Ernst & Young LLP
5 Times Square
New York, NY 10036-6530
Phone: 212 773 3000
December 27, 2002
Mr. Jonathan G. Katz
U.S. Securities and Exchange Commission
450 5th Street, N.W.
Washington, D.C. 20549-0609
Proposed Rule: Retention of Records Relevant to Audits and Reviews
(File No. S7-46-02)
Dear Mr. Katz:
Ernst & Young LLP is pleased to comment on the proposed rule to implement the requirement of section 802 of the Sarbanes-Oxley Act of 2002 (the "Act") related to retention of records in connection with audits and reviews. Overall, we support the goals of the proposed rule, which specifies retention periods for workpapers and also provides for retention of certain documents that "cast doubt" on the accountant's opinion. However, we believe the rule should be modified to specifically incorporate the existing workpaper documentation requirements found under SAS 96, and the rule should define what constitutes "differences of opinion" that "cast doubt" on conclusions reached.
As discussed below, we recommend that the Commission delete the broad language proposed in subparagraphs (1) and (2) of 201.2-06(a), which, if literally applied, would require an accountant to retain virtually every scrap of paper received or created during an audit. The language in subparagraphs (1) and (2) appears to be an overly broad attempt to require the retention of any document that might evidence differences of opinion. Yet, the language of the proposed rule is so ambiguous that meaningful adherence in day-to-day practice would be burdensome and almost impossible to monitor.
We also recommend that the language of 201.2-06(c) be clarified to provide better guidance on what constitutes "differences in opinion." We suggest that the Commission look to the definition of "disagreements" in Item 304 (Reg. S-K § 229.304), and define "differences in opinion" as disagreements, which, if not resolved to the satisfaction of the accountant, would have caused it to make reference to the subject matter of the disagreement(s) in connection with its report.
I. The Commission Should Look To SAS 96 In Setting The Scope Of Documents That Must Be Retained
We do not believe the legislative history of section 802 of the Act can be fairly read as a directive to re-write the professional standards related to retention of audit documentation except, perhaps, to the extent Congress directed the Commission to promulgate rules that would bar destruction of documents that "cast doubt" on the conclusions or views expressed in an audit or review. As stated by Senator Leahy on the Senate Floor:
In light of the apparent massive document destruction by Andersen, and the company's apparently misleading document retention policy, even in light of its prior SEC violations, it is intended that the SEC promulgate rules and regulations that require the retention of such substantive material, including material that casts doubt on the views expressed in the audit or review, for such a period as is reasonable and necessary for effective enforcement of the securities laws and the criminal laws, most of which have a five-year statute of limitations.
148 Cong. Rec. S7419 (July 26, 2002).
Pursuant to section 802(a)(2) of the Act, Congress directed the Commission to develop rules that would require retention of "relevant" (not "all") documents created or reviewed during the course of an audit or review. Specifically, the Act directs the Commission to promulgate rules:
relating to the retention of relevant records such as workpapers, documents that form the basis of an audit or review, memoranda, correspondence, communications, other documents, and records (including electronic records) which are created, sent, or received in connection with an audit or review and contain conclusions, opinions, analyses, or financial data relating to such an audit or review, which is conducted by any accountant who conducts an audit of an issuer of securities to which section 10A(a) of the Securities Exchange Act of 1934 (15 U.S.C. 78j-1(a)) applies.
The task for the Commission is to create a rule that meets the intent of Congress (retention of records that reflect differences in opinion that cast doubt on conclusions reached), but does not impose needless burdens on accountants that would impede audit effectiveness or impose prohibitive conditions in terms of cost or compliance.
Given the criminal penalties that might apply to a violation of section 8021, we believe that rules in this area must be precise and clear, providing adequate notice of the conduct that is required and the conduct that is prohibited. The promulgating release (the "Release") recognizes that existing GAAS standards (SAS 96) require the auditor to prepare and maintain audit documentation of the auditing procedures applied, evidence obtained, and conclusions reached by the auditor in the engagement.2 The Release then sets forth the limitations of SAS 96 that Rule 2-06 seeks to remedy:
SAS 96 states that audit documentation serves mainly to provide the principal support for the auditor's report and to aid the auditor in the conduct and supervision of the audit. In order to ensure that the purposes of the Act are fulfilled, we have included in paragraph (c) of the proposed rules the specific requirement that the materials retained under paragraph (a) would include not only those that support an auditor's conclusions about the financial statements but also those materials that may "cast doubt" on those conclusions. Paragraph (c) is intended to ensure the preservation of those records that reflect differing professional judgments and views (both within the accounting firm and between the firm and issuer) and how those differences were resolved.3
We believe that paragraph (c), with some additional clarification, would capture the legislative intent behind section 802. We are concerned, however, that Rule 210.2-06(a) as proposed is ambiguous and, if read literally, would render the requirements of the rule unnecessarily broad and burdensome.
Section 210.2-06(a) as proposed provides:
(a) For a period of five years after the end of the fiscal period in which an accountant concludes an audit or review of an issuer's financial statements to which section 10A(a) of the Securities Exchange Act of 1934 (15 U.S.C. 78j-1(a)) applies, or of the financial statements of any investment company registered under section 8 of the Investment Company Act of 1940 (15 U.S.C. 80a-8), the accountant shall retain workpapers and other documents that form the basis of the audit or review, and memoranda, correspondence, communications, other documents, and records (including electronic records), which:
(1) Are created, sent or received in connection with the audit or review and
(2) Contain conclusions, opinions, analyses, or financial data related to the audit or review. (emphasis supplied)
Read literally, paragraph (a) would require the auditor to retain virtually every scrap of paper received or created during an audit, for there would be few, if any, documents that arguably did not contain "conclusions, opinions, analyses, or financial data related to the audit or review." 210.2-06(a)(2). The Commission obviously did not intend such a broad reading, as evidenced by the language in footnote 24 of the Release which states: "Superseded drafts or auditor review notes that do not reflect a difference of opinion, however, would not have to be retained." The footnote suggests that the intent of 210.2-06(a) is to require retention of audit workpapers and other documents that reflect a difference of opinion. We believe that our proposed alternative language for Rule 210.2-06(c) (see below) better describes the documents related to differences of opinion that should be retained and that the proposed catch-all language of 210.2-06(a)(1) and (2) not only fails to clarify 210.2-06(c), but is so broad and ambiguous that an accountant would have no choice but to save everything to avoid the specter of criminal prosecution.
Examples of extraneous information that an auditor normally would not retain, but might fall within the broad language of Rule 210.2-06(a)(2), include: bulky client files in paper or electronic format, emails, and personal desk files containing duplicates or drafts of final workpapers or a client's SEC filings. In the course of an audit or review, it is customary for auditors to review certain client records that are not retained in the working papers and that currently are not required by applicable professional standards to be maintained in the working papers. For instance, certain electronic data may be reviewed and tested on line, with the auditors' workpapers noting the test and the information tested without the auditors' obtaining an electronic or hard copy of the underlying data. (See e.g., SAS 96 Audit Documentation "Audit documentation should include abstracts or copies of significant contracts or agreements that were examined to evaluate the accounting for significant transactions. Additionally, audit documentation of tests of operating effectiveness of controls and substantive tests of details that involve inspection of documents or confirmation should include an identification of the items tested." (emphasis supplied).
Although we do not believe it is the Commission's intent to alter these practices, the proposed rule could be read to require retention of all such materials on the ground that they were "received" in connection with the audit and contain financial data. The Release does not present any rationale for retaining this material, nor does the legislative history indicate a specific intent to capture this material separate and apart from audit workpapers that document the procedures performed and the conclusions reached.
In sum, we recommend that subparagraphs (1) and (2) of 201.2-06(a) should be deleted because they create needless ambiguity and burden in light of the specificity provided by paragraph (c). Further, we recommend that the Commission endorse SAS 96 as the operative guidance on documentation retention for audits and reviews, and limit new document retention requirements to the more limited circumstance when differences of opinion cast doubt on the final conclusions reached by the auditor.
II. Section 210.2-06(c) Should Define "Differences Of Opinion" As A Disagreement That, If Not Resolved, Would Require Qualification Or Modification Of The Accountant's Opinion
We believe that section 210.2-06(c) as currently drafted adds to the ambiguity of 210.2-06(a). It provides:
(c) Materials described in paragraph (a) of this section shall be retained whether the conclusions, opinions, analyses, or financial data in the materials support or cast doubt on the final conclusions reached by the auditor. For example, such materials shall include documentation of differences of opinion concerning accounting and auditing issues. "
As drafted, it could be read to require retention of every document reflecting an error however temporary - even typographical or addition errors made in preparing a workpaper (as the erroneous workpaper might cast doubt on the final conclusion). It also could be read to require preservation of each and every exchange of differing views on any topic, however fleeting and trivial the differences.
Audits are an interactive process in which preliminary observations may lead to further questions, additional substantive audit procedures, refinements of views and, after dialogue, to final conclusions. We believe that the Commission did not intend that firms must retain every document generated during the process.4 To the extent the proposed rule could be read otherwise, it would potentially inhibit free and robust discussion and debate that in fact enhance the quality of auditing and financial reporting. Retention of numerous drafts and records of dialogue on resolved issues could also have the unintended effect of making the audit workpapers more difficult to interpret, potentially confusing reviewers concerning what matters were significant or consequential and require their attention.
Accordingly, we suggest that the Commission adopt a bright-line test to remove these ambiguities and to aid auditors in determining the documents they would be required to be retain and those that they would not. The Release makes reference to the language of SAS 22, which in turn refers to documentation of "disagreements." That term is currently defined in the context of reporting changes in accountants in Instructions to Item 304 (Reg. S-K § 229.304) in a way that we believe could provide a useful basis for such a bright-line test. Disagreements are "those that occur at the decision-making level" on "any matter of accounting principles or practices, financial statement disclosure, or auditing scope or procedure, which disagreement(s), if not resolved to the satisfaction of the [former] accountant, would have caused it to make reference to the subject matter of the disagreement(s) in connection with its report." We believe it would be feasible for auditors to maintain records of such disagreements, whether they involve the issuer's management or a partner and another professional within the auditing firm.
III. Ernst & Young's Proposed Alternative
We set forth below our proposed language for Rule 210.2-06:
Rule 210.2-06 Retention of audit and review record.
(a) For a period of five years after the end of the fiscal period in which an accountant concludes an audit or review of an issuer's financial statements to which section 10(a) of the Securities Exchange Act of 1934 (15 U.S.C. 78j-1(a)) applies, or of the financial statements of any investment company registered under section 8 of the Investment Company Act of 1940 (15 U.S.C. 80a-8), the accountant shall retain workpapers that form the basis of the audit or review.
(b) For the purposes of paragraph (a) of this section, "workpapers" means documentation of auditing or review procedures applied, evidence obtained, and conclusions reached by the accountant in the audit or review engagement as required by SAS 96, or rules adopted by the Commission or by the Public Company Accounting Oversight Board. "Workpapers" may include, but would not be limited to, memoranda, correspondence, communications, other documents, and records (including electronic records) which are created, sent, or received in connection with an audit or review and contain conclusions, opinions, analyses, or financial data.
(c) Materials described in paragraph (a) that must be retained include any documents that evidence (1) a disagreement between a partner of a registered public accounting firm and any other partner or employee of the firm or (2) a disagreement between a registered public accounting firm and the client. For purposes of paragraph (c) of the section, "disagreement" means a difference of opinion on any matter of accounting principles or practices, financial statement disclosure, or auditing scope or procedure, which, if not resolved to the satisfaction of the registered public accounting firm, would have caused it to make reference to the subject matter of the disagreement in connection with its report.
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We would be pleased to discuss our comments with the Commission or its staff at your convenience.
Very truly yours,
/s/ Ernst & Young LLP
|1|| Under 802(b) knowing and willful violations of the rules and regulations promulgated by the Commission under 802(a)(2) are criminal, punishable by fines, imprisonment for up to 10 years or both.
|2|| Rel. No. 33-8151 at p. 3.
|3|| Id. at p. 4.
|4|| See, e.g., note 24 of the Release.