Michael D. Larrowe, CPA
Post Office Box 760
Galax, VA 24333
September 25, 2000
Jonathan G. Katz, Secretary
Securities and Exchange Commission
450 Fifth Street NW
Washington, DC 20549-0609
Reference file No. S7-13-00
Dear Mr. Katz:
This correspondence is to offer comment relative to the SEC's proposed rule dealing with auditor independence that would substantially alter Rule 2-01 of Regulation S-X.
We are concerned that the broad limitations on scope of services discussed in the proposed rule would have an unnecessary adverse impact on our clients, the users of their financial information and on our Firm. While we have concerns related to a number of the proposals, summarized below, we are especially concerned about the proposed prohibition on the independent auditor assisting a client with their internal audit function (outsourced internal audit).
One of the cornerstones on any examination is the independence of the persons conducting the examination. Properly structured external examinations (including outsourced internal audit engagements) provide greater assurance of an independent perspective than any internal examination can offer. From a structural perspective, external auditors are clearly more independent of management and fellow employee peer pressure than any client employee could possibly be. The client employee is 100% reliant on that job for employment whereas the client represents only a portion of any external firm's total revenue.
Another issue we believe strongly favors external accounting firms participation in such engagements relates to expertise and supervision. Many smaller companies have promoted someone from within the organization to perform the company's internal audits. As a group, they are understandably less prepared to execute and evaluate internal auditing procedures than the typical audit firm staff professional that is usually better educated (in that discipline) and has more relevant experience. Additionally because smaller companies' upper management are frequently involved directly in a number of areas, the potential for management override of the internal audit function is much greater when conducted by internal personnel.
We do not understand how an external firm's performance of external independent audit services and assisting (under existing rules and guidelines) with the execution of internal audit procedures could impair the effectiveness or reliability of either function. While both processes require independence from management, they do not logically require independence from each other. We believe that because of the increased knowledge of a regulated company an external firm would gain in assisting with the internal audit effort, the oversight interests of the public is improved not lessened.
We believe the following points are also applicable to the scope of services proposal, and as a result, the proposed rule should not go forward.
- The SEC has based its decision to move forward with this rule prohibiting non-audit services without facts or evidence. Even the SEC admits that there is no empirical evidence that non-audit services have compromised audit quality or auditor independence, nor ever caused an audit failure. None of the studies or reports cited by the SEC concluded that the scope of services impaired audit effectiveness, or that an exclusionary ban was necessary or appropriate. The SEC's proposed rule is a solution in search of a problem.
- The SEC ignored the conclusion of the current Panel on Audit Effectiveness of the Public Oversight Board, a panel that was formed at the request of the SEC. The panel concluded that, "both the profession and the quality of audits are fundamentally sound." The panel said it could find no evidence that the provision of non-audit services has hurt audit quality. On the contrary, it concluded that in numerous instances non-audit services contributed to a more effective audit.
- Most dangerous for the accounting profession is the likely prospect that the proposed rule would set a precedent for other regulators. Even accounting firms that do not audit SEC registrants could be impacted by these new rules. The proposed SEC rule would be viewed as the new model by state boards of accountancy, as well as federal (e.g., banking and ERISA) and other regulators. These new proposed SEC rules could influence the regulatory approach to auditor independence outside the United States as well.
- The SEC proposal is bad news for CPAs working in industry, since it would restrict public companies' freedom of choice when seeking outside professional services. The SEC would force public companies to constantly choose whether to hire a firm solely as its auditor or solely as a provider of other services. In fact, under the proposed new rules, a public company might be compelled to dismiss an audit firm that has done consistently outstanding work in order to obtain services from the auditor's non-audit colleagues.
- The SEC claims its proposed rule "would not affect tax-related services" to audit clients. However, it would ban acting as an advocate for an audit client, or providing expert services in administrative proceedings, thus (except in preparing returns) potentially prohibiting CPAs from representing audit clients before the IRS.
- The proposed rule would impute to an accounting firm the activities of virtually any entity with which the accounting firm has a commercially valuable business relationship by viewing such an entity as an "affiliate of the accounting firm."
- Accounting firms effectively would be precluded from entering into almost any joint venture or partnership, since the accounting firm's independence could be impaired as a result of the activities of other parties in which it may have only an immaterial investment, or with which it may be associated in only limited respects, but does not control.
- Regional alliances or cooperative agreements between accounting firms could result in each firm being required to be independent of each other firm's attest clients. Moreover, the restrictions would extend to any alliance or cooperative agreement with overseas accounting and other firms (such as legal service providers).
- In a rush to regulate, the SEC has:
- Adopted a schedule designed to avoid Congressional oversight and preclude meaningful public participation.
- Waited until the eleventh hour of the Clinton Administration to push through a radical rule to restructure the accounting profession, without permitting informed oversight, or policy participation, by Congress or the new Administration. In each of the last 10 annual reports to Congress, the SEC has not mentioned any concerns about the scope of services issue.
- Limited to 75 days the period for commenting on a far-reaching and highly complex proposal, including responding to more than 400 questions, collecting and analyzing a great deal of data and considering alternative concepts for regulating auditor independence.
- Pre-empted the work of the ISB, set up three years ago at the initiative of the SEC to develop a new conceptual framework for auditor independence and appropriate implementing standards.
- Not allowed time for important recent reforms to work, including new disclosure and audit committee requirements adopted by the ISB, the NYSE, the NASD, the American Stock Exchange and the SEC.
- The SEC has needlessly tied its popular and long-overdue modernization of family disqualification rules-depression-era rules that discriminate against working women and two-career families-to its far more controversial scope of services initiative. Modernization of the financial-interest standards can and should occur on an expedited basis, independent of the scope of services initiative. The scope of services initiative requires more time for fact finding and analysis than provided by the SEC's time frame.
- If the rule is adopted, there will be a negative effect on recruiting and retention of the best talent. The best audit professionals will not want to be at a firm where 25% - 40% of the market is "off-limits," and the same is true for the best non-audit professionals. Similarly, the best and brightest students will not be drawn to firms with a limit on upward opportunities. The "audit-only" firms endorsed by the proposal will have difficulty attracting the necessary talent both from accounting programs and from information technology programs, because the best talent will be drawn toward industries with broader career opportunities.
- The SEC lacks authority for its sweeping scope of services rule. The statutory provisions cited by the SEC in the proposed rule pertain to public companies' filing of financial statements that have been audited by independent accountants and do not expressly authorize the SEC to make rules governing or regulating directly the accounting profession itself. The proposed rule is based primarily, if not entirely, on alleged concerns relating to the "appearance of independence" - but not independence in fact. The SEC does not have statutory authority to impose restrictions because of possible perceptions about independence.
- Broad restrictions on non-audit services will likely have the perverse effect of undermining auditor independence by making audit firms overly or exclusively dependent on auditing fees, which would certainly be contrary to the public interest. Such restrictions will also harm the recruitment and retention of the most qualified personnel, causing a possible degradation in audit quality.
- In conclusion, the SEC's proposal to restrict the services offered by accounting firms represents a fundamental restructuring of a profession that has successfully given investors the reliable, independent data they need for the past century. A decision by a government agency to tell some business organizations what services they may offer and to tell other businesses from whom they can buy services is an extraordinary economic intervention without any empirical or other basis. We think most Americans would find this a curious public policy position for their government to take.
We appreciate your consideration of our comments and urge you not to support the scope of services rule.
Michael D. Larrowe, CPA