BDO Seidman, LLP
Accountants and Consultants
330 Madison Avenue
New York, NY 10017
December 27, 2002
Mr. Jonathan G. Katz, Secretary
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, DC 20549-0609
Re: Release No. 33-8151
Retention of Records Relevant to Audits and Reviews
File No. S7-46-02
Dear Mr. Katz:
This letter is the response of BDO Seidman, LLP to your request for comments regarding the above-captioned proposal.
Given the number, breadth, and complexity of the Commission's recent proposals, we are concerned that issuers, auditors, and others have not had sufficient time to fully consider and comment on them. We recognize that the short comment periods for this and other Commission proposals are necessary to meet Congressionally mandated final rule adoption dates. Unfortunately, we feel that this creates a significant risk that the rules the Commission adopts could have unintended or inappropriate consequences. Section 802 of the Sarbanes-Oxley Act ("the Act") appears to recognize this concern by requiring the SEC to promulgate the record retention rules "after adequate notice and opportunity for comment." However, we do not believe 30 days is sufficient time to consider all of the consequences of this proposal, particularly as they relate to foreign auditors. We urge the Commission and its staff to be sensitive to this concern in considering the possible need to modify these rules in the future if adverse consequences become evident.
As discussed below, our principal concern regarding the proposed rules is that they do not clearly define the nature and characteristics of the documents that need to be retained. We expect that this could lead to very literal and overly broad interpretations. This, in turn, could lead to accounting firms retaining an enormous number of non-substantive documents they do not retain today. In our view, this would not be necessary to meet the objective of Section 802 of the Act. Moreover, we do not believe this is what was intended by the Act or that it would be an appropriate result.
As further described in our letter, the consequences of the proposed rules requiring the retention of excessive documentation include:
- Significant administrative costs of designing and installing document storage and retrieval systems, training people to use them, and the incremental time to enter documents into the systems.
- Significant litigation costs related to producing vast numbers of documents to civil plaintiffs, devoting time to these documents during discovery, and annotating each insignificant document retained as to its relevance to the other documentation in the workpapers.
- The likelihood that increasing litigation costs would undermine the remedial intent of the Private Securities Litigation Reform Act of 1995 by giving unfair bargaining leverage to the plaintiffs bar.
- Reduced and inefficient audit performance, adversely affecting the reliability and timeliness of financial reporting.
Our comments in this letter include recommendations for mitigating these potential consequences.
We also have other concerns, the most significant of which is our belief that despite the best efforts of the accounting firms and their personnel, execution will not be flawless. Therefore, we encourage the Commission to (1) make the rules simple and clear and (2) include a reasonableness standard in the rules so that auditors and firms that make good faith reasonable efforts to comply will not be penalized when the inevitable mistakes occur.
Our Principal Concern
We believe that proposed Rule 2-06 of Regulation S-X is written far too broadly. In our view, the Commission needs to modify it so it clearly and specifically describes the nature and characteristics of the documents auditors must retain to protect the public interest.
Proposed Rule 2-06(a) requires an auditor to retain two broad categories of documents:
- Workpapers and other documents that form the basis of the audit or review and
- Memoranda, correspondence, communications, other documents, and records (including electronic records)
We believe we understand the definition of "workpapers" in proposed Rule 2-06(b). It appears to be consistent with the documentation requirements in generally accepted auditing standards1. It also appears to us that "other documents that form the basis of the audit or review" are a subset of workpapers. If our understanding is correct, then we agree with the portion of the proposed rule requiring auditors to retain "workpapers and other documents that form the basis of the audit or review."
We are very troubled, however, by the proposed requirement to retain "memoranda, correspondence, communications, other documents, and records (including electronic records)" that meet the following criteria set forth in the proposed rule:
- Are created, sent or received in connection with the audit or review, and
- Contain conclusions, opinions, analyses, or financial data related to the audit or review.
Our concern is that there is no language in this part of the rule that clearly circumscribes the nature and characteristics of the documents that need to be retained. Therefore, regulators, plaintiffs' counsel, courts, and juries may interpret these provisions in an overly broad manner. For example, such an overly broad document retention requirement would create a situation where the failure to retain any record - no matter how trivial - would give plaintiffs the basis for a spoliation instruction. This would cause accounting firms to compensate by retaining an inordinate number of unnecessary documents.
In analyzing this issue, one should consider the following items that could literally contain "opinions, analyses, or financial data related to the audit or review":
- Notes taken during conversations with clients or accounting firm personnel;
- E-mails to or from clients or accounting firm personnel;
- Review notes and responses that resolve such notes written by engagement team members at all levels;
- Superseded drafts of memos, financial statements, or SEC filings;
- Notes/scribbles on printed e-mails and superseded drafts of memos, financial statements, or SEC filings that reflect incomplete or preliminary thinking; and
- Voicemail messages (if these are viewed as "electronic records").
These items would often reflect cryptic communications about relatively trivial matters and would not appear to serve any useful purpose. However, if they do relate to more substantive matters, then either the document itself or the substance of the communication should be reflected in the workpapers. Once this is done, any of the above items not placed or otherwise reflected in the workpapers would be, in effect, superseded and no longer relevant or substantive. Accordingly, the rules should not require their retention. (We recognize that footnote 24 to the Release indicates that certain of these documents do not need to be retained. We provide comments on footnote 24 later in this letter.)
For the reasons discussed below, we believe a requirement to retain such an overly broad range of documents would be inappropriate.
- Except in cases where they represent an auditor's documentation of his or her final conclusions, we believe that the Act does not intend for auditors to retain items of the nature listed above. Where these items represent preliminary or incomplete thoughts on matters, they are not relevant to assessing the quality of the audit. We believe that only an auditor's final documentation of conclusions and the rationale for them are sufficiently relevant and substantive to require retention. In that regard, Section 802 of the Act requires the Commission to promulgate rules "relating to the retention of relevant records..." (emphasis added). Senator Leahy's statements on the Senate floor quoted in footnotes 9, 11, and 20 in the Commission's Release include the following statement: "[I]t is intended that the SEC promulgate rules and regulations that require the retention of such substantive material ... for such a period as is reasonable and necessary for effective enforcement of the securities laws and the criminal laws ..." (emphasis added).
- We also believe a broader requirement would have consequences that the Act did not contemplate. Senator Leahy's statement quoted above indicates that the intent of the document retention rules is to effectively enforce the securities laws and the criminal laws. In contrast, the Commission's Release indicates that retaining more documents may also have the consequence of benefiting civil litigants. In Section V.B. the Commission states, "... the proposed rules may benefit investigations and litigation conducted by the Commission and others" (emphasis added). We do not believe that this provision of the Act was intended to benefit civil litigants, so we think it is inappropriate to take actions to achieve that purpose. If the Commission adopts a broader document retention requirement, we believe the rule should specifically limit access to the additional documents to the Commission and the PCAOB and prohibit access by private civil litigants. Of course, this differential document availability would entail incremental costs in developing and maintaining document retrieval systems. However, such costs may be far less than the potential (and unnecessary) exposure to civil litigation.
- It appears to us that the Commission also did not intend for auditors to retain non-substantive items. When providing examples of the types of documents, in addition to those that support the auditor's opinion, that an auditor should retain, the Commission mentions only substantive items. The examples provided in the Release are:
- "a memorandum ... prepared by a member of a large accounting firm's national office that is critical of the accounting used by an audit client, or of a position taken by the partner in charge of the audit of those financial statements" and
- "documentation related to an auditor's communications with an issuer's audit committee about alternative disclosures and accounting methods used by the issuer that are not the disclosures or accounting preferred by the auditor."
- The Commission's burden estimates indicate that the Commission does not anticipate any change in auditors' document retention procedures, other than retaining substantive documents such as the ones described in the Commission's examples. The Release states (emphasis added):
"We do not anticipate any significant increase in burden hours for accounting firms or issuers because ... minimal, if any, work would be associated with the retention of these records. The disposal of those records, which would occur in any event, merely would be delayed. In addition, because an already large and ever-increasing portion of the records required to be retained are kept electronically, we do not anticipate that the incremental increase in storage costs for documents would be significant for any firm or for any single audit client. To cover all increases in burden hours, we estimate that, on average, the incremental burden on firms would be no more than one hour for each public company audit client."
If auditors are required to retain only substantive documents, such as final versions of national office memos which are critical of a client's accounting or communications with an audit committee about alternative accounting methods, we believe this burden estimate is reasonable. However, a much broader interpretation of the proposed rule would require auditors to gather and store vast amounts of additional paper documents and electronic records and incur other substantial costs which are discussed further below. In this case, the Commission's burden estimates would obviously be grossly understated.
Requiring auditors to retain a significantly broader range of documents (or having a rule that is so complicated or vague that auditors conclude that simply retaining "everything" is the most practical and safest way to comply) would have the cascading effect of ultimately requiring issuers to incur additional costs in return for little apparent benefit. Initially, auditors would incur the additional document retention costs. However, accounting firms typically bill their costs to clients. Further, we would expect the additional costs as a percentage of audit fees billed to issuers to be disproportionately greater for the smaller accounting firms that generally audit smaller issuers.
We expect that retaining a significantly broader range of documents would increase two types of costs: administrative costs and litigation costs.
Administrative costs would include designing and installing document storage and retrieval systems, training people to use them, and the incremental time it would take to enter documents into the systems (rather than simply discarding them). They would include significant costs to scan manual records, which still may constitute a significant portion of the documentation. We have made rough estimates indicating that, for BDO Seidman, LLP (the U.S. member firm of BDO International), these tasks would entail a one-time cost of $1 million and ongoing annual costs of $500,000 - $1 million. (These estimates do not include any amounts that we would incur if we need to install and operate a system to retain and retrieve voicemail messages. We have not estimated this cost but believe it would be substantial. We also have not factored in the costs of an auditor's time needed to decide whether or not a record needs to be retained.) To put these costs in perspective, BDO Seidman, LLP's billings to public companies for audit and audit-related services were approximately $41 million for the year ended June 30, 2002.
We have not had sufficient time to estimate the costs that would be incurred by the non-U.S. member firms of BDO International that audit issuers (46 member firms), or any other potential consequences of the proposal on them. Since our records retention capabilities in our non-U.S. member firms are generally less than in the U.S., we expect these costs to be even relatively greater for those firms. We expect that this would also be the case for the other international accounting firms.
Litigation costs would include costs to produce vast numbers of additional documents to civil plaintiffs and costs related to the additional time accounting firm personnel and lawyers would need to devote to them during discovery and at trial. They could even include increased damage awards if plaintiffs' lawyers succeed in persuading juries to take non-substantive documents out of context and give more weight to them than they deserve. The resulting threat of increased damage awards could result in increased settlement costs. While we are unable to estimate these costs at this time, we believe they would be substantial. In an effort to mitigate these costs, auditors would probably institute a practice of annotating each insignificant document, communication, and note retained as to its relevance to other documentation in the workpapers. This would require an enormous effort which we estimate would increase annual audit costs by at least 5% and perhaps as much as 15% - 20%.
We believe that increasing litigation costs in this manner would undermine the remedial intent of the Private Securities Litigation Reform Act of 1995, which recognized that the cost of dubious litigation gives unfair settlement bargaining leverage to the organized class action plaintiffs bar. In that regard, we noted above the likelihood that plaintiffs would request spoliation instructions any time a document is not retained. We believe it would be inconsistent with the intent of the Private Securities Litigation Reform Act to shift the focus of liability from whether the auditor met his or her professional responsibilities to whether he or she retained every Post-It note a plaintiff claims he or she should have retained.
- We believe an overly broad document retention requirement would detract from audit quality and, as a result, adversely affect the reliability and timeliness of financial reporting.
- During the course of an audit, auditors typically receive more information than requested or is ultimately useful for audit purposes. Providing auditors with excessive information can be a technique used by fraudsters to obscure their actions. Requiring auditors to focus more attention on retention questions related to every document they receive may increase the risk of undetected fraud.
- The Release asks whether the proposed rules would encourage auditors to replace written communication with oral communication. This may, if fact, occur as a natural consequence. If so, it would be detrimental to the effectiveness and efficiency of the audit process and could delay the timeliness of financial reporting.
- Footnote 20 to the Release indicates that the requirement to adopt these rules was enacted in response to one episode of apparent document destruction by one accounting firm. There is no evidence of a widespread loss of "substantive material ... necessary for the effective enforcement of the securities laws and the criminal laws ..." in other financial fraud cases. We do not believe this single episode warrants the drastic change that would be entailed if retaining a significantly broader range of documents was required.
- The phrase "cast doubt" in proposed Rule 2-06(c) is vague and unnecessary. It will likely be used to attribute doubt to virtually any written remark made during an audit, regardless of relevance and materiality.
How to Modify the Rule
We believe the Commission should modify the proposed rules to require auditors to retain only documents that are (1) relevant to the audit and (2) deal with substantive matters. As part of those changes, we suggest the following:
- Rather than using the phrase "cast doubt" in proposed Rule 2-06(c), we believe a more appropriate standard reflecting relevance and materiality of the issues concerned would be to require auditors to retain memoranda describing differences of opinion on accounting, auditing, and disclosure issues that are material to the issuer's financial statements and the procedures taken to resolve such disagreements. In that regard, matters should not be characterized as disagreements when, similar to Item 304 of Regulation S-K, they constitute initial differences of opinion based on incomplete facts or preliminary information that were later resolved to each party's satisfaction.
It would also be helpful if the final rule incorporated elements of Statement on Auditing Standards No. 22, Planning and Supervision, and the related interpretation referred to in the Release in order to reflect the need to document even disagreements at the assistant level.
- As previously indicated, one of the types of documents that meets the criteria of being substantive and relevant is "a memorandum ... prepared by a member of a large accounting firm's national office that is critical of the accounting used by an audit client, or of a position taken by the partner in charge of the audit of those financial statements." This view appears to be consistent with the AICPA SEC Practice Section's recently adopted membership rule (Section 1000.08(q)) that addresses internal consultation. It requires a firm with 1,500 or more professionals to maintain and disseminate policies that delineate the process for resolving issues through its consultation network. That process requires that the consultation policies address the documentation of consultations that involve significant accounting and auditing matters. In that regard, the following should be documented: the matter, the action taken to address the matter, and the basis for the final conclusion reached. The central feature of this membership rule is that where the engagement team consults on significant issues, the partner in charge of the audit must either follow the position taken by the person consulted or appeal any disagreement to those at a higher level of authority in the firm for ultimate resolution. We believe that the Commission could meet the objectives of the Act by requiring all registered firms to comply with this membership rule.
- Footnote 24 states, "Superseded drafts or auditor review notes that do not reflect a difference of opinion, however, would not have to be retained." We read this footnote to say that (1) all superseded drafts could be discarded and (2) review notes could also be discarded, but only if they do not reflect a difference of opinion. We believe that even review notes that reflect a difference of opinion are no longer relevant if (1) they relate to initial differences of opinion based on incomplete facts or preliminary information that were later resolved to each party's satisfaction or (2) the issue and its resolution have been more formally documented (e.g., in a memo included in the workpapers). With changes to reflect these points, we believe that this guidance should be included in the final rule.
We have a number of comments regarding other aspects of the proposed rules.
- The proposed rules are not specific regarding how they would apply to an issuer filing an initial registration statement. We see no requirement for an auditor to retain anything it would not otherwise retain until the day the client becomes an issuer by filing its initial registration statement. We believe the Commission should communicate its views on this in the release covering the final rules and consider modifying the rules to reflect its views.
- The Release does not state when the rules would take effect but, in footnote 24, raises the prospect of them becoming effective before accounting firms register with the PCAOB. If the Commission adopts a broad retention requirement, firms will need time to develop the necessary systems and train people to use them. Therefore, we believe it would be reasonable to expect U.S. firms to begin to comply with such broad rules in approximately one year, i.e., in audits of issuers' financial statements for periods beginning after December 15, 2003. Even with such an effective date, however, foreign accounting firms (including those which only work on subsidiaries of U.S. registrants) are likely to require more time to prepare.
- Another aspect of the proposal that concerns us relates to the documents we have historically prepared as part of our internal inspections of the quality of our work. In the past, we have shared these documents with our peer reviewer and have discarded them after our peer review was accepted by the SEC. In years between peer reviews, we have discarded these documents after completion of the internal inspection. Since we do not prepare these documents until after we complete the audit engagements which are included in the inspection program, we do not believe they should be considered created, sent or received in connection with the audit or review. Thus, we believe we can discard them as described above. We ask the Commission to communicate its views on this matter in the Release covering the final rules.
- The proposed rules do not state any requirements as to how the documents other than workpapers are to be organized. Our policy has been to file in the workpapers documents that we need to support our opinion, our consultation memos (including any that document internal disagreements), and our documentation of our discussions with audit committees and to discard other documents and records which we consider unnecessary. Since we have no need for these other documents and records, if the Commission adopts a broader rule than we advocate and requires us to retain them, we plan to minimize the effort needed to organize them in a manner that facilitates retrieval. That basic level of effort is reflected in the cost estimates provided above. We would envision having one file for each audit report that would contain all of the other documents. We suggest that the final rule indicate that the means of retaining and retrieving records are flexible.
- The Release asks whether there should be document retention requirements for issuers. We believe that issuers should be responsible for supporting the information they provide in their filings and that auditors should be responsible for supporting their audit report. We do not believe it would be practical for issuers to keep track of which documents an auditor examined and then apply special retention requirements to those documents. We believe that this would be cumbersome, that the cost would outweigh the benefit, and that addressing any perceived problem with audits arising out of record destruction by clients should not be a priority at this time.
- Finally, the Commission should note that despite the best efforts of accounting firms to establish clear document retention policies and train their people in complying with them, and despite the best efforts of the partners and employees who work for those firms to comply, execution will not be flawless. Paper and electronic records do get lost. The execution problems will only increase with the breadth and complexity of the rule.
We believe that it is in the public interest to enable auditors to focus on pressing issues (such as those reflected in other recently adopted and proposed Commission rules and accounting and auditing standards) instead of devoting undue efforts to complying with retention requirements relating to non-substantive documents. Therefore, we encourage the Commission to (1) make the rules simple and clear and (2) include a reasonableness standard in the rules so that auditors and firms that make good faith reasonable efforts to comply will not be penalized when the inevitable mistakes occur.
* * * * * * * *
We appreciate this opportunity to express our views to the Commission. We would be pleased to answer any questions the Commission or its staff might have about our comments. Please contact Wayne Kolins (at (212) 885-8595 or via electronic mail at firstname.lastname@example.org) or Lee Graul (at (312) 616-4667 or via electronic mail at email@example.com).
Very truly yours,
/s/ BDO Seidman, LLP
|1|| The current documentation requirements are contained in recently issued Statement on Auditing Standards No. 96, Audit Documentation. SAS 96 was adopted with SEC input and oversight, and oversight initially by the Public Oversight Board and later the POB's Transition Oversight Staff. Recommendations of the POB's Panel on Audit Effectiveness were considered in its development.