13D or 13G) of more than five percent of a class of an audit client's equity securities, or significant influence or control over an audit client. |
Professional employees who are not covered persons, and their immediate family members. Close family members (other than immediate family members) of covered persons (other than the audit engagement team). |
Significant influence or control over an audit client. |
Close family members of partners who are not covered persons. |
Control over an audit client. |
This construction provides a more meaningful framework because it appropriately restricts the investment of individuals based on the particular person's ability to influence the audit, or based on whether a particular investment could create an appearance issue.
IV. The Proposed Rule Should Provide Certain Exceptions For Employer-Sponsored Benefit Plans
The proposed rule should provide exceptions for employer-sponsored benefit plans of the immediate family members of certain covered persons, when those benefit plans involve: (1) insurance products;37 (2) direct investments;38 and (3) investment company complexes.39 Such exceptions would further the Commission's goal of modernizing the independence rules in light of the increase in dual-career families.40
The definition of covered persons and proposed rule 2-01(c)(1)(ii)(F) would prohibit the immediate family members of covered persons from obtaining an individual insurance policy originally issued by an insurer that is an audit client or an affiliate of an audit client. It is not clear whether the immediate family member of a covered person may obtain insurance through an employer-sponsored benefit plan.
Although there is no evidence of any threat to independence in this situation, the proposed rule presents the dual-career couple with the choice ofselecting a potentially less attractive insurance option or changing the status, role, or location of the auditor, which in many cases would be impractical. For example, an accounting firm may be unable to relocate an uninvolved partner41 from an office that participates in a significant portion of the audit, effectively leaving the couple with choosing a less desirable insurance policy as the only alternative option. An exception for insurance offered under employer-sponsored benefit plans for immediate family members of covered persons would appear to be appropriate.
Proposed rule 2-01(c)(1)(i)(A) would prohibit any investment in an audit client or an affiliate of the audit client by covered persons and their immediate family members. Through the definition of covered person, the proposed rule would prohibit all such investments by the immediate family members of uninvolved partners. This proposed rule does not provide an exception for investments, in the form of stock compensation, by the immediate family members of such persons obtained through employer-sponsored benefit plans.
Under the proposed rule, an accounting firm's independence would be impaired if an uninvolved partner's spouse, who works for an audit client in a non-restricted role, receives matching amounts in the client's common stock for his or her contributions to a 401(k) plan. We believe such a result would be inequitable because the employee might be restricted from selling the stock for a period of time, or until the stock is vested. Furthermore, under the proposed rule, an accounting firm's independence would be deemed impaired if an uninvolved partner's spouse obtains any stock options in an affiliate of an audit client served by the partner's office. There is no evidence of any threat to independence created by stock ownership in such cases, but the inability to participate in these plans would make such employment by immediate family members much less desirable.42
Although we believe that it is unnecessary to include uninvolved partners as covered persons, at a minimum the proposed rule should provide an exception for stock compensation offered under employer-sponsored benefit plans for immediate family members of uninvolved partners. Such an exception should apply to all employer-sponsored benefit plans, such as 401(k) plans; matching share plans; restricted stock plans; stock purchase and award plans; and stock option plans.
C. Investment Company Complexes
Proposed rule 2-01(c)(1)(ii)(G) would prohibit covered persons and their immediate family members from investing in any entity in an investment company complex if the accounting firm's audit client is also an entity in the same investment company complex. Accordingly, the proposed rule would prohibit the immediate family members of an uninvolved partner from investing in an audit client fund or non-client sister fund through an employer-sponsored benefit plan. This result does not promote the Commission's objective of modernizing the independence rules to accommodate two-income families.
Again, although we believe that it is unnecessary to include uninvolved partners as covered persons, at a minimum this proposed rule should provide an exemption for investments by immediate family members of uninvolved partners in client funds and non-client sister funds through an employer-sponsored benefit plan. There is no evidence of any threat to independence presented by ownership of a mutual fund in such cases, particularly when the plan sponsor is not an audit client. However, the inability to participate in the employee benefit plan is a substantial penalty to immediate family members.
V. The Proposed Rule Regarding "Other Financial Interests" Should Be Modified
Proposed rule 2-01(c)(1)(ii) lists several "other financial interests" between an auditor and an audit client that would impair independence because, according to the Release, "they create a debtor-creditor relationship or other commingling of the financial interests of the auditor and the audit client."43 These "other financial interests" include: (1) loans; (2) savings and checking accounts; (3) broker-dealer accounts; (4) futures commission merchant accounts; (5) credit card balances; (6) insurance products; and (7) any investment in an investment company complex. Although we believe that restrictions on certain direct financial interests in an audit client, such as loans and certain credit card balances, are warranted, many of the "other financial interests" in audit clients identified in proposed rule 2-01(c)(1)(ii) are not the type of financial interests that would impair independence. For example, there is no evidence that an auditor's independence would be impaired if a covered person had a checking account containing an immaterial uninsured balance.44
The proposed rule also would prohibit other ordinary consumer transactions. For example, the purchase of an individual insurance policy, by an immediate family member of a covered person, issued by an audit client in theordinary course of business, and under normal terms and conditions, should not impair independence.45 Products or services obtained as a consumer in the ordinary course of business, such as insurance, do not create any incentive that impairs an auditor's objectivity.
The proposed rule on "other financial interests" is also overbroad in its application to a wide range of covered persons. This proposed rule uses the same definition of covered persons applicable for "investments in audit clients" in proposed rule 2-01(c)(1)(ii), even though the delineated "other financial interests" are not of the same nature as investments in audit clients, which are more likely to cause an independence concern. For example, there is no evidence that an accounting firm's independence would be impaired if the spouse of an uninvolved partner had a $10,001 balance on a credit card issued by an audit client.46 Given these concerns, we believe the Commission should follow the ISB's proposed approach of applying restrictions on "other financial interests" to the accounting firm and professional employees directly involved in providing audit services to the audit client.47
A. Applicability In Foreign Countries
The proposed rule on "other financial interests" is premised on the concept that an accounting firm must be independent not only in fact, but also in appearance. However, as discussed in our comment letter on the scope of services provisions of the proposed rule, the appearance of auditor independence varies from country to country.48 What may appear to present an independence issue in one country may be perfectly acceptable, or even required, in another country.
The appearance of independence is dependent on many factors, including the country's culture, economic environment, business traditions, regulatory structure and legal environment. The SEC Staff has acknowledged that the perception of independence is based on these factors.49 However, it does not appear that the proposed rule on "other financial interests" considers these factors. Instead, the proposed rule seems to be premised on the notion that the "appearance of independence" is a universal truth that the Commission can impose on the rest of the world. For example, in many countries, the holding of bank accounts, insurance policies and loans issued by audit clients are not perceived as impairing an auditor'sindependence, provided they are obtained in the ordinary course of business, and under normal terms and conditions.50
Proposed rule 2-01(c)(1)(ii)(A) would prohibit any loan to or from an audit client, an affiliate of an audit client, or any officer, director, or beneficial owner of more than five percent of those entities' equity securities, with certain exceptions for collateralized loans.51 Although the proposed rule captures the accounting profession's agreement that certain loans to and from audit clients might create a financial interest that impairs independence,52 in certain respects the proposed rule is overbroad.
The proposed rule provides no basis for its prohibition of loans to and from beneficial owners of more than five percent of the audit client's or affiliate's equity securities. It appears that the proposed rule is based upon the assumption that such beneficial owners can influence the audit client. However, this would not be the case in the situation of a passive investor. For example, the beneficial owner of 5.1% of the equity securities of an immaterial affiliate of a public audit client, controlled by unrelated third parties, would not be in a position to influence the audit client. Furthermore, the Release provides no explanation of how such a loan would impair an auditor's objectivity. Consistent with our views on affiliates of the audit client, we believe that the relevant issues are whether the beneficial owner could exercise significant influence53 or control over the audit client or a material affiliate of the audit client and whether the beneficial owner's investment in the audit client or an affiliate is material to the beneficial owner.
The proposed rule should also grandfather all collateralized loans obtained from a financial institution under its normal lending procedures, terms and requirements. The Release provides no explanation to grandfather only those loans fully collateralized by primary residences. Independence is unlikely to be impairedby any collateralized loan that was obtained before independence was required, provided the loan remains current as to all of its terms and has not been renegotiated.54
C. Savings And Checking Accounts
Proposed rule 2-01(c)(1)(ii)(B) would prohibit "any savings, checking or similar account at a bank, savings and loan or similar institution that is an audit client or an affiliate of an audit client, if the account has a balance that exceeds the amount insured by the Federal Deposit Insurance Corporation or any similar insurer." We believe that any potential benefit of the proposed rule would be outweighed by the unnecessary burden it would create, especially considering the high level of consolidation in the banking industry. We do not believe an accounting firm's independence is impaired if an audit client acquires a financial institution at which a covered person has a savings account with an immaterial uninsured balance.
The proposal on savings and checking accounts also does not give adequate consideration to business practices in other countries. For example, in some countries, banks and other financial institutions do not fully insure account balances. In the United Kingdom, for example, only 90% of bank account balancesup to a total balance of £20,000 at any one banking institution are currently insured.55 Although having only 10% of the balance uninsured will not impair independence, the operation of the proposed rule in such circumstances would result in an unnecessary and undue burden in requiring auditors to transfer all of their savings and checking account balances to financial institutions that are not audit clients.56 This proposed rule should be modified to prohibit an accounting firm or a member of the audit engagement team from having a savings or checking account at an audit client or a material affiliate of an audit client only if the uninsured balance is material to the accounting firm or individual. This modification would result in a more meaningful rule and would avoid any unnecessary burden for accounting firms and members of the audit engagement team.
In addition, in light of the elimination of the provisions of the Glass-Steagall Banking Act which separated commercial banking from investment bank ing,57 the proposed rule should be clarified to apply to accounts insured by the Federal Deposit Insurance Corporation, or similar insurers, that Investor are now offered by traditional broker-dealers.
Proposed rule 2-01(c)(1)(ii)(C) provides that an accountant is not independent when the accounting firm, any covered person, or any of his or her immediate family members has:
Any brokerage or similar account maintained with a broker-dealer that is an audit client or an affiliate of the audit client, if:(1) Any such accounts include assets other than cash or securities (within the meaning of "security" provided in the Securities Investor Protection Act); or
(2) The value of the assets in the account exceed the amount that is subject to a Securities Investor Protection Corporation advance, for those accounts, under Section 9 of the Securities Investor Protection Act.58
We agree that an auditor's independence will not be impaired by the possession of a brokerage account with a broker-dealer that is an audit client if the value of the assets in the account is within Securities Investor Protection Corporation ("SIPC") coverage. In that respect, this proposed rule presents accountants with additional financial services opportunities, which were otherwise restricted. We suggest that this proposed rule be expanded given that an accounting firm's independence will not be impaired if a member of the audit engagement team has a brokerage account with immaterial assets in excess of SIPC coverage. Accordingly, this proposed rule should be modified to provide that independence will not be impaired if the uninsured assets in the brokerage account are not material to the accounting firm or member of the audit engagement team.
In addition, the proposed rule should also extend the safe harbor for accounts with SIPC protection to instances where the value of assets in the account does not exceed, by a material amount, the aggregate of SIPC protection and the broker-dealer's insurance from unaffiliated private insurers. Independence is not impaired when the total value of the assets in a brokerage account are substantially insured. Finally, the proposed rule should make it clear that this approach also includes similar insurance coverage in foreign countries.
E. Futures Commission Merchant Accounts
Proposed rule 2-01(c)(1)(ii)(D) provides that an accounting firm is not independent when the firm, any covered person, or any of his or her immediate family members has any "futures, commodity or similar account maintained with a futures commission merchant that is an audit client or an affiliate of an audit client."59 Recognizing that SIPC protection is not available for an account maintained with a futures commission merchant, we agree that such accounts might, in certain circumstances, create a perception that an accounting firm's independence has been impaired. However, consistent with our comments on broker-dealer accounts, this proposed rule should provide a safe harbor for accounts held by the accounting firm or members of the audit engagement team where the value of the assets in the account do not exceed, by a material amount, the private insurance coverage established on the account.
Proposed rule 2-01(c)(1)(ii)(E) provides that an accountant is not independent when the accounting firm, any covered person, or any of his or her immediate family members has "any credit card balance in excess of $10,000 owedto a lender that is an audit client or an affiliate of an audit client."60 Because credit card balances are akin to loans, we agree that a credit card balance might create a perception that independence has been impaired. However, the proposed rule should be modified to conform with AICPA guidance that independence is not impaired if the credit card balance owed to an audit client or a material affiliate of an audit client is not in excess of the proscribed limit "by the payment due date."61 This modification will provide definitive guidance to members of the audit engagement team on how to handle credit card balances with audit clients. If the credit card was obtained under normal terms and conditions, it is unimportant what the credit card balance is at any one point, so long as it is promptly paid down when due. In addition, this concept should be extended to bank overdrafts and other similar consumer finance arrangements.
Proposed rule 2-01(c)(1)(ii)(F) provides that an accountant is not independent when the accounting firm, any covered person, or any of his or her immediate family members has "any individual policy or professional liability policy originally issued by an insurer that is an audit client or an affiliate of an auditclient."62 This proposed rule is unnecessary because there is no nexus between insurance coverage and threats to independence. For example, an automobile insurance policy obtained in the ordinary course of business, and under normal terms and conditions, from an audit client will not impair independence. Unlike a material investment in a corporation, the success of which could arguably be relevant to an auditor's decision-making process, one's insurance coverage simply does not create an interest in the actual or perceived success of the insurer sufficient to influence a policyholder's judgment. We note that the ISB's and IFAC's proposed approach would not restrict the ability of accounting firms to obtain any type of insurance coverage from audit clients.63
We are gravely concerned about the limited range of options available to accounting firms for obtaining professional liability insurance. The proposed rule could result in firms being unable to secure adequate insurance. In turn, it could limit insurance companies' choice of auditors. We believe that this is both unnecessary and contrary to the public interest. The application of this proposed rule to both foreign and domestic audit firms is further complicated by the fact that the insurance risk is spread among a number of insurance companies. This complex system ofreinsurance and spreading of risk across a number of insurance companies may effectively prevent accounting firms from obtaining adequate professional liability insurance and insurers from obtaining audits.
We do not believe that insurance coverage impacts auditor independence. However, if the proposed rule is to include a prohibition with respect to insurance products, it should be limited to (1) individual life insurance products with material cash surrender values, and (2) life insurance policies or annuities that are invested in an audit client or a material affiliate of an audit client. These modifications would create a more meaningful rule that identifies those insurance policies that are similar to direct financial interests in the audit client. Furthermore, the proposed rule should provide an exception for policies obtained in the ordinary course of business from an insurer before the insurer became an audit client. This exception is necessary in light of the difficulty that many people face in securing life insurance coverage.
Finally, we believe the proposed rule would not prohibit group insurance policies, such as group health or group life insurance policies. However, this is not entirely clear considering the inclusion of the accounting firm as a "covered person" for purposes of the proposed rule. The proposed rule should not prohibit the accounting firm or any covered person from obtaining group insurance policies from an audit client, and the final rule should make this clear because suchpolicies would not impair an auditor's objectivity if obtained in the ordinary course of business, under normal terms and conditions, including pricing.
Proposed rule 2-01(c)(1)(ii)(G) provides that an accountant is not independent when the accounting firm, any covered person, or any of his or her immediate family members has:
Any investment in an entity in an investment company complex if the audit client is also an entity in the same investment company complex. When the audit client is an entity that is part of an investment company complex, the accountant must be independent of each entity in the investment company complex.64
An "investment company complex" is defined to include, among other things, "[a]ny entity controlled by, under common control with or controlling the investment advisor or sponsor . . . ."65 This proposed rule is overbroad because the definition of an "investment company complex" would unnecessarily prohibit financial relationships with non-client entities that we believe would not impair independence.
If the audit client is a non-fund entity, the proposed rule should not automatically extend the independence requirements to all other non-client non-fund entities in the investment company complex. Rather, consistent with our proposeddefinition of "affiliate of the audit client," independence should be required only with respect to those non-client non-fund entities that are material to the audit client.66
The proposed definition of an "investment company complex" also would include non-client sister funds. In the event that the audit client is a fund entity or the investment advisor of a fund entity, we believe the proposed rule would unnecessarily preclude covered persons who are not on the audit engagement team from investing in non-client sister funds. Permitting these investments does not pose a threat to independence given those individuals would not be investing in an audit client of the accounting firm.
VI. The Proposed Exceptions Would Provide More Meaningful Protection With Certain Modifications
Proposed rule 2-01(c)(1)(iii) sets forth two limited exceptions to the financial interests and relationships set forth in proposed rule 2-01(c)(1)(i) and (c)(1)(ii). This proposed rule provides that an accountant's independence will not be impaired in the following circumstances:
(A) Inheritance and Gift. Any person acquires a financial interest through an unsolicited gift or inheritance that would cause an accountant to be not independent under paragraphs (c)(1)(i) or (c)(1)(ii) of this section, and the financial interest is disposed of as soon as practical, but no longer than 30 days after the person has the right to dispose of the financial interest.(B) New Audit Engagement. Any person has a financial interest that would cause an accountant to be not independent under paragraphs (c)(1)(i) or (c)(1)(ii) of this section, and:
(1) the accountant did not audit the client's financial statements for the immediately preceding fiscal year; and
(2) the accountant is independent under paragraphs (c)(1)(i) and (c)(1)(ii) of this section before the earlier of: (i) accepting the engagement to provide audit, review, or attest services to the audit client; or (ii) commencing any audit, review or attest procedures (including planning the audit of the client's financial statements).67
We agree that the proposed rule should recognize situations in which an accountant might be deemed to lack independence due to events beyond his or her control, such as the receipt of a financial interest through inheritance or gift. We respectfully submit, however, that this proposed rule would be more practical and meaningful with the changes set forth below.
A. The Proposed Exception Should Cover Situations When The Gift Or Inheritance Is Immaterial And The Covered Person Cannot Dispose Of The Financial Interest
The proposed rule should be modified to provide an exception when the financial interest in the inheritance or gift is immaterial to the covered person and the covered person is restricted from disposing of the financial interest for an extended period. There is no evidence that an auditor's objectivity would be im paired when the financial interest is immaterial to the auditor and the auditor cannot dispose of the financial interest. We also recommend that the 30-day divestment period should commence when the auditor has: (1) actual knowledge of the gift or inheritance; and (2) the right to dispose of it.
B. The Proposed Exception Should Be Modified To Cover A Named Beneficiary Of A Trust
The proposed rule provides no guidance on whether an accountant's independence is impaired when a covered person is aware that he or she is a named beneficiary of a trust that has a financial interest in an audit client. We respectfully submit that the proposed rule should provide for an exception when: (1) the indirect financial interest in the audit client is immaterial to the covered person; (2) the beneficiary has no direct or indirect control over the investment decisions or assets of the trust; and (3) the trust was not created by the covered person named as a beneficiary.
C. The Proposed Exception For A New Audit Engagement Should Focus Only On When the Audit Services Are Commenced
Proposed rule 2-01(c)(1)(iii)(B)(2)(i) should be deleted. Requiring an accountant to be independent by the time the firm has accepted the engagement may create an unnecessary burden in some situations. Time will be needed for covered persons and their family members to unwind financial interests or employment relationships. For example, sufficient time will be required for a spouse of a coveredperson to refinance borrowings under an unsecured line of credit previously obtained from the new audit client.68 Requiring these issues to be resolved well in advance of the commencement of audit services is unnecessary and burdensome. The accounting firm's independence (or lack thereof) before the commencement of audit, review or attest procedures is irrelevant because, before that period, the covered person was not in a position to influence the audit.
Accordingly, the definition of "audit and professional engagement period" found in proposed rule 2-01(f)(6)(A) should be modified to read that the "the professional engagement period begins when the accountant begins review or audit procedures."69
VII. Certain Modifications To The Proposed Rule On Employment Relationships Will Further The Commission's Objectives
While we support efforts to modernize the independence rules governing employment relationships with audit clients, we believe the Commission should follow the ISB to develop standards in this area. Indeed, ISB Standard No. 3, "Employment with Audit Clients," addresses many of the topics covered by the proposed rule relating to employment. We also believe that the modificationsdiscussed below would further the Commission's objectives to modernize the independence rules.
A. The Proposed Rule Should Not Restrict The Employment Relationships Of The Close Family Members Of Uninvolved Partners
Proposed Rule 2-01(c)(2)(ii) provides that an accountant is not independent when a "close family member of a covered person in the firm is in an accounting or financial reporting oversight role at an audit client or an affiliate of an audit client, or was in such a role during any period covered by an audit for which the covered person in the firm is a covered person." Although this proposed rule represents a significant step towards modernizing the independence rules regarding the employment of relatives at audit clients, certain modifications are needed to further the Commission's objective of modernizing the independence rules in light of changes to the traditional family structure. Through the proposed definition of a "covered person,"70 the proposed rule would unnecessarily restrict the employment of close family members of uninvolved partners. Considering the remote likelihood that uninvolved partners will be in a position to influence the audit, this restriction should be deleted from the proposed rule.
B. The Proposed Rule On Employment Of Former Employees May Hinder Retired Partners From Serving On Boards
Proposed Rule 2-01(c)(2)(iii) provides that an accountant is not independent when:
A former partner, shareholder, principal, or professional employee of an accounting firm is in an accounting or financial reporting oversight role at an audit client or an affiliate of an audit client, unless the individual:(A) Does not influence the accounting firm's operations or financial policies;
(B) Has no capital balances in the accounting firm; and
(C) Has no financial arrangement with the accounting firm other than providing for regular payment of a fixed dollar amount (which is not dependent on the revenues, profits or earnings of the firm) pursuant to a fully funded retirement plan or rabbi trust.71
While we agree with the direction of this proposed rule, we believe that its requirement that fixed-dollar payments from a retirement plan be fully funded is unnecessary.72 An accounting firm's independence is not impaired by these unfundedpayments if the dollar amount and payment schedule are fixed and immaterial to the firm.73
The proposed rule might result in a retired partner having to choose between accepting a lump sum payment (and the related tax consequences) or not serving on, or stepping down from, the board of directors of an audit client of his or her former accounting firm. As a result, certain registrants, and investors, would lose the benefit of the expertise of these retired partners. The services of these retired partners are now in demand more than ever because of the new self-regulatory organization rules adopted at the Commission's urging which require the members of audit committees to be financially literate, with one member having accounting or related financial management expertise.74
VIII. The Proposed Business Relationship Rule
Proposed rule 2-01(c)(3) provides that an accountant is not independent if:
The accounting firm or any covered person in the firm has any direct or material indirect business relationship with an audit client, an affiliate of an audit client, or with an audit client's or an affiliate of an audit client's officers, directors, or record or beneficial owners of more than five percent of the audit client's or affiliate'sequity securities. The relationships described in this paragraph do not include a relationship in which the accounting firm or covered person in the firm provides professional services or is a consumer in the ordinary course of business.75
Although we agree with the direction of this proposed rule, it provides no basis for prohibiting business relationships with beneficial owners of more than five percent of the equity securities of the audit client or any of its affiliates. It appears that this proposed rule is based on the assumption that such beneficial owners can influence the audit client. This will not be the case in all situations. The determination should be based upon whether such beneficial owners can exercise significant influence or control over the audit client and whether the beneficial owner's investment in the audit client or its affiliate is material to the beneficial owner.
The prohibitions in proposed rule 2-01(c)(3) exclude relationships in which the accounting firm or a covered person provides professional services or is a "consumer in the ordinary course of business." The proposed rule defines a "consumer in the ordinary course of business" to mean a "purchaser of routine products or services on the same terms and conditions that are available to the seller's othercustomers or clients, as long as the purchaser does not resell the product or service or receives a commission or other fee for selling the product or service."76
Active efforts to resell an audit client's products or services could create the appearance that the accounting firm is effectively a distributor of the client's products or services. If this were the case, the accounting firm may appear to have a mutuality of interest in the success of such products and services, and directly benefit through profit margins or commissions on each sale. For these reasons, we generally agree that, depending on the facts and circumstances, reselling activities could be a business relationship. On the other hand, accounting firms sometimes find that a potential third party client is unwilling to consider the accounting firm's proposal to render system integration services, unless the proposed "solution" includes software offered by a vendor, which happens to be an audit client of the accounting firm. In these circumstances, the accounting firm should be permitted to take title to the software and resell it to the third party client, as an accommodation to the third party, provided the accounting firm purchases the software on substantially the same terms and conditions available to the audit client's other comparable customers and the accounting firm does not profit from the transaction (i.e., the purchase price for the software is effectively passed on to the third party client andthe audit firm is not paid a commission on the transaction). Such transactions should not be significant to the financial condition or results of operation of either the audit firm or the audit client.
IX. The Quality Controls Provisions Should Be Modified
We recognize that quality controls should be the first line of defense to guard against independence concerns with respect to an audit client. In April 2000, the SEC Practice Section of the AICPA (the "SECPS") adopted new membership requirements concerning independence quality controls with which SECPS members must comply by December 31, 2000. For many years, the SECPS membership requirements have served as the cornerstone for the profession's peer review program. We oppose the incorporation of these requirements into SEC rules, not only because doing so is unnecessary, but because it will undermine the self-regulatory nature of the accounting profession's program.77
While we oppose codifying SECPS requirements as SEC rules, we believe a reference to compliance with current SECPS quality controls requirementsas a predicate for the firm being excused from inadvertent violations of the independence rules is a viable and desirable alternative.
Proposed rule 2-01(c)(5) provides that an accountant is not independent if the accountant provides any services to the audit client or an affiliate of an audit client for a contingent fee. The proposed definition of "contingent fee" is largely consistent with existing guidance, which has been applied in practice for many years.
There are two problems with the proposal. First, the addition of "value added" to what constitutes a contingent fee represents an unneeded expansion of the definition. Fee arrangements between an accounting firm and its client should not be limited unless they impair independence. Accordingly, accounting firms should not be proscribed from being compensated based on the complexity or inherent risk of the results of the services rendered. Moreover, there are many fee arrangements commonly referred to as "value added" which do not impair independence and should not be deemed the equivalent of a contingent fee.
Second, the proposed rule omits important portions of AICPA Rule 302 and its related interpretation. It does not contain an exception for fees received in tax matters, if determined based on the results of judicial proceedings or the findings of governmental agencies. It also does not contain the interpretive languageon this point set forth in AICPA Interpretation 302-1.78 Under this guidance, a contingent fee "determined based on the results of judicial proceedings or the findings of governmental agencies" is permissible if "the member can demonstrate a reasonable expectation, at the time of the fee arrangement, of substantive consideration by an agency with respect to the member's client."79 This is an important concept because when there is reasonable expectation that a court or governmental agency will be involved in determining a tax matter, the results are not determined by the auditor, and accordingly could not impair independence.
We urge the Commission to simply allow existing AICPA guidance to govern this area and not adopt this proposal.
XI. The Provision Allowing The Commission To Look To "All Relevant Circumstances" Would Not Provide Clear Guidance
In addition to the specific provisions discussed above, the proposed rule also contains a broad provision which states that "[i]n determining whether an accountant is independent, the Commission will consider all relevant circumstances, including all relationships between the accountant and the audit client or the affiliatesof the audit client."80 We believe that this "catch-all" is unnecessary and adds more uncertainty about what precisely the proposed rule prohibits. Indeed, the provision would appear to allow the Commission to find that an auditor's independence has been impaired by a financial interest or activity that is not specifically set out in, or contemplated by, the proposed rule. Such a result would undermine any hope that the proposed rule would provide clear guidance that would allow accountants, clients, and other persons affected by the proposed rule, to understand the prohibited interests and relationships with respect to audit clients.
The Commission's proposed rule governing financial and employment relationships between auditors and their family members and audit clients represents a significant step towards modernizing the independence rules. We believe, however, that it would be preferable for the ISB to develop standards in this area. As discussed in this letter, while we believe the Commission should defer to the ISB, the proposed rule, if adopted, would lead to unintended consequences, would not be in the public interest and would raise a number of concerns. We respectfully request that the Commission consider the changes suggested in this letter which would substantially address our concerns with the proposed rule governing financial and employment relationships.
Respectfully submitted,
/s/ Deloitte & Touche
cc: The Honorable Arthur Levitt, ChairmanThe Honorable Isaac C. Hunt, Jr., CommissionerThe Honorable Paul R. Carey, CommissionerThe Honorable Laura S. Unger, Commissioner
| 1 | 65 Fed. Reg. at 43,151 n.34. |
| 2 | Id. |
| 3 | The existing independence rules relating to financial and employment relationships are set forth in Rule 2-01 of Regulation S-X 17, C.F.R. § 210.2-01, and in extensive interpretations, guidelines and examples in Section 600 of the Codification of Financial Reporting Policies, Matters Relating to Independent Accountants (the "Codification").
The existing independence rules, for example, attribute to an accounting firm the investments of widely dispersed partners and professional employees regardless of whether those partners or professional employees rendered any services to the audit client. See Codification § 602.02.b. |
| 4 | The ISB was formed in 1997 as a result of a cooperative action between the Commission and the American Institute of Certified Public Accountants ("AICPA"). It was officially authorized in 1998. In its Authorizing Release, 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. Commission Statement of Policy, Securities Act Release No. 7507, 63 Fed. Reg. 9,135 and 9,136 (1998). |
| 5 | For example, proposed rule 2-01(c)(1)(ii)(G), in certain respects, follows ISB Standard No. 2, "Certain Independence Applications of Audits of Mutual Funds and Related Entities." Furthermore, ISB Standard No. 3, "Employment with Audit Clients," directly addresses the provisions of the proposed rule relating to an auditor's employment with audit clients. See Written Testimony of Witnesses at SEC Public Hearing on Proposed Rule Amendments Regarding Auditor Independence (July 26, 2000) (Testimony ofWilliam T. Allen, Chair of ISB, at 9) (providing outline of differences between ISB No. 3 and the proposed rule). |
| 6 | See proposed rule 2-01(f)(4)(i)(c). For this purpose, it would appear that an "undertaking" may encompass any type of formal arrangement between the parties designed to further each party's business interests. Such relationships may or may not result in the establishment of a legal entity in which business is conducted or the receipt of a debt or equity interest in a legal entity. Indeed, the most common relationship we enter into with a third party, is often referred to as a "strategic alliance," and normally comprises only an agreement dealing with matters such as the coordination of marketing activities, training on each party's products and services, and cost sharing onproduct development. These provisions represent documentation of activities that would otherwise be conducted on an informal basis. The third parties which enter into such agreements with us often have similar agreements with other accounting firms. |
| 7 | Proposed rule 2-01(f)(2). |
| 8 | Section 210.1-02(b) of Regulation S-X defines an "affiliate" as any "person that directly, or indirectly through one or more intermediaries, controls, or is controlled by, or is under common control with, the person specified." 17 C.F.R. § 210.102(b). |
| 9 | For example, the Release states that the portion of the definition relating to "a person controlling, controlled by, or under common control with the firm, shareholders of more than five percent of the firm's voting securities, . . . and entities five percent or more of whose [voting] securities . . . are owned by the firm," is based generally on the provisions in Section 2(a)(3) of the Investment Company Act of 1940 (the "Investment Company Act") and on the definition of affiliate in Regulation S-X. However, the Release does not explain why a definition found in the Investment Company Act is applicable to auditor independence. Rather, the purpose of the Investment Company Act is to provide a framework to regulate the investing, reinvesting and trading in securities by investment companies, not the independence of auditors. See Section 1 of the Investment Company Act. |
| 10 | See proposed rule 2-01(c)(1)(iv)(A). |
| 11 | Release, 65 Fed. Reg. at 43,178. |
| 12 | Id. |
| 13 | Proposed rule 2-01(f)(5). The Release explains that the term "significant influence" should be determined in light of the guidance in Accounting Principles Board ("APB") Opinion No. 18, "The Equity Method of Accounting for Investments in Common Stock" (Mar. 1971). 65 Fed. Reg. at 43,179. APB Opinion No. 18 recognizes that "an investment of 20% or more of the voting stock of an investee should lead to a presumption that in the absence of evidence to the contrary an investor has the ability to exercise significantinfluence over an investee. Conversely, an investment of less than 20% of the voting stock of an investee should lead to a presumption that an investor does not have the ability to exercise significant influence unless such ability can be demonstrated." APB Opinion No. 18 ¶ 17. APB Opinion No. 18 also recognizes that "significant influence" can be exercised in several other ways, including, among others: representation on the board of directors; participation in policy-making processes; material intercompany transactions; and interchange of managerial personnel. Id. |
| 14 | See proposed rule 2-01(c)(1)(i). |
| 15 | See proposed rule 2-01(c)(1)(ii). |
| 16 | See proposed rule 2-01(c)(3). |
| 17 | See proposed rule 2-01(c)(2). |
| 18 | Affiliates of the audit client can either be "upstream" such as a parent, or "downstream" such as a subsidiary. Materiality should be measured by determining whether the entity is material to the parent or "upstream" entity. Indeed, the current independence rules appropriately recognize that materiality is relevant in determining whether independence is required. See Codification ¶ 602.02.b.iii. ("Interests in Nonclient Affiliates and Investee Compa nies") and Accounting Series Release ("ASR") No. 79 (Apr. 8, 1958).
As noted in the Release, the "materiality" concept for purposes of auditor independence should not be confused with the meaning of "materiality" pursuant to Staff Accounting Bulletin ("SAB") No. 99 used in other contexts of the federal securities laws. See 65 FR 43,160. |
| 19 | See proposed rule 2-01(c)(1)(ii)(C). |
| 20 | Proposed rule 2-01(f)(13). |
| 21 | Proposed rule 2-01(f)(9). |
| 22 | Release, 65 Fed. Reg. at 43,180. |
| 23 | The term "foreign practice" will be used in this letter to refer to non-U.S. practices of the international accounting organization of which the accounting firm is a part. |
| 24 | See proposed rule 2-01(f)(13)(iv). |
| 25 | Release, 65 Fed. Reg. at 43,180. |
| 26 | See proposed rule 2-01(f)(13)(iii). |
| 27 | Release, 65 Fed. Reg. at 43,180. Generally accepted auditing standards require the audit engagement team to consider discussing matters that may affect the audit with other professional personnel of the firm responsible for non-audit services to the client. AICPA SAS No. 22, AU § 311.04b and AUI § 9311.03. |
| 28 | The ISB is contemplating the same approach. The ISB draft Exposure Draft,"Financial Interest of the Auditor in, and Family Relationships between, the Auditor and the Audit Client" (June 19, 2000) (hereinafter, the "ISB draft Exposure Draft"), also goes further to exclude as covered persons a partner or manager who participates in a non-audit engagement for less than ten hours because that "person's services could not have any direct effect on the financial statements being audited . . . [and] to avoid imposing unnecessary independence restrictions on a partner or managerial employee with only nominal involvement with the client and little risk of impacting the audit." Id. at 10-11. |
| 29 | Proposed rule 2-01(c)(1)(i)(D). |
| 30 | Release, 65 Fed. Reg. at 43,160. |
| 31 | Id. |
| 32 | Codification ¶ 602.02.b.iii. See also ASR No. 79 (Apr. 8, 1958) (providing for a materiality analysis when considering indirect investments). |
| 33 | See, e.g., Codification ¶ 602.02.b.i. and ASR No. 79 (Apr. 8, 1958). |
| 34 | See ISB draft Exposure Draft. |
| 35 | See id. at 4 n. 1. |
| 36 | Proposed rule 2-01(c)(1)(i)(B). |
| 37 | See proposed rule 2-01(c)(1)(ii)(F). |
| 38 | See proposed rule 2-01(c)(1)(i)(A). |
| 39 | See proposed rule 2-01(c)(1)(ii)(G). |
| 40 | See Release, 65 Fed. Reg. at 43,151. |
| 41 | The term "uninvolved partner" as used in this letter refers to those partners, principals and shareholders that are "covered persons," as defined in the proposed rule, because they are located in an office that participates in a significant portion of the audit, but are not on the "audit engagement team" or "chain of command." |
| 42 | See ISB draft Exposure Draft at 16 (explaining that independence risk is low for investments of relatives of uninvolved partners through employee benefit plans). |
| 43 | Release, 65 Fed. Reg. at 43,161. |
| 44 | See proposed rule 2-01(c)(1)(ii)(B). |
| 45 | See proposed rule 2-01(c)(1)(ii)(F). |
| 46 | See proposed rule 2-01(c)(1)(ii)(E). |
| 47 | See ISB draft Exposure Draft, at 5 n. 5. |
| 48 | See, e.g., Auditor Independence: An International Perspective, Falk et al., (October 1998) at 11 and 12. |
| 49 | Staff Report on Auditor Independence, Office of the Chief Accountant, SEC (March 1994). |
| 50 | This approach is consistent with the recent proposal by the International Federation of Accountants ("IFAC"). See IFAC Exposure Draft, Independence Proposed Changes to the Code of Ethics for Professional Accountants (June 2000) (hereinafter "IFAC Exposure Draft"). |
| 51 | The proposed rule provides an exception for the following loans obtained from a financial institution under its normal lending procedures, terms and requirements: (1) automobile loans and leases collateralized by the automobile; (2) loans fully collateralized by the cash surrender value of an insurance policy; (3) loans fully collateralized by cash deposits at the same financial institution; and (4) a mortgage loan collateralized by the accountant's primary residence provided the loan was not obtained while the borrower was a covered person in the firm or an immediate family member of a covered person in the firm. Proposed rule 2-01(c)(1)(ii)(A). |
| 52 | See AICPA Code of Professional Conduct ¶ 101-5. |
| 53 | Absent evidence to the contrary, beneficial ownership of twenty percent or more of an audit client's equity securities should be considered to constitute significant influence over the audit client. See APB Opinion No. 18. |
| 54 | See AICPA Code of Professional Conduct ¶ 101-5. |
| 55 | See The U.K. Deposit Protection Scheme under the U.K. Banking Act (1987). |
| 56 | See Written Testimony of Witnesses at SEC Public Hearing on Proposed Rule Amendments Regarding Auditor Independence (September 13, 2000) (Testimony of Graham Ward, President, The Institute of Chartered Accountants in England and Wales, at 3) ("In such circumstances, the application of the proposed rule would stop an auditor and his immediate family from having any deposit at an audit client bank, however small"). |
| 57 | Gramm-Leach-Biley Financial Modernization Act, Pub. L. No. 106-102, 113 Stat. 1338 (1999).
The Glass-Steagall Act is the name commonly used to refer to ¶¶ 16, 20, 21 and 32 of the Banking Act of 1933, 12 U.S.C. ¶¶ 24, 78, and 377-378 (1994 & Supp. II 1997) (repealed 1999). |
| 58 | Proposed rule 2-01(c)(1)(ii)(C). |
| 59 | Proposed rule 2-01(c)(1)(ii)(D). |
| 60 | Proposed rule 2-01(c)(1)(ii)(E). |
| 61 | AICPA Code of Professional Conduct ¶ 101-5. |
| 62 | Proposed rule 2-01(c)(1)(ii)(F). |
| 63 | See ISB draft Exposure Draft; and IFAC Exposure Draft. |
| 64 | Proposed rule 2-01(c)(1)(ii)(G). |
| 65 | Proposed rule 2-01(f)(16). |
| 66 | See supra footnote 20 (discussing how to apply the materiality standard). |
| 67 | Proposed rule 2-01(c)(1)(iii). |
| 68 | See proposed rule 2-01(c)(2)(ii). |
| 69 | See proposed rule 2-01(f)(6). |
| 70 | See proposed rule 2-01(f)(13)(iv). |
| 71 | Proposed rule 2-01(c)(2)(iii). |
| 72 | See AICPA Code of Professional Conduct ¶ 101-2. |
| 73 | See ISB Standard No. 3, "Employment with Audit Client." |
| 74 | See Exchange Act Release Nos. 42231, 42232, and 42233. |
| 75 | See proposed rule 2-01(c)(3). |
| 76 | Proposed rule 2-01(f)(11). |
| 77 | The proposed rule to the extent it, in effect, requires firms to adopt specified quality control procedures raises substantial issues concerning the Commission's authority. See Memorandum from Ralph Ferrara, General Counsel of the Commission, to Clarence Sampson, Chief Accountant of the Commission, Oct. 18, 1979. In addition, as proposed, the rule would be impossible to implement. To the extent it goes beyond existing SECPS guidance, it may conflict with limits in foreign jurisdictions on the firm's ability to compile some of the information the proposed rule would require. |
| 78 | AICPA Interpretation 302-1 [ET section 302.02]. |
| 79 | Id. |
| 80 | Proposed rule 2-01(e). |