U.S. Senate Permanent Subcommittee on Investigations
January 13, 2003
The Honorable Harvey L. Pitt
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Re: File No. S7-49-02: Proposed Rules to Strengthen Auditor Independence
Dear Mr. Chairman:
During 2002, the U.S. Senate Permanent Subcommittee on Investigations conducted an in-depth, bipartisan investigation into the collapse of Enron Corporation. Among other problems, the Subcommittee investigation reviewed evidence indicating repeated failure by Enron's auditor, Arthur Andersen, to take the steps necessary to ensure that Enron issued accurate financial statements and complied with generally accepted accounting principles (GAAP) in its business transactions. In light of the Subcommittee's work and Congress' enactment of the Sarbanes-Oxley Act, I am writing in strong support of the proposed rule issued by the Securities and Exchange Commission (SEC) to strengthen auditor independence. I would also like to offer several suggestions to clarify or strengthen certain aspects of the proposed rule.
This letter offers specific comments on four matters: (1) a recommendation to codify pre-approval guidance for audit committees using the basic principles identified in the preamble to the proposed rule to identify non-audit services that may impair auditor independence; (2) strong support for the proposed restrictions on auditors providing certain tax services to audit clients; (3) a recommendation to expand the required communications by auditors to audit committees; and (4) strong support for the provisions mandating partner rotation and limiting auditor compensation.
Pre-Approval Guidance for Audit Committees
In accordance with the Sarbanes-Oxley Act, the proposed rule limits auditor engagements by prohibiting a registered public accounting firm from providing non-audit services to its audit clients, unless the services are approved in advance by the company's audit committee. The proposed rule also identifies and expands upon nine specific categories of non-audit services that the Sarbanes-Oxley law has generally prohibited auditors from providing to their audit clients.
In explaining the nine categories of prohibited non-audit services, the preamble to the proposed rule identifies four basic principles that Congress and the SEC have used to identify non-audit services that impair an auditor's independence. These four basic principles are that an auditor should not audit his or her own work, perform management functions, act as an advocate for an audit client, or act as a promoter of an audit client's stock or other financial interest.
These principles provide important guidance and context to the prohibitions on non-audit services. Currently, however, they appear only in the preamble to the proposed rule. The proposed rule would be significantly strengthened if these principles were added to the text of the rule as explicit guidance for an audit committee to consider when determining whether to approve non-audit services outside of the nine prohibited categories. These principles could be incorporated in the proposed rule by inserting a new clause at the end as follows:
"210.2-01(7) Audit committee administration of the engagement. An accountant is not independent of (a) an issuer ... or (b) an investment company ... unless: ...
Codifying these basic principles in the text of the rule would provide valuable pre-approval guidance for audit committees considering whether to allow an auditor to provide non-audit services that fall outside of the specified nine categories. Without such codification, the proposed rule provides these audit committees with virtually no principles to guide their deliberations.
The Sarbanes-Oxley Act states that a registered public accounting firm may provide "tax services" to an audit client "only if the activity is approved in advance by the audit committee." The proposed rule does not, however, either define the term "tax services" or provide other regulatory guidance on this issue in the text of the proposed rule. Instead, only the preamble to the proposed rule offers guidance on the SEC's interpretation of the statutory language, and seeks comments on whether the rule should set up categories to distinguish between permitted and prohibited tax services.
I strongly support the preamble's statement that Congressional intent was to allow auditors to provide their audit clients with "traditional tax preparation services" such as preparing an audit client's tax return, but not tax services that would violate the four basic principles protecting auditor independence. These principles, again, state that auditors should not audit their own work, perform management functions, act as an advocate for an audit client,or act as a promoter of an audit client's stock or other financial interest.
The preamble provides two examples of "tax services" that would violate the basic principles: (1) an auditor's formulation of tax strategies or tax shelters designed to minimize an audit client's tax obligations; and (2) an auditor's appearance before a tax court as an advocate for the audit client. The proposed rule correctly notes that such tax services could require an auditor to audit his or her own tax work, to become an advocate for a client's position on novel tax issues, or to assume a management function. They could also violate other prohibitions in the Sarbanes-Oxley Act such as prohibiting an auditor from providing valuation services or serving as a client's legal counsel or expert witness.
The Permanent Subcommittee on Investigations is currently examining a wide range of issues related to tax shelters. Our investigation has determined that a number of accounting firms are heavily involved in devising tax shelters and selling them and related services to clients, including audit clients, for substantial sums. We have also seen evidence that, in some cases, accounting firms have instructed their auditors, when they learn of events generating client income, to alert the firm's accountants with tax shelter expertise so these tax shelter experts can contact the audit client and suggest a tax strategy. The accounting firm may then charge the client either a flat fee for use of the tax shelter or a fee reflecting a percentage of the tax savings promised by the tax strategy. A recent AICPA decision allowing accounting firms to use contingent fee arrangements has apparently encouraged companies to purchase services related to tax shelters from these firms.
A Subcommittee hearing held on December 11, 2003, examined an abusive tax shelter called Slapshot which had been designed by J.P. Morgan Chase and sold to Enron for a fee in excess of $5 million. Enron worked with J.P. Morgan and certain law firms to determine how the funds flow and loan and interest payments associated with this tax structure should be handled. The role of Enron's auditor, Arthur Anderson, was unclear. If, however, Andersen had advised Enron on the tax strategy and how the Slapshot transactions should be handled on Enron's financial statements, Andersen auditors would later have been required to evaluate the financial statement information and the advice provided by their colleagues. The conflicts of interest inherent in this situation illustrate the dangers of allowing an auditor to provide an audit client with any services associated with a tax shelter. These services should instead be provided by a separate accounting firm or other party, subject to review by the company's auditor.
The SEC also requested comment on whether an auditor should be allowed to provide a tax opinion to an audit client, including a tax opinion on a tax shelter. In the Slapshot case, Enron obtained a tax opinion supporting the tax shelter from a Canadian law firm. If, instead, it had obtained the tax opinion from Andersen, another set of conflicts would have arisen, since Andersen auditors would have had to evaluate the Andersen tax opinion and decide whether to criticize or challenge the work of Andersen colleagues. The better practice envisioned by the Sarbanes-Oxley Act is, again, to ensure that such a tax opinion is provided by someone other than the auditor charged with reviewing it.
The preamble correctly observes that the Sarbanes-Oxley Act was intended to allow some but not all tax services to be performed by auditors for their audit clients. The fact that the proposed rule does not directly address the complex issues associated with tax services is a major failing of the proposed approach.
To correct this deficiency, the proposed rule could, as suggested earlier, incorporate the basic principles protecting auditor independence in the text of the rule to guide audit committees asked to determine whether to allow the company auditor to provide specified tax services. In addition, the rule could insert a new provision prohibiting a registered public accounting firm from providing the following "tax services" to an audit client:
"210.2-01(4)(xi) Tax Services. Any tax opinion for an audit client, any appearance in tax court to advocate on behalf of an audit client, any service related to a tax shelter or tax strategy involving an audit client, or any other service involving a tax matter where it is reasonably likely that the results of such service will be subject to audit procedures during an audit of the audit client's financial statements or where it is reasonably likely that the result will be that the auditor will perform management functions or act as an advocate for an audit client; except that a registered public accounting firm may provide services related to preparing an audit client's tax return, ensuring an audit client's compliance with tax laws, or recovering taxes improperly paid by such audit client;".
Communication with Audit Committees
Section 204 of the Sarbanes-Oxley Act requires auditors to communicate certain information to the audit committee of a publicly traded company regarding the company's accounting practices and financial statements. The proposed rule essentially reproduces the statutory language, stating in Section 210.02-07 that a registered public accounting firm must report to the audit committee "all critical accounting policies and practices," and "all alternative treatments of financial information" discussed with company management including the "ramifications" of such alternatives and the "treatment preferred" by the accounting firm. The proposed rule would be strengthened, however, if language were added making it clear that, in addition to providing information about company practices and available alternatives, the auditor must also provide the audit committee with its professional judgement regarding the quality, acceptability, clarity, and aggressiveness of the issuer's financial statements and accounting practices.
This recommendation is based upon an extensive examination conducted by the Permanent Subcommittee on Investigations into the role of the Enron Board of Directors in the company's collapse, including the role played by Enron's audit committee. The Subcommittee held hearings and issued a bipartisan report which, among other issues, looked at what the Board and audit committee knew about Enron's accounting practices and what it did in response.
The Subcommittee's bipartisan report concluded that the Enron Board of Directors had "contributed to the collapse" of Enron "by allowing Enron to engage in high risk accounting, inappropriate conflict of interest transactions, extensive undisclosed off-the-books activities, andexcessive executive compensation." The report described key documentation showing that Andersen had considered Enron's accounting practices to be among the most aggressive of its clients and told Enron's audit committee that the company was engaged in "high risk" accounting practices that "push[ed] limits" or was "at the edge" of acceptable practice. At the hearing, the head of Enron's audit committee testified that "[w]e knew that the company was engaged in high-risk and innovative transactions," but did not recall being told by Andersen that the company's accounting practices were aggressive or that they placed the company at high risk of non-compliance with GAAP. Instead, he and other Board members stated that Andersen had given the company a clean audit opinion each year and had never expressed a specific objection to any Enron financial statement, accounting practice, or transaction, "despite evidence indicating that, internally at Andersen, concerns about Enron's accounting were commonplace."
A key lesson from Enron and other corporate disasters over the last few years is that accounting firms need to be more honest and direct in communicating with audit committees about the extent to which company accounting practices and financial reporting are aggressive, misleading, or carry a high risk of non-compliance with GAAP. This same problem was identified two years ago by a Blue Ribbon Commission on Improving the Effectiveness of Corporate Audit Committees. This Commission's report stressed the importance of frank communications between auditors and audit committees to ensure sound financial reporting. That Commission provided ten recommendations to improve audit committee operations, including a requirement that auditors "discuss with the audit committee the auditor's judgments about the quality, not just the acceptability, of the company's accounting principles as applied in its financial reporting ... [including] such issues as the clarity of the company's financial disclosures and degree of aggressiveness or conservatism of the company's accounting principles and underlying estimates and other significant decisions made by management."
The current proposal fails to make it clear that an auditor needs to tell the audit committee of a publicly traded company when company management is pushing the envelope on accounting rules. This information is critical if audit committees are to stop public companies from using high risk accounting practices. The following language, which could be incorporated into the proposed rule as a new paragraph (3), would accomplish this objective. It would explicitly require a registered public accounting firm to report to the company's audit committees regarding:
"210.2-07(a)(3) The quality, acceptability, clarity, and aggressiveness of the financial statements, financial reports, accounting principles, and related decisionmaking of the issuer;".
This new provision would ensure that audit committees are told how aggressive their company's accounting practices are and alert them to when closer scrutiny of the company's accounting practices or financial statements is warranted. It would also put an end to claims of ignorance by Board members when confronted with evidence of high risk or misleading accounting practices.
Partner Rotation and Compensation
Finally, I would like to express strong support for the proposed rule's provisions implementing the five-year partner rotation requirement in the Sarbanes-Oxley Act; applying that rotation requirement to not only the lead and reviewing audit partners, but also other partners, principals and shareholders on the audit engagement team; and prohibiting each of these persons from receiving compensation related to the sale of non-audit services to the audit client. These proposed rules comply with Congressional intent, place important limits on practices that foster conflicts of interest, and provide a reasonable approach to strengthened auditor independence.
The SEC also requested comments on whether companies should be required to undergo periodic, forensic audits to evaluate the work of their financial statement auditors, and whether companies ought to be able to choose between partner rotation versus forensic audits. Forensic audits perform a different function than financial statement audits and are better designed to uncover fraud or dishonest accounting. Given the widespread corporate misconduct and misleading accounting uncovered in recent years, forensic audits should be mandatory for publicly traded companies on a periodic basis. However, this requirement should supplement rather than replace the rotation requirement, since they address different concerns involving uncovering corporate misconduct versus curbing auditor conflicts of interest.
Finally, at times in the proposal, the SEC requests comments on whether different rules should be developed and applied to smaller corporations or auditing firms or to companies or firms organized outside of the United States. Such distinctions should be rejected, since they distort the market as well as corporate and accounting operations and do not contribute to restoring auditor or financial statement integrity. All public companies and accountants should operate on a level playing field under the same rules promoting auditor independence, honest accounting, and accurate financial statements.
Thank you for this opportunity to offer comments on the proposed rule. If your staff has any questions or concerns about this letter, please have your staff contact Elise Bean, staff director and chief counsel of the Permanent Subcommittee on Investigations, at (202) 224-9505.