November 29, 1999
Mr. Jonathan G. Katz
Secretary
U.S. Securities and Exchange Commission
Mail Stop 6-9
450 Fifth Street, NW
Washington, DC 20549
Re: File No. S7-22-99 (Release No. 34-41987)
Audit Committee Disclosure
This letter is the response of Arthur Andersen LLP to the Securities and Exchange Commission's request for comments on Release No. 34-41987, "Audit Committee Disclosure," addressing disclosure requirements for audit committees and the requirement for registrants' auditors to review interim financial statements.
Summary
We believe enhancing audit committee disclosures and requiring reviews of interim financial information will increase investors' confidence in the financial reporting process for many of the reasons discussed below. Although we have some recommendations regarding specific aspects of the proposals, we generally support the Commission's proposal. The original recommendations of the Blue Ribbon Committee (BRC) on Improving the Effectiveness of Corporate Audit Committees have received much attention and we believe the Commission has dealt appropriately with the most significant concerns regarding the recommendations. We believe the Commission's proposal represents an appropriate balance between costs and benefits to investors. Our specific comments focus on two aspects of the proposal: the review of interim financial statements and the audit committee report.
Specific Comments
Reviews of Interim Financial Statements
Need for Reviews: We agree with the Commission's proposal to require reviews of interim financial statements prior to the filing of a Form 10-Q or 10-QSB. Under current professional auditing standards, that review would be performed in accordance with Statement on Auditing Standards No. 71 (SAS 71). As mentioned in the proposal, all "Big 5" auditing firms currently require timely quarterly reviews as a part of their client acceptance criteria. Arthur Andersen implemented this policy for a variety of reasons, including many of the benefits identified by the Commission in its proposal. Although interim reviews do not provide the same level of assurance as an audit, we believe timely reviews of interim financial information will:
Cost of Reviews: The cost of requiring timely reviews of interim financial statements will vary depending upon the registrant. For registrants whose interim financial statements currently are reviewed by the auditor on a timely basis, we believe that cost increases will be nominal. For registrants whose interim financial statements currently are reviewed by the auditor on a retrospective basis in accordance with Regulation S-K Item 302(a), our experience indicates that although timely quarterly reviews are somewhat more costly than retrospective reviews, the net cost increase generally is not significant. For registrants whose interim results are not currently reviewed by the auditor either on a timely or retrospective basis, we believe that there will be increased costs. Incremental costs result primarily from the need to perform certain procedures multiple times throughout the year. In addition to reading three additional sets of financial statements, certain procedures may be necessary on an interim basis based on the company's specific facts and circumstances and the auditor's risk assessment. Offsetting these costs, however, is the shifting of certain work from year-end to earlier periods, time savings in fixing problems that may not otherwise have been discovered until year-end, and the strengthening of internal controls resulting from the discipline involved in the review process. We believe that the Commission's proposal represents a reasonable balance between the needs of investors and the cost to registrants.
Scope of Reviews: We agree with the Commission's proposal to require timely reviews of interim financial statements in all Form 10-Q and 10-QSB filings. We believe that any additional costs to registrants are balanced by investor needs for reliable interim information. As noted above, we do not believe these additional costs are significant. Arthur Andersen's current internal policy requiring interim reviews for domestic filers does not provide for size-based or other exemptions.
In addition to the requirements for a review of financial statements in a Form 10-Q or 10-QSB, we suggest that the Commission require SAS 71 reviews of interim financial statements included in registration statements filed by domestic and foreign registrants. Interim information is particularly meaningful in registration statements because it represents the most recent financial picture of a company. Further, we note that the current proposal is inconsistent in that interim financial statements in a Form 10-Q incorporated by reference into a Form S-3 would be subject to a review, whereas interim financial statements included in a Form S-1 would not be subject to a review.
Timing of Reviews: The proposal asks whether the reviews of interim financial statements should be completed prior to a company's earnings release or before the filing of Form 10-Q or 10-QSB. From the perspective of investor protection, we believe it would be preferable to require reviews prior to the release of earnings. However, we observe that to require the completion of a review prior to a quarterly earnings release would be a higher standard than currently applies to the release of annual results. In addition, we believe that it will take time for some companies to effectively build the review into their normal quarterly process. Requiring the completion of reviews prior to the earnings release could result in companies delaying the earnings release as they become accustomed to the review process. We do not believe this a desirable result. In addition, the Commission should keep in mind that the Auditing Standards Board (ASB) proposal to require communications with the audit committee prior to the filing of a Form 10-Q or 10-QSB will further add to the timeline.
As a result, we recommend that the Commission require reviews of interim financial statements prior to the filing of the Form 10-Q or 10-QSB as proposed. Once companies and auditors become accustomed to the review process and there has been further research to determine if the additional benefits of accelerating the review outweigh the incremental costs, it may then be appropriate for the Commission to reconsider this issue. If a decision is made now, or at some point in the future, to require reviews of interim financial statements prior to the earnings release, then we suggest that the Commission also require a review of the fourth quarter financial information prior to the release of the annual results. In that way, all earnings releases will have been subject to the same level of auditor involvement.
The proposal asks whether our views on the question of timing would change if a recent proposal to accelerate the due date of Forms 10-Q and 10-QSB were adopted. We believe the credibility and timeliness of interim information are both very important, but we do not believe that credibility should be sacrificed in the interest of timeliness. If both proposals are adopted, we suggest that they be implemented in stages so that the acceleration of due dates for Forms 10-Q and 10-QSB is delayed until companies and auditors have made the review a normal part of the process as discussed above.
Adequacy of SAS 71: We do not believe that any modifications are needed to SAS 71 beyond those currently proposed by the ASB. The current standard provides sufficient guidance with regard to the procedures an auditor should perform in conducting a review.
Review Report: The proposal asks whether the Commission should require that the auditor's review report be filed as an exhibit (Item 601 of Regulation S-K) to the Form 10-Q or 10-QSB. We support a requirement to present a review report as an exhibit to a Form 10-Q, Form 10-QSB or registration statement so long as the report is filed under the current framework for auditor liability. Currently, when a review report is included in a filing, it is not considered "filed" and as such Section 11 liability does not attach to the report. Given the limited scope of a review, we do not believe it is appropriate, nor do we believe it was the intent of the Blue Ribbon Committee to increase the auditor's liability. In addition, SAS 71 was written in the context of the current framework of liability; were the auditor's liability and responsibility to increase, we believe the scope and reporting under SAS 71 would require expansion.
We believe that requiring the report to be filed as an exhibit would benefit both auditors and investors. If the Commission requires an interim review, investors should understand the scope of the procedures involved in a review. Absent having access to the auditor's review report, investors might place more reliance on the review process than is appropriate based on the limitations of a review. The review report communicates the work that has been performed and the limited reliance that should be placed on the results of the review. In addition, without seeing the report, investors would not know whether the auditor qualified its report for any reason.
As an alternative, the proposal suggests requiring disclosure that the review has been completed and eliminating the requirement to file the report when this disclosure is made in a Form 10-Q or 10-QSB. We do not believe this alternative approach is desirable because the investor would not be informed of the results of that review and would not be apprised of the limited scope of the procedures performed. It also provides no control mechanism for the auditor to insure that its work is completed before the interim financial statements are filed. Essentially, this alternative places the registrant in the position of reporting on behalf of the auditor. We do not believe that is an appropriate result.
Item 302(a) of Regulation S-K: We suggest that the Commission delete the requirements to present selected quarterly financial data under Item 302(a). Our understanding is that this rule was initially put in place due to the Commission's concerns regarding the quality of quarterly reporting. Item 302(a) was adopted to provide some minimal level of assurance on quarterly data. This limited assurance is currently provided because Item 302(a)(4) requires, in essence, retrospective reviews of the quarterly information in accordance with SAS 71. If the Commission's proposal to mandate reviews is adopted, we believe this item is no longer necessary. If the Commission believes that quarterly financial information should be presented in summary form in the annual report, then we believe that requirement should apply to all domestic registrants.
Other Ways to Enhance Interim Reporting: The proposal asks for suggestions regarding other ways in which the quality and reliability of interim reporting could be enhanced. Some ideas that have been suggested by the financial community include auditor and management reporting on internal controls, management reporting on financial statements and auditor reporting on Management's Discussion and Analysis.
We believe that annual reporting on the adequacy of internal controls over the financial reporting process by both management and auditors will improve the quality of financial reporting. Internal controls over financial reporting are the foundation for managing the risks of financial reporting. Strengthening risk management and internal control is the only means of securing lasting improvements in financial reporting in times of rapid change. In particular, we believe such reports would add further credibility to interim reporting as there is inherently more reliance placed on internal controls during interim periods due to the lack of audit procedures being performed on an interim basis. We believe that the benefits of such reporting outweigh the costs.
We believe an annual and interim reporting requirement from management on the financial statements also would benefit investors. If the current proposal is adopted, there will now be two parties reporting on a Company's financial statements - auditors and audit committees. Because management is the party primarily responsible for the preparation of the financial statements, we believe an annual and quarterly report furnished by management should be developed and disclosed in Form 10-K or 10KSB and Form 10-Q or 10QSB as appropriate. We note that such a report was recommended on an annual basis in the report of the Treadway Commission in 1987. We also observe that a number of companies have adopted the use of this report as a "best practice." If such a requirement were adopted, we would suggest a management report covering the control environment and the financial statements, which includes the following:
We support auditor involvement and reporting on Management's Discussion and Analysis. However, we are opposed to regulators mandating such involvement and reporting and believe it should be based on users' demand for such services. The benefits and cost of reviews of this information are less susceptible to estimation and evaluation and, for that reason, we recommend that the evaluation of cost/benefit for these be left up to the users.
Audit Committee Report
Usefulness to Investors: We believe the proposed audit committee report would provide useful information to investors. The report is an acknowledgement to the shareholders that the committee has fulfilled certain of its responsibilities. Requiring the committee to sign the report should increase the committee's and shareholders' awareness of the committee's responsibilities.
Sufficiency of Report: On the whole, we believe that the proposed disclosures in the audit committee report are sufficient. The goal of the Blue Ribbon Committee was to increase the effectiveness of the audit committee. We believe the disclosures proposed by the Commission will serve that purpose and that incremental disclosures (e.g. detailed disclosures regarding the nature of the accounting issues discussed with the Committee) are not necessary. Simply requiring the proposed limited disclosures will achieve the desired effect of getting the audit committee more focused and aware of these issues. The audit committee's negative assurance serves as a summary of the results of those discussions to the shareholders.
Negative Assurance: We support the Commission's proposal to require the audit committee to provide negative assurance rather than positive assurance regarding the results of the committee's discussions with management and the auditor. The audit committee's role in the financial reporting process is an oversight role, not that of a preparer or auditor. The negative assurance report is an appropriate balance between the needs of investors, the limitations of audit committees and costs to the shareholders. Although we support the Commission's approach to reporting by audit committees, we believe it is important to consider responses from directors and the legal profession on this issue. If the negative assurance report is perceived to substantially increase director liability with the result that qualified board members are discouraged from serving on the audit committee, then we suggest that the Commission reconsider its proposal.
Auditor Independence Disclosures: We believe that the disclosures proposed by the Commission are adequate and that detailed disclosures of specific matters of discussion between the auditors and the audit committee would be inappropriate. When the Commission rescinded Accounting Series Release (ASR) 250, it did so after reaching the conclusion that the registrant's audit committee was in the best position to evaluate auditor independence due to its ability to have an interactive dialogue with the auditors and better understand the nature and scope of other services and relationships. We believe this logic is equally applicable here and thus it would be inappropriate to mandate the disclosure of information for which the shareholders have no reasonable basis to evaluate. The recently expanded guidelines required by the Independence Standards Board (ISB) Standard No. 1 as well as the proposals by the stock exchanges and the Commission should help to alleviate the Commission's concerns in this area.
Location of Report: We recommend that the audit committee report be filed with the Form 10-K or 10-KSB rather than the proxy statement. The focus of the audit committee report is on the financial statements; therefore, we believe it would be more useful to investors to have the report presented in some proximity to the financial statements. In addition, we note that foreign private issuers are not subject to proxy requirements and thus, to the extent they had an audit committee, they would be excluded from this reporting.
Transition: We have some concerns regarding both the transition of the new rules and transition with respect to future changes in the composition of the audit committee. As currently proposed the audit committee would be reporting on the "financial statements included in the Annual Report on Form 10-K". This would include 3 years of income statements for Form 10-K filers and 2 years for Form 10-KSB filers. It is not clear whether the Audit Committee Report would require the current committee members to discuss all three years financial statements in its first report or just the current year. In addition, it is not clear as to what would be required of a newly formed audit committee. Is it reasonable to require a newly formed audit committee to provide negative assurance on financial statements that were created when the committee did not exist? We recommend that the Commission address this issue in its final rules. One approach would be to limit the required discussion and negative assurance to only the current year's financial statements.
Other Items
1940 Act Investments Companies: We see no need to exclude investment companies from any of the proposed requirements. The rules would have to be structured a little differently given the nature of investment companies and how they are organized, but conceptually they should be subjected to the same audit committee or board oversight disclosure and interim financial statement review standards.
Foreign Private Issuers: We agree with the Commission's proposal to exclude Foreign Private Issuers from the requirements to obtain reviews of interim information filed on Form 6-K under the 1934 Exchange Act. Because the Commission's current rules do not require all Foreign Private Issuers to file interim financial statements, we believe it would be unfair to require only those companies who file interim financial statements to be subjected to a review. In addition, we believe it would be a dramatic departure from the current rules and a burden to implement a quarterly reporting scheme for foreign registrants.
As mentioned earlier in our letter, we recommended that the Commission also require a review of interim information included in registration statements under the 1933 and 1934 Acts. If the Commission adopts this recommendation, we believe it should apply to both domestic and foreign filers.
With regard to the audit committee report, we support the concept that Foreign Private Issuers should be required to furnish this level of assurance on their financial statements. If the purpose of the Audit Committee Report is to improve quality of financial reporting and to increase the effectiveness of the board oversight function, we see no reason to exclude foreign registrants from this process. Although we acknowledge that it might be appropriate to give foreign registrants relief from certain requirements, we believe the board oversight process is valuable to the quality of the financial reporting process. To exclude Foreign Private Issuers from this process also exacerbates the current unlevel playing field that exists between requirements of domestic registrants and requirements of foreign registrants. We recognize, however, that corporate governance requirements are different in other countries, and that as a result not all companies may have an audit committee. In addition, the customary role of the board of directors is different in many countries. For these reasons, we believe this issue needs further research prior to implementation to ensure that a uniform rule can be adopted which addresses the unique aspects of the corporate governance process of Foreign Private Issuers.
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We appreciate the opportunity to comment on the rules the Commission has proposed.
If you would like to discuss our comments, please do not hesitate to contact us. Please contact Ms. Amy A. Ripepi at 312-507-7258 or via electronic mail at amy.a.ripepi@us.arthurandersen.com
Very truly yours,
/s/ ARTHUR ANDERSEN LLP