5 September 2000


Mr J G Katz
Securities and Exchange Commission
450 Fifth Street NW
Washington DC
20549 - 0609


As referred to in our letter to you of 13th July, the SEC's Auditor Independence Rules have an impact on auditing in the United Kingdom, where over 110 companies have additional listings in the US. Accordingly the Institute, as one of the appointed regulators of accountants in the UK, has been following with interest the SEC's proposals to amend these rules.

We have now considered the Commission's proposal and wish to register a number of comments on certain aspects of that proposal.

This letter will form the basis of our proposed testimony before the Commission on 13th September. We have annexed to this letter a number of appendices which will not form part of our testimony but which we hope will add further useful detail to some of the points raised.

We fully support your overriding objective of independence in auditing. This objective of independence should be an aim throughout the world. There are, however, some points of principle in your approach with which we disagree. In outline:

We consider these and other issues in more detail below.

Approach to Auditor Independence

The accounting profession in the UK is resolute in its commitment to objectivity and independence in auditing. However, the approach to Auditor Independence adopted in the UK, and indeed by IFAC, differs from that followed by the SEC. Our ethical requirements on objectivity and independence are based on a framework approach which sets out fundamental ethical principles, a reasoned analysis of the possible threats to these principles and linked guidance on the safeguards which may be necessary to mitigate those threats. The ethical requirements are backed by professional education and firm enforcement through our monitoring and discipline processes. Monitoring is carried out by the chartered accountancy profession's Joint Monitoring Unit, which visits the major audit firms on an annual basis. Each such visit includes an assessment of audit firms' compliance with our independence requirements. We believe that this approach is in practice more rigorous than a detailed rule-based approach and offers a number of advantages.

  1. The onus is placed on the auditor actively to consider independence issues for each engagement and to demonstrate that a responsible conclusion has been reached.

  2. It prevents the use of narrow legalistic interpretations to circumvent requirements1. As a leading UK journalist in the field put it recently: "Principles encourage compliance. Regulations encourage deception".

  3. It allows for the almost infinite variations in individual circumstances that arise in practice throughout the world.

  4. It can cope with the rapidly evolving business and audit environments of the modern world.

  5. It allows for absolute prohibitions where, but only where, no adequate safeguards are feasible.

Proposal to modernise the Independence Rules

Notwithstanding our differences in approach, we of course share the key aim of ensuring that auditors are independent and can, to a reasonable and informed observer, be seen to be independent.

Although we have reservations about a rule-based system, we welcome your intention to update some of the more out of date rules and to establish governing principles to determine what rules should be set. However, we believe that these principles should be enhanced in a number of ways, in particular by:

  1. the inclusion of a reference to lack of independence as a result of overfamiliarity or client intimidation;

  2. careful linking of the principles to the definitions (see Appendix 1);

  3. recognition that many of the threats need to be considered in the context of materiality and probable influence (see Appendix 2);

  4. recognition that many of the threats can be addressed by the provision of safeguards other than resignation as auditor;

  5. defining the advocacy threat more precisely and linking it more closely to the financial statements or other subject of the audit engagement (see Appendix 3).

Financial, employment and business relationships

Subject to some points of detail relating to the specific definitions, we welcome the proposal to rationalise the rules on these relationships. As you may be aware, some of the existing rules have had rather strange consequences when applied in a UK context. An example of this occurred earlier this year, when a close relative of a non-audit partner in the London office of one of the large accountancy firms, was appointed to a key post at a client with a listing in the US. In order to deal with the situation, it was proposed to move the partner to another office within Europe. Nevertheless, although this office was in a different country, it was still within 500 miles of London and accordingly fell foul of the SEC's independence rules.

We would add that the characteristics of many of the investment vehicles caught by the proposal are not always the same in other countries as in the US. An example of this is that in the UK, deposits with banks and similar institutions are only insured up to 90% of their value. In such circumstances, the application of the proposed rule would stop an auditor and his immediate family having any deposit at an audit client bank, however small. Another example is that there is no concept in the UK of a Rabbi Trust and therefore the proposals would require a firm to buy out the unfunded pension rights of a retired partner who wished to take a job with an audit client. Many firms are not in a position to provide such funding for a potential connection which, in a large firm, will not have any material impact on the audit team.

We are also concerned that the proposals for investment company complexes will restrict competition for audit engagements in the fund management industry. In the UK there are a limited and consolidating number of investment company complexes but partners in accounting firms are self-employed and so must make their own arrangements to save for retirement. In this environment the proposals would restrict the ability of directors of individual investment funds to choose alternative auditors and lead to major expense of transferring the personal investments of partners in the event that any single fund wished to make a change. It is unlikely that many large firms will wish to compete for such business in the context of this expense.

Non-audit services - performance

Our principal concern about the new proposal relates to the detailed and precise prohibitions intended to be placed on certain non-audit services provided by auditors of companies with SEC regulated listings. As noted above, we believe one of the advantages of the framework approach to be its ability to cope with many different circumstances. Detailed rules can be a blunt instrument, sometimes imposing inappropriate solutions or indeed simply missing the problem.

The framework approach starts from the premise that where an auditor provides non-audit services, there may be a threat to independence which must be mitigated by adequate safeguards that the auditor will have to demonstrate.

In a few instances, such as participation in client management, no safeguards are possible, in which case prohibitions are appropriate. Except in those few circumstances, we believe that it is important that companies should be allowed to purchase, and auditors be allowed to provide, additional services if companies decide this is in the best interests of their shareholders. Our view is based on a number of factors.

  1. There is no evidence that the provision of significant levels of non-audit service has resulted in a decline in the quality of the audit. We note that this view is shared by the Public Oversight Board's Panel on Audit Effectiveness, in its exposure draft of 6 June 2000.

  2. For listed company corporate reporting to remain relevant it will need to evolve to take in more non-financial matters: consider current trends in corporate governance and environmental reporting. Audits and auditors will need to evolve alongside these developments and this will be hampered by restricting the range of non-audit work auditors can carry out.

  3. The argument that provision of non-audit services by auditors should be prohibited because it creates economic dependency on the client is flawed. Audit appointments and fees are determined by the directors of the company being audited, so the auditor can never be wholly economically independent: the issue is one of degree. The threat of dependency arises when the amount of total fees from a client constitutes a significant proportion of the accounting firm's income. We believe that this threat is most appropriately dealt with by imposing a limit on the proportion of a firm's total fee income that can be earned for all assignments from any one client.

  4. By trying to prohibit some advisory services while allowing others the rules contain arbitrary distinctions which will not stand the test of time. For example, the substantial extension of the prohibition on advisory services on human resource and remuneration matters covers but one area of importance to the company's management, yet it is accepted in many areas that the distinction required is between participation in client management, which clearly impairs independence, and giving advice, which does not.

  5. It is not in the interests of shareholders to impose legal requirements which limit a company's freedom to take best advice. Where safeguards can be put in place, it is appropriate to allow managers, within guidelines approved by Audit Committees, to make their own decisions on the use of their auditors for non-audit services, when that offers the greatest value to shareholders.

  6. Almost any large audit firm that engages in non-audit activity is likely to have a relationship or business connection with many large companies. Unnecessary restrictions could greatly restrict directors' choice of firms able to take on a multinational audit and hamper their freedom to change auditors, which may be of concern to competition authorities (see Appendix 4).

  7. Indeed, there must be a concern that if such restrictions result in a radical restructuring of the auditing profession, the quality of the people carrying out the audits may ultimately reduce. An indication of the attractiveness of a varied profession is that over the last decade, a period of considerable expansion in non-audit work, the percentage of students qualifying with the Institute with first or upper second class degrees, has increased from around 45% to approximately 75%. It is important for professional auditors to have a high level of general ability to understand business and to hold their own against skilled, knowledgeable and articulate business people as clients. The reversal of this trend, together with the reduced international co-operation that would result from fragmentation of the firms, would lead to a reduction in audit quality, an objective that none of us share.

  8. The international accounting bodies IFAC and FEE (Fédération des Experts Comptables Européens) have adopted a similar approach to our own. We understand that the European Commission Committee on Auditing's revised proposals on Statutory Auditor Independence will also endorse this approach.

We believe that the core principle to be observed in deciding whether auditors should provide non-audit services is best expressed as follows: auditors must not be put into the position of having to audit a significant component of the financial statements to which they are linked, either because they have generated the information themselves, or because they are in an advocacy position in respect of that information. This is not inconsistent with the four governing principles in your proposal, though we believe that a different manner of implementation would be more effective.

It follows from this principle that an auditor should never take management decisions and that it may also be appropriate to prohibit valuation and legal advocacy work that involves an element of subjective judgement and is material to the audit engagement. However, in other areas, for example, internal audit and other outsourcing, and indeed legal and valuation work that does not fall within the above definitions, adequate safeguards can be put into place to ensure that management retains decision making and control and the output is subject to proper audit scrutiny. Blanket prohibitions are therefore inappropriate. The decision on whether non-audit services can be provided by the auditor must reflect the circumstances.

Non-audit services - disclosure and approval

We endorse the proposal to disclose non-audit services to shareholders. The detailed requirements proposed would however cause practical difficulties. For example, audit committees in the UK tend to meet 3 or 4 times a year, which is not frequent enough for them to become involved in management decisions on appointment of advisors for all engagements. Additionally, there may be cases where questions of commercial confidentiality mean that detailed disclosure is not in the shareholders' best interests.

Non-audit fees paid to auditors in the UK have had to be disclosed, by law, for some years. The Auditor Independence Working Party commissioned by the ICAEW earlier this year, has recently recommended that this disclosure be extended to describe the broad nature, but not the full details, of the services provided2.

On the subject of fees, we agree that charging a fee for the audit that was contingent on the outcome of the audit would clearly be inconsistent with maintaining auditor objectivity and should be prohibited. However, we see no justification for a comprehensive ban on contingent fees in relation to non-audit services. Provided such a contingent fee, after taking account of available safeguards, does not pose a significant self-interest threat in relation to the objectivity of the audit engagement, we would consider it acceptable.

Significant strides have been taken in terms of the independence and functions of Audit Committees for listed companies in the UK in recent years. We note similar developments in the US through the work of the Blue Ribbon Committee, the SEC and others. Against that background, we believe that adequate disclosure, together with proper attention by Audit Committees and firm enforcement of ethical guidance, should present shareholders with a sensible basis on which to determine whether they are being appropriately served in respect of the provision of professional services.

Application of SEC rules in the UK

The application of rules designed for one legal and cultural environment to another can cause unintended results. We have mentioned that some of our investment vehicles have different characteristics from those in the US. Some of the SEC's regulations would also conflict with European laws, for example in relation to regulations concerning investment advice, executorship procedures and requirements for fairness opinions (see Appendix 5).

Legislation, making available in the UK the rights of the European Convention on Human Rights, comes fully into effect in October 2000. We are still taking advice and assessing the impact of this legislation on the Institute as regulator and on our members. We recognise however that aspects of guidance on independence for practising members, their spouses and family members may well be affected and it is probable that there will be conflicts between the Commission's requirements and UK law as a result of this.

The Institute takes its regulatory role very seriously. As noted above, we believe that our combination of guidance on the safeguarding of fundamental ethical principles, prohibitions in a limited number of appropriate circumstances, professional education, and rigorous monitoring and enforcement mechanisms have at least as stringent an impact as the proposed SEC rule change.

We understand and share your aim of ensuring investor confidence in auditor independence. However, extending the detailed requirements of rules developed in a US context to countries such as the UK may not be the best way of achieving that aim and could have unfortunate unintended effects.

We would invite you to consider whether the cause of high quality and objective auditing would be better served by introducing, alongside revisions to US domestic arrangements, a system of mutual recognition of other countries' independence procedures where these are effectively enforced, as in the UK.


The UK has a great interest in the workings of the US capital markets, having nearly four times as many companies with US listings as any other country outside North America. Accordingly, we very much appreciate the opportunity to comment on your proposal.

We support your intention to promote the role of principles in rule setting. We would urge you to go further and seek to make the principles themselves, rather than detailed rules with inevitable loopholes, the foundation of your arrangements. Such an approach fosters world economic growth because it is

If nevertheless you consider that some detailed rules to deal with circumstances specific to the US are essential, we would urge you to consider a system of recognition of arrangements in other countries that achieve the same objective by different means.

We have not dealt in this response with the large number of specific questions in your consultation paper except where they affect the public interest. However, if the result of the consultation is significant further change to the proposals, we would welcome a further opportunity to respond.

I would be happy to discuss any points with you in more detail.


1 The Institute's guidance states: "Members should be guided, not merely by the terms, but also by the spirit of this Guide and the fact that particular conduct does not appear among a list of examples does not prevent it from amounting to misconduct."
2 The working party report recommends that "The analysis should at least be between services for which the directors believe that it is neither practical nor appropriate to use other than the auditors, and other work."


Clarification of definitions

We had hoped that the proposed rule changes would lead to a more streamlined structure in which there was greater clarity, so that the scope for surprise reinterpretations would be reduced. It is important to minimise the likelihood of an auditor change enforced by a surprise interpretation of SEC rules, which would damage investor confidence in the home market if the outgoing firm had already completed their audit in full compliance with domestic GAAS and reported to shareholders.

We believe there are many terms in the proposals that need further amplification but would highlight in particular the definitions of "office", "expert", "chain of command" and "accounting or financial reporting oversight role".


Materiality and probable influence

The application of the four principles, and of the detailed rules, allows for no concept of materiality, meaning in this context the likelihood that the issue identified would influence, or appear to influence, the objectivity of those engaged on the audit. For example, no reasonable investor is likely to regard the auditor as having impaired independence if,

  1. in a firm with fee income of over $10 billion, co-sponsorship of a recruitment fair by a part of the firm unconnected with the audit leads to sharing in profits of $20,000; or

  2. in a $1million audit client, a separate team has undertaken work on a performance based fee arrangement where the variable element is $50,000.

We consider that, except in relation to the personal direct investment rules where, because of the importance of perception, materiality should not apply, all of the requirements should be subject to an assessment of whether a reasonable and informed investor would consider that there was any likelihood that the issue could have any influence on the audit team's judgement.

This would clearly need to be couched in prudent terms so that it would only exclude genuine de minimis cases. There have been a number of such cases recently which have detracted from the credibility of the SEC rules in the eyes of the UK business community.


The advocacy principle

The use of the term `advocacy', without qualification, can lead to unnecessarily strict limitations. In the UK the ethical guidance distinguishes advocacy "in a simple sense [that] is always present where a firm supports its client's interests" from advocacy "in a sharpened form,... where the firm supports its client in an adversarial situation." It is the latter form of advocacy, which can lead to an impairment of objective judgement

If the advocacy principle does not distinguish between the two then, interpreted strictly, it appears to forbid an audit firm from undertaking a number of types of engagement that do not necessarily represent insurmountable threats. For example:

  1. Providing tax opinions to clients who are structuring transactions or making other changes, even though the decision to implement the recommendation relies on independent negotiation between the principals. If it is recognised that tax work is closely aligned to auditing and it is not the intention of the proposals to change this, then the proposals will need to be clarified.

  2. Providing tax opinions to authorities in support of treatments in tax returns, even though this activity is covered by UK ethical rules limiting the extent to which the opinions represent advocacy. It would not be practical for a company to engage its auditor to prepare its tax return (the traditional service) but then to engage a different firm to discuss specific issues with the fiscal authorities. Again, if it is intended that audit firms should continue to provide these services, it is important that the proposals should say so.

  3. Acting as expert witness in litigation, under a UK code of practice which, by law, requires the expert to maintain objectivity.

  4. Providing independent accountants' reports under securities market listing rules on a company's published profit forecast, working capital position, statement of merger benefits, product technology or other statements made in connection with a take-over offer or defence. This role is regarded as critical in ensuring that such statements are soundly based and thus in protecting investors.

  5. Work typically carried out by the audit firms of the purchaser and vendor in agreeing the amounts to be included in completion accounts on an acquisition.

  6. Most publicly disclosed web-site assurance products, where a firm's name and reputation assists in engendering confidence among counter parties.


Unnecessary restriction of competition and the consequences thereof

We do not believe that it is economically sound to impose artificial restrictions unless there is a compelling reason to do so.

Some of the proposals would restrict provision of certain non-audit activities by firms to companies which are not audit clients, thus leading to a potential reallocation of work between the firms. However, there are other proposals which effectively prevent the non-audit parts of firms from competing for any work, even for non-audit clients, against rivals which do not have SEC registered audit clients. Such issues arise because the professional services market is changing and new business models place much more emphasis on the sharing of risk through alliances and alternative pricing arrangements. Some proposals would make it impossible for a firm to enter into such arrangements even with non-clients without the risk of breach of the rules as a result of matters beyond the control of the firm. Examples of those which cause concern are discussed below:

  1. Business in the UK is increasingly driven through strategic alliances and joint ventures. One effect of 2-01(c)(3), as written, is to prevent any such ventures and weaken a firm's ability to compete in many spheres of business. For example, if an audit firm co-sponsors a trade exhibition with a non client, that non client cannot have any joint venture with, or other over 5% investment in an affiliate of, one of the firm's audit clients even if it is entirely unconnected.

  2. Increasing amounts of work undertaken for hi-tech start up companies which are not audit clients are paid for by taking equity shares. If this leads to an interest of over 5%, 2-01(c)(1)(i)(D)(2) prevents any audit client from having an interest in that company.

  3. The "mutual or conflicting interest" principle might be interpreted as preventing a firm, as liquidator, from selling a business in liquidation to an audit client. This restriction might prevent the liquidator fulfilling his duty to get best value for creditors and therefore no insolvency practitioner could be associated with a large accounting firm. In the UK, the accounting profession was born from liquidation and insolvency work and this is not a service that could easily or quickly be assumed by any other body. A similar restriction would apply to certain corporate finance activities undertaken by the large firms.

It will be clear that the impact of these issues is not just a reallocation of non-audit work from one firm to another. These are not activities that, under the proposals, can be reasonably undertaken by any business associated with an auditor of an SEC registrant. Moreover, these activities are generally associated with services to growing businesses. There is a risk that the proposals will remove an important source of professional support to job creation and the enterprise economy.

The differing pressures between those countries that have SEC registrants as clients and those that do not may lead to the break up of the major firms. This could not only result in multi-national businesses finding it difficult to employ auditors with the necessary depth and breadth of experience, but could also lead to a reduction in audit quality as a result of reduced international co-operation that would result from fragmentation of the firms.


Inconsistency with local legislation

We set out below examples of situations where local legal requirements result in a need for non-audit services, which we believe it should be permissible for the auditors to provide, with appropriate safeguards, but the provision of which would appear to infringe SEC independence regulations.

Investment Advice

Many accounting firms in the UK give financial planning advice under the Financial Services Act and are regulated by us in this activity. A requirement of this Act is that their advice to any client should not be restricted by, for example, any factors influencing or biasing the accountant's recommendations. Rule 2-01(c)(4)(H) prevents the investment advisory part of a firm from giving advice which includes investments in audit clients or in collective investments in investment company complexes one of whose funds is an audit client. This prevents the investment advisors from giving their clients balanced advice. Where the advice is being given in a separate office and the audit team is unaware of it, we cannot see that this restriction is necessary.


The 30 day time limit in rule 2-01(c)(1)(iii)(A) is unworkable in the UK legal environment where an accountant may be appointed executor to the estate of a deceased person without his knowledge. In a complex estate it may take some months to get control of the assets, to agree on actions to be taken with the other executors and, if necessary, the court, and to arrange for appropriate disposals.

Preparation of local statutory accounts and returns

In many countries including the UK, all incorporated businesses, including wholly owned subsidiaries, are required to prepare accounts no matter how small they are. This is a specialist activity where the interests of the regulators are best served by allowing the accountants to prepare the financial statements of unlisted companies, with suitable safeguards, as specified in our independence guidance. We believe that the restriction in 2-01(c)(4)(A)(2) should apply only to those financial statements, which form part of the audit trail in preparation of returns which fall within the SEC's jurisdiction..

A similar consideration should apply to tax and other regulatory returns.

Fairness opinions and valuations

In many European countries, valuations and fairness opinions are required as a matter of creditor protection on capital reorganisation or similar transactions. In certain countries (though not the UK) these opinions must be given by the auditors and therefore the proposals in 2-01(c)(4)(C) conflict with those laws. We believe that, at the very least, the reference to "results [that] will be audited by the accountant" should relate only to the audit for the purpose of SEC filings. This would exempt valuation work relating to items which are eliminated on consolidation, items where the value arrived at is not relevant to, or has only an indirect effect upon, the financial statements or amounts which are wholly immaterial such that they would not require audit in context of the registrant's accounts.

We also believe that auditors should be permitted, with appropriate safeguards, to carry out valuations based on verification of amounts included in a standard valuation model where there is no scope for judgement. For example, UK tax law requires a fairness opinion in relation to changes in a share option scheme on completion of a rights issue, although the formula set out in the scheme documentation rarely gives any scope for judgement in this opinion.

In such instances, we believe that safeguards can be put into place and that it is in the best interests of the various regulators involved and the revenue authorities that independent opinions should be given by the auditors. These opinions do not conflict in any way with audit responsibilities.