Mr Jonathan G. Katz
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549-0609
Düsseldorf, 18th September 2000
Sub.: Revision of the Auditor Independence Requirements;
SEC's proposed rule
The IDW is grateful for having the opportunity to submit its comments concerning the SEC's proposed rule governing auditor independence.
I. General Remarks
- SEC stresses the importance of auditor independence (page 4). We share the view that independent auditors play a key role in providing assurance to investors that the financial information disclosed by issuers is reliable.
- Furthermore SEC emphasises the importance of both independence in fact and in appearance. The statement on page 5 that independent auditors should not only be independent in fact but that they should avoid situations that may lead outsiders to doubt their independence can be fully supported also from our national and from a European point of view.
- We do not share however the concern by SEC expressed on page 10 that "as auditors become involved in a broad array of business arrangements with their clients, they come to be seen by themselves, their firms, their clients and
investors less as exacting, skeptical professionals who must be satisfied before signing off on the financial statements, and more like any other service vendor who must satisfy the client to make the sale." On the contrary, one could argue the other way round: with an increase of consultancy services the auditor will make all attempts to provide an excellent audit work in view of a threatened loss of the services and therefore a loss of income in case he fails to meet the requirement of an appropriate audit. The same argument applies to the statement in section 5 on page 10 that "as non-audit services become more important to a firm, that firm may care less about auditing and more about expanding its service lines."
- We have some doubts concerning the example in section 4 on page 10 that "an audit firm may agree to perform the audit of a start up - company for fees significantly below market rates for a few years, in anticipation of "recouping" such an investment in the client through a subsequent initial public offering or performance of consulting services". This example mixes the problem of predatory pricing or "lowballing" with the provision on non-audit services, which should be avoided.
- We welcome the goal expressed on page 12 to preclude non-audit services only to the extent necessary to protect the integrity and independence of the audit function and not to extend the proposals to services provided to non-audit clients. For that reason and for the above mentioned arguments we support the intention to make a distinction between the different non-audit services, that means to permit some significant non-audit services instead of introducing a blanket ban.
- On page 15 four principles are mentioned which in the opinion of the Commission incorporate situations that the SEC believes reasonable investors would agree impair an auditor's independence, when the auditor
- has a mutual or conflicting interest with the audit client
- audits the accountant's own work
- functions as management or employee of the audit client
- acts as an advocate for the audit client.
Three of these principles are in line with the threats or risks to auditor independence enumerated by FEE (our European professional body to which the IDW contributes significantly) in its common core of principles published in 1998. In addition FEE mentions the so called familiarity threat (a risk that the statutory auditor may become over-influenced by the client's personality and qualities and consequently too sympathetic to the client's interest) and the intimidation threat (the possibility that the statutory auditor may become intimidated by a threat, by a dominating personality, or by other pressures, actually offered by the client or an associate of the client or by some other party).
The above described third situation, that the auditor functions as management or an employee of the client in our opinion does not reflect a principle sui generis but entails extremely high real or perceived self-interest and self-review threats to independence.
- The discussion how to meet the above mentioned threats opens the door to a general discussion as to which approach should be preferred:
- a conceptual approach with safeguards to offset the risks and certainly with prohibitions whenever safeguards are not possible
- a prescriptive approach with a mass of detailed rules by far not being able to cover all perceivable situations when the auditor's independence might be impaired.
The weakness of a pure prescriptive approach, obviously preferred by the SEC, is demonstrated indirectly by the statement on page 16 section 2 that the list which specifies a number of the relationships and other situations that might impair an auditor's independence is not exhaustive and that all situations in which an auditor might lack independence cannot be foreseen by the Commission.
We are therefore of the opinion that a conceptual approach - provided it assumes only a supporting function not replacing clearly defined rules - is preferable to a purely prescriptive approach adopted by SEC.
II. Detailed remarks
Ad C. Specific Applications of the Independence Standard
Financial relationships (page 16 ff.)
- We agree to the proposal to limit the group of persons who cannot invest in an audit client to "covered persons in the firm" and their "immediate family members". The proposal meets the reality of audit firms acting on a global basis. We share the expectation that the proposal will increase significantly the group of persons who can invest in an audit client without impairing the auditor's independence.
- In case of an indirect financial interest in the accountant's audit client we agree - for practical reasons - to consider the aspect of materiality, that means not to assume a violation of independence rules by the auditor unless the indirect investment exceeds five percent.
- We are not in favour however of introducing a limit on the portion of an investee's total assets that can be invested in an audit client without independence being impaired in addition to or in place of the proposed indirect investment test because of the indicated practical problems to determine how much of an investment company's assets are invested in an audit client or how much of an issuer's securities are owned by an investment company.
- In the case of the two exceptions (inheritance and gift, new audit engagement) and under the indicated preconditions we share the view of the SEC that reasonable investors would not necessarily perceive the accountant to be incapable of exercising objective and impartial judgement.
Employment relationships (page 17 ff.)
- In our opinion reasonable investors would question the accountant's independence if an immediate family member of a person on the audit engagement team is employed by the audit client in any position or if a close family member holds a "key position" at an audit client. From a third party's perspective we believe that the ISB's stricter position with respect to immediate family members is necessary to ensure an auditor's independence.
- Where a former employee of an accountancy firm has an employment relationship with an audit client in our opinion the accountant's independence is impaired if significant connections remain between the former employee and the accounting firm. This implies that the former employee should not be permitted to derive retirement or other benefits from the accounting firm unless these are made in accordance with pre-determined arrangements that cannot be influenced by any remaining connections between the employee and his former firm.
- It seems to be important to emphasise that the materiality of any financial ties should be assessed from the perspective of the firm, not from that of the former employee.
- A mandatory "cooling-off period" for former partners and professional staff of an audit firm who join audit clients seems to be arbitrary and, therefore, should not be required.
Ad D. Non-Audit Services
- The proposed rules in this area govern non-audit services provided by an accountant to an audit client during the audit and professional engagement period. We agree to the approach not to extend the rules to non-audit services when provided to persons other than audit clients because it could be questioned in which way the accountant's independence could be impaired in this case.
- We disagree with the general rule that an auditor's independence is impaired if providing services to an audit client. In our view the provision of non-audit services to an audit client has no impact on the accountant's independence provided there is no involvement of the accountant in any decision-making of either the audit client or its management. In this case a self-review threat cannot be assumed.
- The proposed general prohibition of non-audit services totally ignores the benefits of providing such services to audit clients. In our opinion it should be recognised that the provision of non-audit services to an audit client brings benefits to both the client and investors as it increases the statutory auditor's understanding of the client's business and is likely to result in a better audit. Consequently, many companies would be adversely affected if they were denied the right to obtain other services from their statutory auditors.
- In our view practical experience has demonstrated the difficulty and the inefficient rigidity of drawing up a list of prohibited non-audit services as done in appendix A. In addition, it has to be emphasized that such a list which cannot be all-inclusive would in any case be arbitrary.
- Nevertheless there is a specific issue requiring particular attention because of its sensitivity in terms of independence in appearance. We share the view that performing bookkeeping or preparing financial records or statements for an audit client would appear to reasonable investors to impair an auditor's independence. However, as there may be bookkeeping tasks that do not involve financial information or that do not otherwise need to be considered in the audit, we support the approach (page 32) to narrow the definition to services involving, maintaining or preparing the audit client's or it's affiliate's accounting records or financial statements or generating financial information to be disclosed by the audit client or its affiliate to the public.
- In no. 5 of our general comments we already supported the approach of allowing certain non-audit services to be provided to audit clients instead of banning all non-audit services for audit clients. At any rate tax services should be allowed including action for the client before the courts or the tax administration for tax litigation which is an area where the appearance of independence would normally not be at risk, because interested third parties understand that the statutory auditor has the most appropriate technical expertise and is best placed to defend his client in cases which are generally not significantly subjective.
Ad E. Contingent Fees
- We agree to the proposed rule that an accountant is not independent if he provides any service to an audit client or an affiliate of an audit client for a contingent fee or receives a contingent fee from an audit client or an affiliate of an audit client. We do not see any circumstances in which or particular types of services for which a contingent fee arrangement would not impair independence. However, as already mentioned in no. 4 of our general remarks, it should be avoided - as done on page 44 - to mix the problem of predatory pricing with contingent fee arrangements.
Ad F. Quality Controls
- It seems to be reasonable that independence rules provided by SEC contain a limited exception for firms that have appropriate quality controls to address independence and meet other conditions.
Ad H. Proxy Disclosure Requirement
- We have certain reservations concerning the proposal to re-instate a requirement that companies include in their proxy statements certain disclosures about non-audit services provided by their auditors during the last fiscal year. In our opinion and according to all our experience disclosure of the total amount of non-audit fees or of the relationship between audit and non-audit fees does not give a true picture of the risks to the objectivity and independence of a statutory auditor.
We hope that our comments prove of use to you and that you will be in a position to consider them in the discussion of the proposed rule. Should you have questions, please do not hesitate to contact us.