Deloitte & Touche LLP
November 25, 2002
Mr. Jonathan G. Katz
RE: Release Nos. 34-46685; IC-25773
Dear Mr. Katz:
Deloitte & Touche LLP is pleased to respond to the request for comments from the Securities and Exchange Commission (the "Commission") on its proposed rule, Improper Influence on the Conduct of Audits, File No. S7-39-02.
We strongly support the goals of the President of the United States, the United States Congress, and the Commission to improve the quality and transparency of financial reporting. The implementation of the Sarbanes-Oxley Act of 2002 (the "Act") is the primary vehicle by which positive changes will come about and we are committed to assisting the Commission in the adoption of responsible rules that improve the quality of financial reporting and help to restore investor confidence in our capital markets. One element of the implementation of the Act is the Commission's proposed rule concerning improper influence on the conduct of audits.
Deloitte & Touche strongly supports the objectives of the Commission's proposed rule under Section 303(a) of the Act and any efforts to prevent improper influence on the conduct of audits. It is in the best interest of investors to prevent persons from fraudulently influencing, coercing, manipulating, or misleading any independent public accountant engaged in the performance of an audit or review of financial statements. However, in order to meet the objectives of Section 303(a) of the Act and prevent unintended consequences, we believe the following comments should be considered prior to adoption of the final rule.
II. Answers to Specific Questions
This section provides our views on certain of the specific areas for which comments were requested in the proposing release.
Should we define by rule the scope of "any other person acting under the direction" of an officer or director?
The proposed rule includes in the definition of any other person acting under the direction of an officer or director "all partners or employees of the accounting firm that might be working for the issuer." The Commission proposes that this definition "in appropriate circumstances ... may include other partners or employees of the audit firm such as consultants or forensic accounting specialists retained by counsel for the issuer."1 Taken to an extreme, the proposed definition could potentially result in a charge that the accounting firm was misleading itself. We believe that these results are inconsistent with the objectives of the Act.
Under professional standards, the auditor is required to consider the implications on the audit of non-audit services provided to the audit client and consult with persons in the accounting firm that have provided those non-audit services to the audit client. AICPA Statements on Auditing Standards (SAS), Planning and Supervision (AU 311.04), require that the auditor, in planning the engagement, "discuss matters that may affect the audit with firm personnel responsible for non-audit services to the entity." Additionally, in practice, the terms of a permitted consulting or forensic engagement typically are made explicit to permit the audit team to have access to those professionals of the accounting firm who might otherwise be requested to hold confidential information obtained in the non-audit engagement.
We believe that the proposed definition of "any other person acting under the direction of an officer or director" may create an unintended disincentive for professionals that work within the same firm to communicate openly with the audit team for fear that any communication they make to the audit team may be construed as "improperly influencing the auditor." Any reluctance on the part of professionals at the accounting firm to communicate with the audit team may impair the accounting firm's ability to conduct the highest quality audit. This proposed definition should be modified so that only advisors not employed by the external audit firm can be viewed as potentially improperly influencing the audit.
Additionally, the proposed definition of "any other person acting under the direction of" an officer or director extends to third parties such as vendors and customers. As a result, it would be possible for third parties to be accused of improperly influencing the audit. In the course of an audit, information obtained from third parties, such as confirmation replies, provides the most reliable form of audit evidence. We are concerned about the potential impact of the proposed rule on the ability to obtain third party information as audit evidence. In adopting the final rules, the Commission should ensure that an auditor's ability to obtain information from third parties is not impaired or stifled due to a third party's concern regarding the risk of being accused of improperly influencing the audit.
Should the types of conduct that might constitute actions to fraudulently influence an auditor be set forth in the rule? If so, which items listed in the preceding paragraph should be included or excluded? What additional types of conduct, if any, should be included?
We support the inclusion of examples that may constitute "improper influence." However, we have the following comments:
The phrase "offering future employment or contracts for non-audit services" should be deleted from the first example. We believe the intent of the first example "offering or paying bribes or other financial incentives, including offering future employment or contracts for non-audit services" was to prevent companies from bribing their auditors in exchange for favorable treatment. However, based on the language in the proposed rule, the phrase "offering future employment" could be interpreted as a complete prohibition on companies offering employment to anyone who is a member of the audit team or works for the external audit firm. We believe this is inconsistent with Section 206 of the Act, which requires a one-year cooling off period for registered public accounting firms when individuals who worked on the audit take certain positions at the company. Section 206 states the following:
Also, the Commission's independence rules as embodied in Rule 2-01(c) of Regulation S-X, and professional standards embodied in Independence Standards Board's Standard Number 3, Employment with Audit Clients, and the AICPA Code of Professional Conduct currently include stringent safeguards relating to situations in which an individual participating in an audit is offered employment by, or seeks employment with, a client during the conduct of the audit engagement. Therefore, we believe the phrase "offering future employment" should be deleted from the first example.
However, if the Commission determines not to delete the phrase "offering future employment," at a minimum, its meaning should be clarified to reflect that the prohibition is limited to offering future employment specifically in exchange for favorable treatment. The current language of the proposed rule is extremely vague and suggests that simply offering future employment to anyone at the external audit firm may be viewed as improper influence. As discussed above, this is inconsistent with Section 206 of the Act, which requires a one-year cooling off period for registered public accounting firms when individuals who worked on the audit take certain positions at the company.
Because Section 206 does not include a complete prohibition on hiring individuals from the external audit firm, we do not believe this complete prohibition was the intention of the Act. As such, language in the proposed rule that suggests a complete ban should be modified such that it is clear that only offering employment to the auditor in return for something else (i.e., a "quid pro quo") may be considered "improper influence."
In addition, we believe the phrase "contracts for non-audit services" should be deleted from the first example. The Commission has announced that it will propose a rule that will prohibit audit partners from being compensated for selling non-audit services. Further, under the Act, the audit committee is required to pre-approve all audit and non-audit services provided by the external auditor. We believe that the soon to be published rule and the pre-approval requirements under the Act more appropriately address the concerns over the potential for an audit client to use non-audit services to improperly influence the audit partner. We also believe that including this language in the example may create confusion as to whether or not external audit firms are precluded from providing non-audit services.
If the Commission determines to retain this phrase, at a minimum, the final rule should clarify that the illustrative list of the types of conduct that may be viewed to constitute improper influence on the audit is not intended to proscribe the external audit firm's ability to provide permissible non-audit services to the audit client, assuming the requisite pre-approval from the audit committee has been obtained.
Additional examples should be added to the list of what may be considered "Improper Influence." A majority of the examples included in the list of actions that may be considered improper influence are examples that we believe are unlikely to occur or that occur extremely rarely, such as physical threats, bribery, and blackmail. Efforts to improperly influence auditors are more likely to occur by knowingly providing inaccurate or misleading information or failing to provide key information to the auditor. As stated in The Report of the National Commission on Fraudulent Financial Reporting (the "Treadway Commission"), "Fraudulent financial reporting can involve many factors and take many forms. It may entail gross and deliberate distortion of corporate records, such as inventory count tags, or falsified transactions, such as fictitious sales or orders. It may entail the misapplication of accounting principals."2 In this study of the causal factors leading to fraudulent financial reporting, the Treadway Commission found that in a large majority of the cases studied, "the company's top management, such as the CEO, the president, and the CFO were the perpetrators. In some cases, the company made deliberate misrepresentations to the independent public accountant, sometimes through falsified documents and records."3
In light of the forms that "improper influence" typically takes, we believe additional examples should be added to the list as follows:
Should proposed rule 13b2-2(b)(2) provide a specific definition of "engaged in the performance of an audit"?
The Commission, in Rule 2-01 of Regulation S-X, previously defined the Audit and Professional Engagement Period as follows:
(5) Audit and professional engagement period includes both:
We believe that the definition in Rule 2-01 of Regulation S-X previously adopted by the Commission is appropriate and that to provide an additional definition would be unnecessary as well as confusing for, among others, registrants and their auditors.
Is subparagraph (b)(2) of the proposed rule helpful or necessary? Should it be deleted? If subparagraph (b)(2) should be adopted, are the examples appropriately illustrative? Should more, or fewer, examples be included in the rule? If so, what examples should be added or removed?
We believe that the definition of "Audit and professional engagement period" set forth in Rule 2-01 of Regulation S-X previously adopted by the Commission more appropriately addresses the examples that have been listed as well as other procedures performed by the auditor not listed. We believe that an approach that provides a list of examples would be confusing for, among others, registrants and their auditors. For example, under the proposed rule, the list of example services to which improper influence would apply does not include other reports filed with the Commission, such as reports related to internal controls over financial reporting. We believe that the scope of the rule prohibiting improper influence on the auditor should be broadened by eliminating the examples and expanding the prohibition of improper influence to "any procedures performed by the auditor related to any report that is filed with the Commission during the audit and professional engagement period."
Is it necessary or appropriate to expressly extend the prohibition on improper influence on the conduct of audits, and existing rule 13b2-2, to officers and directors of the investment company's service providers? If so, which service providers should be covered?
The Commission has previously concluded pursuant to Rule 2-01 of Regulation S-X that the control group included in an investment company complex includes the investment company and the service providers to those investment companies, such as the investment advisor, sponsor, depositer, trustee, and administrator. Consequently, it is not inconsistent that the Commission would extend the prohibition on "improper influence" to the investment company's service providers as listed above. We believe that the proposed rule, which is directed to those entities that "provide service to the investment company," is more appropriate and that Rule 2-01 should be conformed to be internally consistent with this proposal.
Quality financial reporting is essential to maintaining confidence in our financial markets. Open and full disclosures from management to the auditor are essential to maintaining the effectiveness of the audit process. Although integrity cannot be legislated and no law can provide a guarantee that acts to mislead or improperly influence auditors will cease, we believe effective implementation and enforcement of Section 303(a) will provide an additional measure in the prevention of false and misleading statements to auditors in connection with the audit and review of financial statements. We also believe that in order to avoid unintended consequences, the issues enumerated above should be addressed.
If you have any questions, please contact Robert J. Kueppers at (203) 761-3579.
cc: The Honorable Harvey L. Pitt, Chairman of the Securities and Exchange Commission