November 29, 1999
Jonathan G. Katz, Secretary
U.S. Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549-0609
Re: File No. S7-22-99
We are pleased to have the opportunity to comment on the Proposed Rule of the Securities and Exchange Commission (Commission), Audit Committee Disclosure.
We consistently have been supportive of the efforts of the Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees (Blue Ribbon Committee), and our CEO, James Schiro, was a member of the Committee. In this regard, we view the various proposals by the New York Stock Exchange, the National Association of Securities Dealers, the American Stock Exchange, and the Auditing Standards Board of the AICPA, as well as the Commission, as consistent with the intent of the recommendations of the Blue Ribbon Committee. We believe the combined impact of these rules will lead to a marked improvement in financial reporting through the interactive efforts of audit committees, management, and external auditors.
The Proposed Rule modifies, to some extent, the recommendations of the Blue Ribbon Committee that were directed to the Commission, and also includes a number of interesting questions on related matters. We have limited our comments to those areas where we believe we can be helpful in our comments.
Pre-Filing Review of Quarterly Financial Statements
We support the proposed requirement that registrants obtain a review by an independent public accountant of their interim financial statements prior to filing Form 10-Q. We also support the proposed requirement that generally accepted auditing standards (presently SAS 71, Interim Financial Information) should define the standards and procedures used in such reviews. Furthermore, we support retaining the existing requirement for including an accountant's review report in a filing when the filing company states that the interim financial statements have been reviewed.
The Release requests comment on the need for independent accountants to review interim financial statements before they are filed with the Commission, as the Proposed Rule would require. As noted in the Release, the major accounting firms recognize the value of timely reviews and generally require them as a condition of their engagement as auditors. We believe the benefits of performing preissuance reviews include the following:
While we firmly believe that the quality of interim financial reporting will be improved by involvement of the independent accountant, it is very difficult to predict with certainty whether "more reliable and credible" interim financial statements will result (as is asked in one of the questions posed in the Release). Similarly, we cannot predict whether fewer restatements as a result of year-end audits will occur, due in part to the different nature of procedures performed in reviews and audits.
We believe that these benefits are applicable to registrants of all size, including (and perhaps even more so) for smaller companies. Therefore, we support extending the requirement to registrants of all size, with certain exceptions based on the nature of the entity. When we introduced this policy in our firm, we recognized that certain entities would not benefit from such reviews. Accordingly, a broker or dealer registered only because of section 15(a) of the 1934 Act is not subject to our policy. Also, our policy does not apply to investment companies registered under the Investment Company Act of 1940, public commodity pools that file Forms 10-Q and Forms 10-K with the Commission, and foreign private issuers that file information on Form 6-K. We suggest that the Commission consider providing the same exceptions; we note that foreign private issuers would be exempt under the Proposed Rule. (Our views with respect to investment companies are expanded upon later in this letter.)
The Release requests comment on whether modifications to Item 302(a) of Regulation S-K are needed. The original reason for the exemption for smaller entities contained in Item 302(a) was to provide relief for smaller registrants from the need to have their interim financial information subjected to review by independent accountants. Although we see no reason why those registrants who will be required to obtain such reviews under the Proposed Rule should not also include Item 302(a) quarterly financial information in their annual report, this modification appears to be outside the scope of the current Proposed Rule.
The Release also requests comment on the costs of performing such reviews. Since we presently have a policy of performing preissuance interim reviews, there should be no incremental cost if this were made a requirement. We estimate that, when we first implemented our policy, the incremental annual effort was in the range of 5-10% of then-current annual audit effort, although for some clients it could have been as much as 20%. Furthermore, we believe that the relative cost of performing preissuance reviews is higher for smaller, less sophisticated entities. This is due to: (1) the relatively lower cost of auditing smaller entities and, therefore, the relatively higher impact of adding three visits to the company during the year, and (2) the less structure in such entities resulting in additional need to follow up on inquiries and analytical procedures. These are obviously broad generalizations and may not apply in all situations.
The Release requests comment on matters relating to the accountant's report. It is important to note that the benefits described above that we believe result from these reviews are directed principally at improving the process of disseminating interim financial information. Accordingly, we do not believe that any incremental benefit is to be gained by requiring accountants' reports to be routinely included in Forms 10-Q and 10-QSB.
Further, we suggest that the Commission recognize that there may be certain circumstances in which it is not practicable for an accountant to perform such a review. Specific situations where this might occur include:
Furthermore, there may be situations, even with continuing clients, in which there are significant internal control deficiencies or unresolved issues resulting from the accountant's review that would preclude the accountant from completing an interim review or issuing an unmodified review report. We suggest that the Proposed Rule require disclosure of the fact that the company's accountant has not completed the review of interim financial statements, when that is the case. In addition, if the accountant was precluded from completing the review due to significant internal control deficiencies or other unresolved issues, or would have or has modified his or her report, the registrant should describe these circumstances. In this manner, the information that would have appeared in the accountant's report, pursuant to paragraphs 30 to 32 or paragraph 41 of SAS 71, would be disclosed. This "exception reporting" should serve as a sufficient alert to readers without the need to read a standard report in filing after filing.
The Release also requests comment on whether any modifications to SAS 71 are needed. We believe that SAS 71 has proven to be effective yet flexible guidance for accountants in reviewing interim financial information and that, aside from the proposed revisions dealing with communications of the nature described in SAS 61, it does not merit further revision at this time. We suggest that the Commission and/or the self-regulatory organizations consider incorporating in their rules a requirement that the audit committee (or, at least, its chair) attempt to communicate with the accountant on a timely basis regarding quarterly financial information. This would complement the proposed revisions to SAS 71, and set up a process analogous to the proposed rules related to communications pursuant to SAS 61 and ISB Standard No. 1, as implied by the proposed contents of the Audit Committee Report included in the Proposed Release. This would recognize the necessary roles of both the accountant and the audit committee in bringing about such discussions.
Regarding the timing of quarterly reviews, we believe that mandating their completion prior to the earnings release would be both impractical and counterproductive. (We have the same concern regarding the communication requirement in the proposed amendment to SAS 71, and will be commenting to the Auditing Standards Board on this.) Recognizing concerns about insider trading and differential disclosures, companies know they need to release their quarterly earnings as soon as practicable. On the other hand, while companies and their accountants are best served by discussing significant accounting matters prior to earnings release, many aspects of the accountant's review can, of necessity, only be conducted after the company closes its books and prepares complete financial statements. Compressing the timeframe for completing the review may lead to either delays in dissemination of financial information to the marketplace or pressure on the accountant to reach premature conclusions.
The Audit Committee Report
We are not in a position to assess whether the proposed audit committee report will enhance audit committee performance, the objective of the Blue Ribbon Committee's recommendations. However, we believe that some of the changes from the initial recommendation reflected in the Proposed Rule are good, while we continue to have a serious concern about one part of the proposed report.
The underlying thoughts to our comments in this area are that: (1) we believe the Blue Ribbon Committee intended the reporting requirement to function more as a behavior modifier than as a communication device, and (2) the report should not create an inhibiting factor for audit committee participation. As a result, we believe that the report should focus on process and not conclusions, consistent with the present intent of Item 7 of Regulation 14A (which the Proposed Rule would amend).
In particular, we agree with the broadening of the scope of the second part of the proposed report to include a reference to all matters required to be discussed by SAS 61, and to not unduly focus on the "quality" discussion included in the recent proposed SAS of the Auditing Standards Board. We also agree with the approach taken to not require specific disclosure of significant accounting issues or other specific matters discussed, as these types of disclosure could cause a reluctance to have the "open and frank" discussion that the Blue Ribbon Committee rightfully believed is so important.
On the other hand, consistent with our thoughts above, we are concerned that the inclusion of part (a)(4) of the proposed Item 306 will be misunderstood by many, and be particularly disconcerting to potential audit committee members. Our strong preference would be to eliminate this part of the proposed report and have the report focus solely on the process followed by the audit committee.
However, if the Commission insists on some conclusionary statement by the audit committee, we could support an alternative formulation, based largely on the suggestion developed by the major accounting firms. To accomplish this, part (a)(4) could be revised to read: "Based on the review and discussions referred to in paragraphs (a)(1) through (a)(3) of this Item, the audit committee recommended to the Board of Directors that the audited financial statements be included in the company's annual report on Form 10-K."
We note that the audit committee disclosures called for in the Proposed Rule would be included in companies' proxy statements and, therefore, can only be applied as written to registrants with publicly traded common stock. This is consistent with the proposed rules of the New York Stock Exchange, which state that they apply to companies listing common stock on the Exchange. We recommend that the Commission's rules specifically indicate that, with the possible exception of the requirement for timely reviews of quarterly information by an independent accountant, they apply only to registrants with publicly traded common stock and not to other registrants, e.g., those with publicly traded debt only.
Our comments above are made in the context of the proposed rules and their general applicability. Recognizing the unique characteristics of registered investment companies, we have focused separately on the proposed rules and their impact on such entities.
The Release requests comments on whether any or all of the proposals should apply to investment companies registered under the Investment Company Act of 1940 (the 1940 Act). We believe they should not. The Commission's proposals are driven largely by concerns about "earnings management" and the quality of financial reporting. The relative lack of enforcement actions or press commentary on financial reporting matters relating to registered investment companies (as well as our own experience with the industry) indicates that there is little or no basis for such concerns within this industry. The value accounting model followed by investment companies leaves very little room for financial reporting abuses. The single most important area of judgment (fair valuation of securities for which market quotations are not readily available) already requires board oversight under the 1940 Act and related Commission rules.
If the Commission decides to apply some or all of the proposals to investment companies, we recommend that it address the following concerns regarding the application of the proposals to registered investment companies:
1. A review of interim financial information should not be required. As noted above, we did not apply our policy regarding such reviews to investment companies. (We believe that the other major accounting firms made the same exclusion.) Investment companies issue financial statements semi-annually in accordance with Section 30(d) of the 1940 Act. However, registered investment companies report net asset value per share either daily or (for many closed-end funds) weekly, greatly limiting the extent to which investors need to rely on interim financial statements. The Commission itself has recognized the limited utility of conventional interim financial information for closed-end funds several years ago by eliminating the requirement that quarterly financial information be included in such funds' annual reports.
2. Audit committees serving investment companies often have responsibility for a large number of funds in a single complex, with staggered fiscal year-ends. Because of the relatively straightforward nature of investment company financial reporting (including most fund groups' use of a standardized format for presentation of financial statements), the audit committee can fulfill its oversight responsibility on a complex-wide basis without performing specific fund-by-fund reviews. If the Commission adopts disclosure requirements relating to the functioning of the audit committee, the requirements should permits disclosures based on a complex-wide approach.
3. While many closed-end investment companies issue annual proxy statements pursuant to exchange listing requirements, most registered investment companies are not required to issue annual proxy statements and do so only when circumstances require a meeting of shareholders. Any disclosure requirements established for investment companies should be confined to either the Statement of Additional Information (under Forms N-1A or N-2) or Form N-SAR, both of which are available on EDGAR. We do not support adding any of these requirements to the annual report to shareholders. This document should remain focused on the essential information a shareholder needs to understand the performance of his or her investment in the fund and should not be obscured by technical disclosure of corporate governance matters that may be of interest to only a minority of investors in the fund.
4. The 1940 Act and rules thereunder establish standards for determining whether a director is independent. The Commission has recently proposed rules that would modify those standards and establish new disclosure requirements for the vast majority of registered investment companies. If disclosures about the independence of audit committee members are to be required for investment companies, we believe the standard for independence and the mechanism for disclosure should be established in coordination with this recent proposal.
The Release is silent with respect to the effective dates of the various aspects of the Proposed Rule. Unless otherwise stated, the Proposed Rule presumably would be effective upon publication. We believe it is important to be clear as to when the new rules would be effective. In order to support an integrated use of the Final Rule, we believe that all parts should be effective with respect to the same fiscal year of a registrant. In this manner, the audit committee report can credibly relate to the matters addressed by the audit committee in the year leading up to the report.
For example, if the Final Rule is approved by the Commission in December 1999 (the stated goal of the Staff), it would make sense for the proxy disclosures relating to calendar year-end companies to be implemented in proxy statements filed in early 2001, relating to the activities of the audit committee in the year 2000. It would be impractical for the audit committee report to be implemented in proxy statements filed in early 2000, since the underlying activities were not required for the preceding year. In essence, the Final Rule should be applicable to the next fiscal year beginning after the issuance of the Final Rule.
We also believe that the portion of the Final Rule relating to required reviews of interim financial statements should be effective with the first quarter in the fiscal year beginning after the effective date of the Final Rule.
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We would welcome the opportunity to discuss our comments further. You may contact Robert H. Herz at (973) 236-7217 or James S. Gerson at (973) 236-7247 for further information.
Very truly yours,