September 25, 2000
Mr. Jonathan G. Katz
Securities and Exchange Commission
450 5th Street. N.W.
Washington, D.C. 20549-0609
Re: Proposed Rulemaking Regarding Revision of the Commission's Auditor Independence Requirements
SEC File No. S7-13-00
Thank you for the opportunity to supplement our oral testimony with written comments on your proposed rulemaking regarding auditor independence. These comments reflect the richness and diversity of the 33,000 members of the New York State Society of Certified Public Accountants, including the Professional Ethics Committee, the SEC Practice Committee, the Auditing Standards and Procedures Committee, and a task force of officers and oversight committee chairs. The various viewpoints reflect those of individuals who participated in committee discussions, rather than the firms they each represent.
We commend the Commission on their goal of enhancing investor confidence and protection of the public interest through the proposed rules. As the home of the "Trusted Professional", we agree with the goal, but concerns about how these proposed rules will affect individual CPAs and their practices keep us from endorsing them fully. The following are our major concerns.
We agree with the "general standard for auditor independence" and the need for overriding principles. However, these four governing principles should not be "determinants" of independence, but should be used to help formulate independence rules. They would better serve accountants, registrants, and investors as "guiding factors," concepts for application in given facts and circumstances in the context of a more robust framework, such as that which the Independence Standards Board (ISB) is developing. Significant problems arise in the application of these four "governing principles" to practice situations.
The guidance is too abstract for any practical usefulness and, therefore, may be counter-productive. For example, Society committees could not reach a consensus on how to assess compliance with the provisions of the proposed rules because the principles that form their basis are open to broad interpretation. When exactly does an independent auditor perform a "management function" that impairs independence? Since advocacy is anticipated in many situation that involve auditors, including current SEC requirements for "preferability" letters, which advocacy activities impair independence. Rules that are too "broad brush" and open to differing interpretations will cause confusion and disruption not only for audit firms, but also for their clients. How will registrants know which specific activities they should plan to take to someone other than their auditor?
We believe that the proposed "mutual or conflicting interests" factor requires further definition because all audit firms have an inherently mutual interest with their audit clients, namely quality financial reporting. This guiding factor should be restricted to those interests that subordinate the auditor's judgment to that of management. Furthermore, we believe that an auditor may acceptably act as an advocate for an audit client if the auditor's judgment is not subordinated to management's.
The audit committee requirements already adopted by the ISB, the New York Stock Exchange, the National Association of Securities Dealers, the American Stock Exchange and the SEC already create a mechanism to monitor and evaluate whether the auditor has in fact subordinated his or her judgment to that of management. Strengthening the corporate audit committee structure and operation is key to ensuring that the auditor's judgment is not subordinated to management's.
Recently, the Public Oversight Board Panel on Audit Effectiveness concluded, "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. Because "perception" is the issue, we believe that disclosure of non-audit fees empowers the investor to assess the potential for impairment. Moreover, coupling full disclosure with registrants' market choices to use auditors for non-audit services would provide valuable data for researching the correlation of auditors' provision of non-audit services to investment risk and return.
Outsourcing internal audit does not subordinate the auditor's judgment to management where appropriate levels of management retain the decision making power as laid out in American Institute of Certified Public Accountants' Interpretation 101-13, Extended Audit Services. Furthermore, current rules require the internal audit function, even when outsourced, to report to the audit committee, another layer of independent control.
We are very concerned about how the proposed rules on non-audit services could reduce the quality of financial reporting of smaller SEC registrants. Committee members have indicated that the financial accounting sophistication of some SEC clients is insufficient to completely satisfy the details of certain accounting standards and that these clients expect their accountants to advise and assist them in these situations. We recommend an exclusion for smaller SEC registrants that do not have the trained resources to navigate the complex SEC reporting and accounting standards without the assistance of their accountant. The auditors are often the most knowledgeable participants in very complicated accounting transactions and must first educate and then guide their clients. In this way the accountant's navigational assistance keeps the small SEC registrant on course and actually improves financial reporting.
In a related concern, committee members discussed the potential unintended consequences that the proposed prohibition of certain consulting services to audit clients may have on other sectors. If so, all audit firms, regardless of size or sector of practice, would be affected. Will other regulators, including other federal agencies and state boards of accountancy, adopt similar rules to prohibit consulting services for audit clients? A "no" answer to this question will cause turmoil, confusion, and conflict. A "yes" answer causes other problems. What should be a "win-win" scenario may inadvertently become a "lose-lose" set-up for the audit profession and their clients, including SEC registrants.
Limiting the provision of expert services that otherwise enhance financial statement quality could have a very damaging impact on the general performance of business and the economy. In many communities, accounting practitioners serve as business advisors and may be the sole resources in their community for Information Technology and other consulting services. The success of businesses and the economy is often linked with the broad availability of consulting services offered by CPA firms of all sizes.
The current SEC definition of an "affiliate" in 602.02.b.iii, Interests in Nonclient Affiliates and Investee Companies, distinguishes investees that are greater than 50 percent controlled from those that are less than 50 percent controlled (accounted for on the equity method). The proposed rules redefine an "affiliate of an audit client" as any entity that has "significant influence" over the audit client. Under the SEC's current interpretation, "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." We prefer the unambiguous current definition of an affiliate to the proposed redefinition, which is far too broad for reasonable implementation.
Furthermore, we believe that the proposed definition of an "affiliate of an accounting firm" is overly restrictive. While we agree that the concept of independence should extend to controlled entities of accounting firms, a five percent ownership interest is nominal, generally immaterial, and too low a threshold for general application. We suggest that a higher threshold would be more consistent with the current business environment.
Because of these broadened definitions of "affiliate," every business alliance or affiliation that the audit client or the auditor enters into, and in turn the alliances and affiliations of those related entities that meet the SEC's new definition of an affiliate, will have cascading independence implications. For example, a 25 percent-owned investee would be an affiliate of a company under the proposal and the company's auditor would be required to be independent of it, even if the company has no control over the investee and the investment is immaterial to it. Furthermore, the auditor would be required to be independent of the 20 percent-owned investee of the company's 20 percent-owned investee and so on. Accordingly, a 20 percent-owned investee of a 20 percent-owned investee of a company that enters into any restricted relationship with its auditor would preclude the auditor from auditing the investor company, and this would be without any regard to any materiality test (i.e., if the second tier investee is immaterial to the first tier investee which is immaterial to the investor company, independence restrictions would still apply).
Private Standard Setting
A recurring concern raised by committees has been the clear preference for the Independence Standards Board to be given implementation support and the necessary time to work effectively. Many believe that the reforms related to disclosures and audit committee requirements adopted by the Independence Standards Board, the stock exchanges, and the SEC are steps in the right direction.
We believe strongly that standard setting is best done in the private sector. At this time the ISB is making progress on a number of projects; now is not the time for the SEC to step in with dramatic changes. We believe the ISB's efforts should continue to be supported. In addition, as we have commented before the Public Oversight Board Panel on Audit Effectiveness and elsewhere, the Society wholeheartedly endorses a stronger relationship between the accountant and audit committee, the first line of defense regarding auditor independence.
Another concern is the proposed fee disclosure requirements. The August 2000 CPA Journal includes a commentary on those requirements by Robert Waxman, which indicates the level of detail required by the proposed rules. Nonaudit services and the fee information now go to the audit committee under ISB #1. Perhaps it would be more meaningful to investors to know that the audit committee has reviewed this information and is satisfied, with aggregate disclosure of the audit and non-audit fees similar to the British approach. Disclosure of fees for non-audit services closes the "perception gap"
Auditor Investment Rules
Many in the Society applaud your proposals that reduce the number of circumstances in which client employment of family members impairs independence. All those from two career households know the pressures that raising a family while meeting the demands of the accounting profession can create. The arbitrary and inequitable nature of the unduly restrictive current rules in this area causes problems for families and inhibits the attraction and retention of high-quality people for the profession without providing a corresponding benefit to the public interest.
The potential negative impact of the current rules in a small city with a single major employer is obvious. However, even in a city the size of Seattle the job market is often dominated by two employers that are both audited by the same firm. For far too many families, normally happy events like admission to the partnership, promotions and successful audit proposals have required one spouse to resign a position to resolve an imaginary independence issue.
The proposed rule puts the focus where it belongs - on employment positions that exercise significant influence over accounting records and financial reporting, and on positions in the audit firm which truly have the ability to influence the conduct of the employer's audit. We encourage you to move swiftly to adopt your family employment proposals to eliminate the injustice that the current rules unnecessarily impose on the men and women of this profession and their families.
On the other hand, we encourage you to move more deliberately in regards to the proposals related to the provision of non-audit services. Although the Commission may believe that the proposed rules are targeted to affect only SEC registrants and their auditors, we believe the effect will be more widespread. All CPA firms with clients who may become registrants at some time in the future will have to be aware of, and comply with, these rules in advance of any registration. In the same respect, businesses contemplating public offerings will have to rethink the terms of their engagements with audit firms.
Thank you for the consideration you have given us in accepting these comments. We would be pleased to respond to any questions you may have.
P. Gerard Sokolski, CPA
New York State Society of Certified Public Accountants