BDO Seidman, LLP
January 13, 2003
Mr. Jonathan G. Katz, Secretary
Re: Release No. 33-8154
Dear Mr. Katz:
This letter is the response of BDO Seidman, LLP to your request for comments regarding the above-captioned proposal.
We strongly support the need to strengthen the public's recently tarnished perception of auditor independence. In that regard, we agree with certain aspects of the Commission's proposals, particularly those that would enhance the audit committee's role in the audit process. We believe that enhancing the audit committee's role in the administration of an engagement is a constructive step toward improving audit quality. We also believe that mandating the types of communications with audit committees called for by proposed Rule 2-07 of Regulation S-X is appropriate. While we support these types of constructive changes to enhance auditor independence, we believe that many of the Commission's proposals, particularly those that go beyond the requirements of the Sarbanes-Oxley Act (the "Act"), will not benefit investors or serve the public interest. Therefore, we believe that major changes need to be made before adopting final rules.
Summary of Our Major Concerns
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 know that we have not had sufficient time to do so. Given the Congressionally mandated final rule adoption date of January 26, we are also concerned that the Commission and its staff will not have sufficient time to consider thoughtfully the comments on the proposals and craft the appropriate changes. We are especially concerned about the lack of time for the Commission to fully consider and react to comments on this particular proposal, given the 13-day period available to do so, the complexity of the issues it addresses, the major changes we believe are necessary, and the profound adverse effects many of these rules (particularly those dealing with partner rotation) will likely have on accounting firms, issuers, and the public interest if the Commission adopts certain of them in their current form. These adverse effects include reducing the quality and increasing the cost of audits and the disproportionate impact on smaller issuers and accounting firms. Accordingly, we urge the Commission to adopt only the rules that are unequivocally mandated by the Act at this time and to consider the other proposals over a more appropriate period. We also urge the Commission to provide ample transition periods so there will be time to modify these rules before they take effect in order to avoid unintended or inappropriate consequences.
We have the following additional reasons for believing the Commission should limit the auditor independence rules it adopts to those that are unequivocally mandated by the Act:
The Act and the many rules the Commission is in the process of adopting make sweeping changes to improve the reliability of corporate reporting. These changes are designed to:
Given the nature and magnitude of these changes, we expect them to make significant progress toward their intended objectives. Therefore, we believe the Commission's appropriate response is to adopt only the Congressionally mandated rules, observe their effects for a suitable time, and then consider additional measures such as those proposed only if there is persuasive evidence they are needed. We also believe that doing more at this time could be interpreted as the Commission usurping the responsibilities of the PCAOB and audit committees, thereby undermining investor confidence in them.
In addition, we believe the Commission needs to make a number of changes to the proposed rules to:
In considering these changes, we urge the Commission to use its exemptive authority under Section 36(a) of the Exchange Act1 to the extent necessary to ensure that the final rules best serve the public interest and protect investors. In that regard, we believe it is important to recognize that Section 3(c)(2) of the Act preserves the Commission's exemptive authority, as follows:
Our more specific comments on the proposed rules and our recommendations for alternative approaches are set forth below.
We believe the proposed partner rotation requirements are by far the most troublesome aspect of this proposal in that they can pose the most harm to the very investors the Commission and Congress are obligated to protect. As such, they require the greatest Commission attention as it considers the revisions to reflect in the final rules. The proposal appears to presume that all accounting firms have an unlimited array of interchangeable partners possessing similar skills and industry expertise. This is a fallacious assumption and, as such, provides an unsuitable foundation for the proposed rules.
Our most significant concerns regarding the partner rotation requirements are:
We are concerned about these aspects of the partner rotation requirements because we believe they would have effects that would run counter to the public interest by:
More specifically, adopting the rules as proposed is not appropriate for the following reasons:
Smaller accounting firms typically have fewer partners in each office who are appropriately suited to serving the needs of the SEC registrant clients of that office. Thus, when partners rotate, a smaller firm is more likely to need to ask one or more of the rotating partners to move or to ask a partner who is not located close to a client to serve that client. Both of these situations significantly disadvantage those firms. They put them at a cost disadvantage, they disrupt the personal lives of the partners involved and their families (discouraging some of the best and brightest young people from pursuing careers in which they specialize in serving SEC registrants) and, in cases where the partner serves a client from a different location, it is more difficult to compete by providing responsive service to the client.
Although these problems are most severe for smaller accounting firms, we believe they are significant issues for all firms. For example, we understand that the audits of certain major corporations include the active participation of hundreds of partners around the world. Requiring most or all of them to rotate would cause similar problems.
These problems are present any time an office serves SEC registrants and has a limited number of partners who are appropriately suited to serving those clients. They are more severe in small firms and small offices of large firms. They are probably most severe in non-U.S. offices (regardless of size) that audit a limited number of foreign registrants or subsidiaries of domestic registrants.
If the proposal causes larger companies to rotate accounting firms more frequently, it will increase the pressure on auditors to sell audits to those companies at the expense of providing auditing services to their current clients, particularly their smaller clients. We have witnessed this many times over the past year as Arthur Andersen's clients "rotated" to new accounting firms.
Rotating auditors requires a great deal of incremental time from company personnel as well as auditors. In smaller companies, a greater portion of that time is spent at the upper management level. Smaller companies tend to be more thinly staffed at that level. This makes changing auditors more burdensome for smaller companies.
The key decisions on audits are made by the lead engagement partner. The audit approach developed and key decisions made by other line partners (including partners who audit foreign subsidiaries) are reviewed and approved by the lead engagement partner. Our firm has policies requiring lead engagement partners to periodically visit significant subsidiaries and review the work performed by the local engagement teams. We also require local engagement teams to communicate proposed audit adjustments and significant issues addressed in the audit to the lead engagement partner. Given the degree of direction and decision-making by the lead engagement partner, we believe requiring other partners who perform portions of the audit to rotate will provide marginal benefits and not justify the costs.
In the Release, the Commission states, "Partners assigned to `national office' duties (which can include both technical accounting and centralized quality control functions) who may be consulted on specific accounting issues related to a client are not considered members of the audit engagement team even though they may consult on client matters regularly. While these partners play an important role in the audit process, they serve, primarily, as a technical resource for members of the audit team. Because these partners are not involved in the audit per se and do not routinely interact or develop relationships with the audit client, we do not believe that it is necessary to rotate the involvement of these personnel." We believe that excluding these partners from the rotation requirement is not only appropriate but absolutely necessary. We believe that other partners who play similar technical consultation roles should also be excluded from the rotation requirement. Examples of such partners include (1) local office partners with whom the engagement team consults on accounting and auditing issues, (2) information systems audit specialists, and (3) tax partners.
The supposed need for this lengthy time-out period does not seem to be supported by any sound evidence. Rather, it seems to be based solely on the Commission's assumptions about investors' perceptions.
We believe the Commission is focusing on this issue from the wrong perspective. The Commission seems to be focusing on this issue from the perspective of investor perception, rather than the perspective of whether insufficient time-out periods have been a cause of audit failures. (The Commission states, "If a shorter time-out provision is used, investors might believe that partners merely would be placed in [a] secondary role for a year or two, only to resume the same roles that they previously occupied and to return to the prior engagement team's approach to the accounting and auditing issues.") However, we are not aware of any evidence suggesting that investors perceive time-out periods to be too short or that insufficient time-out periods have caused audit failures. Moreover, it is not economically feasible for firms to hold partners in unproductive roles for two years until they can rotate back on engagements.
The Commission states in the Release that the five-year time-out period is to ensure that there will be a periodic fresh look at the accounting and auditing issues related to a company, suggesting that if the time-out period is shorter, this will not occur. We think this line of thinking is unfounded because:
Many audits where a partner is in his or her sixth or seventh year and would therefore be subject to the rotation requirement will be substantially complete when the rules are adopted later this month. Given the cost, delay and risk of mistakes it would cause, it is not reasonable to require firms to change partners late in the process of completing an audit. In addition, where multiple partners on an engagement are in or about to start their sixth or seventh year, immediately applying the rule would require large scale partner changes on engagements and not permit the staggered changes the Commission seems to agree are appropriate.
These safeguards include:
We believe that these safeguards are sufficient and warrant the Commission adopting only those rotation and time-out requirements required by the Act.
We do not believe the alternative of relying on forensic audits in lieu of rotation is viable. It is not clear to us what the scope of such audits would be, whether accounting firms would be willing to perform them, how much they would charge to accept the related risk, or when they would need to be performed. If they were performed after a filing was made, the consequences to issuers if the forensic auditor arrived at a different conclusion would be onerous. Accordingly, we believe issuers would insist that they be completed before a filing was made. We believe this would unduly delay filings and is inconsistent with the Commission's goal of providing investors with more timely information. It is also not clear to us how this would interrelate with the inspections to be performed by the PCAOB. It appears to us that this would add a significant layer of cost in exchange for uncertain value.
For the reasons discussed above, we recommend the following:
Auditors' Scope of Practice
The following section of this letter contains our comments on proposed Rule 2-01(c)(4) of Regulation S-X covering prohibited non-audit services. Our most significant concerns are as follows:
Rule 2-01(c)(4) currently contains exceptions to the general rule prohibiting auditors from providing bookkeeping services to their clients. These services are permitted (1) in emergency situations and (2) in extremely limited situations in which de minimis services can be provided to a client's foreign operations. The emergency situation exception has apparently served the public interest. We believe it was appropriate for it to be available in response to the crisis that followed the events of September 11, 2001. We are not aware of situations where providing services in accordance with the limited exception for foreign operations has impaired an auditor's independence in appearance or in fact. Accordingly, we recommend that the Commission retain these exceptions when it modifies Rule 2-01(c)(4).
We believe the Commission's rules should recognize the fact that, despite the best efforts of issuers and accounting firms to establish, communicate and enforce clear policies prohibiting foreign operations from engaging auditors to provide bookkeeping services, compliance with these policies is not flawless. Inadvertent exceptions have occurred in the past and can be expected to occur in the future. If inadvertent exceptions involve accounts that are immaterial to the financial statements the issuer files with the Commission, we believe it is unfair to an issuer, its investors, and its auditors to deem the auditor not independent and require the issuer to engage a new auditor. After all, immaterial components of an issuer do not have to be audited at all. Why should a more stringent standard apply to those same components if foreign auditors have performed bookkeeping services relating to them?
Consider the following hypothetical example:
In such a situation, we do not believe it is in the interest of the issuer or its investors to require the issuer to incur the cost and suffer the adverse capital markets consequences that would result from requiring the company to engage another accounting firm to audit its financial statements. Therefore, we believe the rules should permit exceptions that (1) are inadvertent, (2) involve subsidiaries, divisions, or accounts that are immaterial to the financial statements the issuer files with the Commission, and (3) are approved after-the-fact by the issuer's audit committee. This would be consistent with the interests of investors and would generally conform with the approach the Commission proposes to take in Rule (c)(7) in situations where an issuer fails to receive audit committee pre-approval of a permitted non-audit service.
Incorporating financial statement materiality in the bookkeeping services rule would also be consistent with proposed Rule 2-01(c)(4)(ii), which permits design or implementation of systems that generate information that is insignificant to the financial statements and proposed Rules 2-01(c)(4)(iii) and (iv), which prohibit valuation and actuarial services only "where it is reasonably likely that the results of these services will be subject to audit procedures."
Proposed Rule 2-01(c)(4), as written, seems to provide the type of exception we recommend. That rule states that it applies only to services "where it is reasonably likely that the results of these services will be subject to audit procedures during an audit of the audit client's financial statements." However, it is not clear to us whether we are reading this provision correctly. The commentary in the Release states that the proposal "continues the prohibition on bookkeeping, but ... propose[s] to eliminate the limited situations where bookkeeping services may be provided under the current rules." We recommend that the Commission be clear on this point in the adopting Release and the final rule.
In addition, we recommend that the Commission define the term "bookkeeping." A narrow interpretation of this term could lead one to question whether an auditor (1) proposing an adjustment that the client then records, (2) providing significant assistance with drafting financial statement footnotes dealing with complex disclosures, or (3) providing significant assistance to foreign registrants or subsidiaries (e.g., in converting from local GAAP to U.S. GAAP or in preparing statutory accounts after the audited financial statements are filed) could be viewed as providing bookkeeping services. We believe these services do not cause independence issues, since the auditor either reviews the issuer's work, provides technical accounting advice, or performs services which do not form the basis of the audited financial statements and, in all cases, the auditor's involvement improves the quality of the issuer's financial reporting.
Financial Information Systems Design and Installation
Given the consequences of violating the proposed ban on financial information systems design and installation services, we believe the Commission needs to more clearly define what constitutes "designing or implementing" a financial information system. It is not clear how one would distinguish (1) evaluating systems and recommending improvements, which would be allowed, from (2) designing and implementing a system, which would be prohibited.
With respect to transition, the Commission should recognize that companies might currently be subject to system design and installation contracts that may contain termination penalties. We suggest that the Commission permit companies with such contracts to complete them.
With respect to companies filing initial registration statements, we suggest that the rules permit these companies to complete contracts entered into before the initial filing of the registration statement. Since the largest accounting firms have all taken actions to exit the systems design and installation business, we do not expect that a liberal rule applicable to initial registrations would lead to widespread abuse.
Appraisal or Valuation Services
We believe the Commission's proposed approach of permitting limited appraisal and valuation services (i.e., in situations where the results of that work are not likely to be subject to audit procedures) is appropriate. However, we are concerned that the description of the prohibited services in the proposed rule is written so broadly that it might be construed to apply to discussions between an auditor and a client that are aimed at ensuring compliance with GAAP that occur before a valuation is performed by the client (e.g., an auditor advising a client on the appropriate approach to use and factors to consider). We believe the purpose of such discussions is to assure high quality financial reporting and note that an auditor would need to have such a discussion with a client after a valuation had been performed if the valuation had been performed inappropriately. We believe the Commission should modify the rule to clearly permit services involving advice provided to ensure compliance with GAAP.
The Commission should also provide an exception for valuations where (1) the client provides all the assumptions, takes responsibility for the assumptions, and is capable of making informed decisions regarding the assumptions and (2) the auditor merely operates a standardized model to produce the valuation (e.g., Black-Scholes valuations of stock options). Since no professional judgment is involved, in these circumstances we believe producing valuations would not impair independence.
Internal Audit Outsourcing
We have a number of concerns regarding the proposed rules that would ban internal audit outsourcing services.
We do not think the rule as drafted is operational because it is not clear to us what activities are prohibited. We think the goal of defining the term "internal audit outsourcing services" is one that has never been achieved. Companies and auditors have been able to operate in spite of this problem because the restrictions that recently became effective provide exceptions for smaller companies and for large issuers that perform a major portion of their internal audit work. If the Commission totally bans these services, it must clearly define them. If it does not clearly define them, companies and auditors will likely avoid performing any service that could possibly be construed as internal audit services. We believe that this result would run counter to the public interest.
In our opinion, performing extended audit services (i.e., performing substantive audit work on specific account balances or evaluation and testing of internal controls beyond what is necessary to complete the audit of the financial statements or attest to management's assertion regarding the adequacy of internal controls and procedures for financial reporting) does not impair an auditor's independence, and it is in the public interest for companies to engage their auditors to perform such services. Based on the Commission's comments in the section of the Release discussing management functions, it appears to us that the Commission agrees. We also believe it is in the public interest to permit issuers to turn periodically to qualified professionals who know their business, i.e., their auditors, for assistance with discrete non-recurring projects that could be construed as "internal audit" activities if they were performed on a continuing basis. Such projects are often performed in response to a suspected problem and need to be completed in a short time.
To avoid these problems, we believe the Commission needs to clearly communicate the nature and characteristics of "internal audit" activities. In addition, since performing "discrete" internal audit projects would apparently be permitted and it is only "outsourcing" arrangements that would be banned, the Commission also needs to define the characteristics that distinguish discrete projects from outsourcing arrangements. However, if the proposed total ban is adopted, we believe many small businesses would not be able to afford such a function or engage others who are unfamiliar with their operations to perform it. We believe that professional internal audit functions improve management's control over and the effectiveness of a company's operations and the quality of its financial reporting. Accordingly, we believe it is in the public interest to encourage companies to develop and operate internal audit functions. This is consistent with a recent proposed change to the listing standards of the New York Stock Exchange. Given the benefits of an internal audit function and the potential adverse effect on the reliability of financial reporting if smaller issuers are unable to maintain such a function, we encourage the Commission to exempt small companies from the ban. We believe that an appropriate measure of the size and sophistication of a company that should be exempt from the ban is the definition of "accelerated filer" in the Commission's recently adopted amendments to Exchange Act Rule 12b-2. We believe that any company that does not meet this definition should be permitted to engage its auditor to perform internal audit services, subject to the safeguards in the current rules.
With respect to transition, the Commission should recognize that companies with outsourcing arrangements will need time to transition to new arrangements or develop in-house capabilities. We suggest that the Commission take an approach similar to the one it took when it revised the internal audit outsourcing rules in 2000 and require issuers to comply with the new rules 18 months after they are adopted.
We also suggest that the rules apply only to companies in fiscal years beginning after they become Exchange Act registrants, in order to avoid unduly restricting the ability of companies considering an initial registration to receive the benefits of an internal audit function during the period before they complete the registration process.
We do not believe that evaluating or recommending improvements to internal accounting, disclosure, or risk management controls results in an auditor auditing his or her own work. We also believe it does not impair his or her independence with respect to the financial statement audit or the engagement to attest to management's report on internal controls. In our view, these services are consistent with the auditor's requirement under Section 404 of the Act to report on internal controls. The fact that the auditor reports that assessment in a less formal manner (i.e., in the form of comments and recommendations) does not change the nature of the function the auditor is performing. We believe this is a valuable service and that it is in the public interest for auditors to provide it.
The services discussed above involve existing controls. We believe the nature of the service is key - not when the auditor performs the service. Therefore we believe an auditor should also be permitted to perform similar services regarding the design of proposed control structures.
Proposed Rule 2-01(c)(4)(vii)(E) would permit an auditor to advise a client on the competence of candidates for accounting, administrative, or control positions. We believe it is in investors' interests for an auditor to be able to comment on other aspects of a candidate's skills and to provide advice when a candidate is being considered for other positions. This is particularly true when the candidate is a current or former employee of the accounting firm, and the firm knows the candidate well. Assuming the requirements of the cooling off period, if applicable, have been met, when a client calls an auditor to discuss one of the firm's current or former employee's qualifications, it is in investors' interests for the auditor to answer questions about the person's interpersonal skills and work ethic, as well as the person's competence. As long as the client makes the hiring decision, we believe that performing this service does not put the auditor in a position of performing a management function. This service also does not result in an auditor auditing his or her own work or serving as an advocate. The fact that an auditor has a degree of "interest" in the advice proving to be correct should not cause the Commission to prohibit the auditor from providing it. Auditors provide companies with advice on a wide variety of matters with widely varying degrees of formality. Anytime an auditor expresses a view on anything, he or she runs the risk of losing credibility if that view proves to be incorrect. The rules should not put a damper on communications between auditors and management.
The commentary in the Release states, "[A]n auditor's independence also is impaired when the auditor advises an audit client about the design of its management or organizational structure." We do not find anything in the text of the proposed rule that communicates this prohibition. In addition, we do not think providing advice on these matters should be prohibited for the reasons discussed above. Further, we think such a prohibition would be too broad. For example, we think an auditor recommending to a client that it create or strengthen an internal audit department is a form of providing advice about organizational structure that is consistent with an auditor's role and in the public interest.
In the Release, the Commission asks whether it impairs an auditor's independence if he or she provides consultation with respect to the compensation arrangements of the company's executives. We do not believe that providing advice on these matters impairs independence, because we do not believe it violates any of the three principles. We think it is important to note that such advice most often relates to the accounting and tax aspects of compensation arrangements. We think providing such accounting and tax advice is clearly permitted.
As noted in the Release, in some jurisdictions it is mandatory that someone licensed to practice law perform tax work. Therefore, under the proposed rule an accounting firm providing such services would be deemed to be providing legal services. In some jurisdictions, for example Germany, tax work is defined as legal work, and accounting firms hold a limited license to perform this legal/tax work. We believe that a foreign accounting firm should be permitted to provide, either itself or through an affiliated law firm, the same tax or other services that a U.S. accounting firm could provide. The nature of the service is important - not the form of the entity that delivers it. In this case, the nature of the services is such that providing them does not violate any of the three independence principles.
The provisions of the Act and its legislative history clearly indicate that auditors may perform tax services without exception provided they are pre-approved by the audit committee. Therefore, we fundamentally disagree with the Commission's view stated in the Release that accounting firms may not provide certain tax services to their clients without impairing their independence. Moreover, in an apparent attempt to address the highly publicized issue of abusive tax shelters, the Release provides conflicting and vague guidance, resulting in an unworkable model for auditors and issuers.
We agree with much of the following statement in the Release relating to Congressional intent to limit the proscribed services:
However, in the case of tax services, we believe it is inappropriate for the Commission to attempt to make the "proper interpretation ... in light of the three basic principles." In that regard, the Senate Report quoted in the Release states:
The July 25, 2002 statements by Senator Sarbanes quoted in the Release repeat these points.
To use the basic principles as criteria for determining whether certain tax services should not be permitted does not necessarily have a logical basis. For example, while tax return preparation is clearly permitted and has not raised independence issues, the previous tax returns and related tax compliance work may impact or even form the basis for the tax accrual in the financial statements. Does that mean that providing these permissible tax services could be viewed as auditing one's own work?
We believe that the Senate report communicates Congress' intent to not limit the tax services auditors can provide to their clients. The report states Congress' intent "to draw a clear line around a limited list of non-audit services" (emphasis added). The list in the Act does not include tax services, which are expressly permitted under Section 201. The report then goes on to explain how the "simple principles" apply. Nowhere in this explanation does it state that these principles lead to the prohibition of providing tax services.
The following is an analysis of how tax services may be viewed in the context of the three broad principles:
The Release indicates that independence problems may arise when the services involve formulation of tax strategies, an example of which is a "tax shelter," according to the Release.
If the Commission ultimately decides to prohibit certain tax services, we believe it needs to communicate clearly in the final rule the types of services prohibited and the reasons why they are prohibited. In that regard, the Release discusses the nature of tax services in a number of sections. We suggest that it would significantly aid in understanding the Commission's views if all of the discussion were presented in one place.
We believe that drawing the line between permitted and prohibited tax services in a clear and reasonable manner is critically important. If that line is not clear, issuers are likely to avoid risk of not complying with the rule by assigning the more complex tax projects to firms (either law firms or other accounting firms) other than the firm that performs their audit. This could disadvantage the issuers, because the firms to which they assign the work may not be familiar with the issuers' businesses and, therefore, may not be in a position to provide the highest quality tax services. This could also result in issuers incurring additional internal and external costs for the time it may take the other firms to learn about the issuers' businesses. In addition, if a substantial amount of this work moves from accounting firms to law firms, this could reduce the desirability of a tax career in public accounting. Over time, this could reduce the pool of qualified tax resources available to serve as technical resources for audit engagement teams. The audit of the tax accrual requires extensive knowledge about both the tax law and regulations and the client's business. Such a reduction in the pool of qualified tax resources at accounting firms would also disproportionately disadvantage smaller issuers, who rely more heavily on their accounting firms for tax services.
The Commission requested comment on whether "providing tax opinions, including tax opinions for tax shelters, to an audit client or an affiliate of an audit client under the circumstances described above would impair, or would appear to reasonable investors to impair, an auditor's independence." The "circumstances described above" to which the Commission appears to be referring are "when the auditor provides a tax opinion for the use of a third party in connection with a business transaction between the audit client and the third party."
A properly issued tax opinion, including a tax opinion that may be relied upon by an individual or entity other than the client ("third party tax opinion") sets forth the facts and circumstances of a transaction, supplemented by representations of the client, and provides, based upon relevant tax authorities applied to the facts, circumstances, and client representations, in a neutral, impartial manner an opinion with respect to the tax consequences of the transaction. Generally, issuers of tax opinions, whether law or accounting firms, will not issue a third party tax opinion unless the facts, circumstances, and applicable law allow them to reach an opinion as to which they believe a court would conclude that the standard set forth in the opinion (i.e., "will," "should," "more likely than not," or otherwise) is clearly satisfied.
Accordingly, we do not believe the tax department of a public accounting firm providing a third party tax opinion impairs or appears to reasonable investors to impair an auditor's independence. Further, since there is a body of standards upon which to base the opinion, we do not see any difference between providing tax opinions and providing reports on the application of accounting principles, which are permitted under the Commission's rules and Statement on Auditing Standards No. 50.
We suggest that the Commission make a number of modifications to the proposed rule.
We do not think the Commission should extend the rule to cover management positions beyond those specified in 206 of the Act. The restrictions on employment reflected in the Act are limited to the chief executive officer, controller, chief financial officer, or any person serving in an equivalent position. Generally, these are the positions likely to be filled by persons on the engagement team with the potential to influence the results of the audit - i.e., the engagement partner or concurring review partner. We believe that limiting the management positions to those specified in the Act will provide reasonable safeguards. We think further restrictions will unnecessarily and unfairly limit (1) the ability of issuers to hire the right people for their accounting functions and (2) the career opportunities for young people in the accounting profession. We do, however, suggest that the Commission consider future rulemaking to expand the positions covered by the rule to include members of the audit committee because of the potential for these persons to influence the audit.
We recommend that the Commission narrow the group of accounting firm personnel it covers. The proposed rule would cover all members of the "audit engagement team." We think the rule should not apply to the following those people:
We also suggest that the Commission change the manner in which the proposed rule calculates the cooling off period. The rule prohibits hiring a person if he or she was a member of the audit engagement team "during the one year period preceding the date that audit procedures commenced." Therefore:
We suggest that the Commission address these concerns and simplify the measurement of the cooling off period by simply prohibiting an issuer from employing a person who last performed audit or review services for the client within one year of their employment date.
We share the Commission's concerns that this rule could inappropriately restrict the ability of certain companies to hire qualified personnel. We believe this rule would have a particularly adverse effect on smaller companies. Therefore, we suggest that the Commission exempt a company from this requirement if (1) it does not meet the definition of an "accelerated filer" in the Commission's recently adopted amendments to Exchange Act Rule 12b-2 and (2) the person being employed was not a partner with the accounting firm. By limiting the exemption to auditors who were not partners, we believe the Commission would satisfactorily minimize the risk that the person could adversely influence the quality of the audit.
We believe that companies filing initial registration statements also warrant special consideration. We suggest that the rules apply only to companies in fiscal years beginning after they become Exchange Act registrants, in order to avoid unduly restricting the ability of companies considering an initial registration to upgrade their management team if necessary before offering securities to the public.
With respect to transition, we believe the Commission should grandfather all employment arrangements where employment had been offered, been accepted, or commenced before the final rules appear in the Federal Register.
Given the significant reduction in the non-audit services auditors would be able to provide to their publicly held audit clients, we do not believe it is necessary for the Commission to adopt the proposed rule prohibiting partner compensation for performing or selling non-audit services. Moreover, we believe that the changes in the professional environment brought about by audit failures, the demise of Arthur Andersen, and legislative and regulatory actions have had the effect of forcefully reminding auditors that the most important thing they can do to protect or enhance their compensation is to perform high quality audit work. We also note that this rule is not required by the Act. We think the Act and the other rules the Commission proposes to adopt provide sufficient safeguards. For these reasons, we see no need for the Commission to adopt this rule at this time.
If the Commission nevertheless decides to adopt this rule, we believe it should modify it in the following ways:
Audit Committee Administration of the Engagement
We believe that enhancing the audit committee's role in the administration of an engagement is a constructive step toward improving audit quality. However, we have two principal concerns with proposed Rule 2-01(c)(7) of Regulation S-X:
Neither the Release nor the proposed rule provides guidance regarding the level of detail in which services must be itemized when the audit committee considers them. For example, there is no guidance as to whether it would be sufficient for an audit committee to pre-approve "statutory audits in XX countries and state tax return preparation services for fiscal 200X" or whether the audit committee must pre-approve each of the statutory audits and tax return preparation services individually. We believe the final rule should provide the audit committee the discretion to determine the level of itemization needed to effectively consider the services to be provided by the auditor.
The provisions regarding audit committee approval of services after-the-fact when inadvertent mistakes occur are rigid in that they impose a quantified limit (5% of the total fees paid to the accounting firm) and they must be approved before the completion of the audit. The consequences of a significant failure to comply with the pre-approval rules are severe to both the accounting firm and the issuer. Therefore, we believe the best means of determining whether a failure is significant enough to warrant these consequences is to leave that decision up to the judgment of the representative of the investors - the audit committee, and the Commission should revise the rule to provide for this.
Our other concerns are as follows:
Communications with Audit Committees
We believe that mandating the types of communications with audit committees called for by proposed Rule 2-07 of Regulation S-X is appropriate.
We are concerned, however, about the consequences if the auditor fails to comply with this rule in some respect. While we do not see any consequences stated in Article 2 of Regulation S-X, proposed Exchange Act Rule 10A-2 states, "It shall be unlawful for an auditor not to be independent under ... [Rule] 2-07." From this we infer that an auditor would not be considered independent and would be considered in violation of the Exchange Act if the firm failed to comply with Rule 2-07 in some respect. The requirements of Rule 2-07 are very general and require significant judgment to apply. We do not believe that it is reasonable to impose such harsh consequences if an auditor's compliance with the Rule 2-07 is less than flawless. We believe a higher level of misconduct (e.g., intentional or reckless disregard for the rule) should be required before this occurs. In addition, we do not understand why or think it is appropriate for a violation of this rule to cause an auditor's independence to be impaired. We do not believe such a violation runs afoul of any of the three principles upon which independence is based: functioning as management, auditing one's own work, or serving as an advocate.
The proposed rule would not require that the communications be made in writing. We support this approach. We believe that the key here is to encourage an open and frank discussion of the topics covered by the rule. We believe that requiring these communications to be made in writing would cause auditors to be more cautious about what they communicate, thereby reducing their effectiveness and producing a result which is inconsistent with the intent of the proposed rule.
It appears to us that Exchange Act Rule 10A-2 quoted above is meant to communicate that issuers must comply with Rule 2-07 after they complete their initial registration and become required to report under the Exchange Act. We suggest that the Commission communicate its views on whether Rule 2-07 applies in periods prior to filing an initial registration statement in the adopting release and consider modifying the rules to make them more clear on this point.
We believe the changes the Commission has proposed to the fees disclosure will result in more meaningful information for investors. However, we doubt that investors will find the extensive disclosures of the details of the audit committee's operating policies and actions useful, and we suggest that the Commission require disclosure only if the pre-approval requirements of Rule 2-01(c)(7) are not met.
We have a few technical suggestions regarding these proposed rules:
The Commission stated that it is considering relocating the rules covering auditor independence from Regulation S-X to the Exchange Act rules. We recommend that the Commission not do this. The independence rules apply to filings under the Securities Act as well as the Exchange Act, and we believe this is better conveyed by placing the rules somewhere other than in the Exchange Act rules. In addition, auditors are accustomed to finding the independence rules in Regulation S-X. We believe that moving the rules would simply further complicate the task of complying with the myriad of new rules.
In addition, we do not believe it is appropriate to hold an auditor in violation of the law in all instances where a violation of the independence rules occurs. The requirements of the independence rules are very general and require significant judgment to apply. Good faith reasonable efforts by auditors are unlikely to prevent all violations. We believe a higher level of misconduct (e.g., intentional or reckless disregard for the rule) should be required before an auditor is considered to have violated the law.
Finally we do not believe an auditor should be held responsible for matters beyond their control, such as failures by issuers or their audit committees to comply with the rules.
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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), Lee Graul (at (312) 616-4667 or via electronic mail at email@example.com), or Larry Shapiro (at (212) 885-8560 or via electronic mail at firstname.lastname@example.org).