Institute of Chartered Accountants of Scotland
Jonathan G Katz, Esq
8 January 2003
Dear Mr Katz
STRENGTHENING THE COMMISSION'S REQUIREMENTS REGARDING AUDITOR INDEPENDENCE: FILE NO. S7-49-02
We have considered the SEC's proposed rule on strengthening its requirements regarding auditors' independence, and I am pleased to set out our comments below.
1. THE IMPORTANCE OF THE PUBLIC INTEREST
1.1 Having received its Royal Charter in 1854, The Institute of Chartered Accountants of Scotland is the oldest professional body of accountants in the world. It has over 15,000 members worldwide, with around two thirds of its active membership working in business and one third in practice.
1.2 The Institute's objective is to uphold the integrity and standing of the profession of chartered accountancy in the interests of society and the membership, through excellence in education and the development of accountancy and through services to members and the enforcement of professional standards.
1.3 The Institute has been active in the auditing and corporate governance debate in the UK and internationally ever since it was instrumental in initiating the setting up of the Cadbury Committee in the early 1990s. As its members work inter alia as finance directors, analysts, auditors and regulators, the Institute is well-placed to comment on all aspects of the auditing and corporate governance framework.
1.4 As its Charter requires, the Institute must act primarily in the public interest, and our proactive projects, responses to consultation documents etc. are therefore intended to place the general public interest first. Our Charter also requires us to represent our members' views and protect their interests, but in the rare cases where these are at odds with the public interest, it is the public interest which must be paramount.
2. GENERAL COMMENTS
2.1 The Profession's Ethics - Detailed Rules v Broad Principles?
2.1.1 We strongly support the application of an ethical framework for auditors which is based on broad principles, rather than on detailed rules. Only by defining and applying broad principles can the ethical framework be sure of applying to all circumstances, which might arise in practice. The benefits of such an approach have been recognised recently by the European Commission in its Recommendation "Statutory Auditors' Independence in the EU: A Set of Fundamental Principles" and also by the International Federation of Accountants.
2.2 Sarbanes-Oxley Act and the Need for Global Solutions
2.2.1 We support the overall objectives of the Sarbanes-Oxley Act, aimed at restoring confidence in the capital markets. However, it is essentially a US political response to primarily US problems, and one that is likely to present difficulties in its application to foreign registrants. For foreign registrants, its provisions may be unnecessary, burdensome or even impossible to apply.
2.2.2 In the global environment in which the larger companies operate, it no longer seems sensible to pursue national solutions. Consequently, we would advocate the adoption of an auditor independence framework based on the International Federation of Accountant's ethical code, which forms the foundation of ethical frameworks around the world and has recently been substantially adopted by the EU.
2.3 Extra-Territorial Application and Mutual Recognition
2.3.1 We are concerned that legal and regulatory rules in the UK and in the rest of the EU may prevent compliance with some of the detailed requirements imposed by the SEC which extend to foreign registrants and their auditors.
2.3.2 We see the immediate solution to this problem as being based on the principle of mutual recognition, such that the SEC would recognise the measures that other jurisdictions have implemented to achieve similar objectives to those which the SEC is seeking to achieve. Accordingly, we recommend that the SEC grants exemptions for foreign registrants, to the extent that the Sarbanes-Oxley Act allows it do so, so that aspects of the proposed rules would not be imposed where the registrant's home state has in place measures which achieve the same effect. In the longer term a global solution, as discussed above, is needed.
2.4.1 There seems to be little acknowledgement in the proposed rules of the concept of materiality: if a matter is immaterial to all parties there could be no compromise to independence. Materiality, however, should be considered not only in quantitative terms, but also qualitatively. For example there may be non-audit services that generate insignificant fees for the accounting firm but represent, or may be perceived to represent, a significant threat to the auditors' independence and objectivity.
2.5 Breadth of Application
2.5.1 We believe it is unnecessary for the proposed rules to impact upon individuals in audit firms who cannot be in a position to exercise significant influence on the audit opinion, for example because their work is subject to review by others, or because of the immateriality of their role in relation to the listed entity's group accounts or to the audit. This is particularly the case in the wide range of individuals to whom the proposed rotation and cooling off rules apply. These are considered further below.
2.6 Letter from the Fédération des Experts Comptables Européens
2.6.1 We wish to express our support for the letter dated 20 December 2002 from the President of the Fédération des Experts Comptables Européens ("FEE") to the SEC. The Institute of Chartered Accountants of Scotland is a member body of FEE, and endorses the points that are set out in the letter.
3. SPECIFIC ISSUES
3.1 Cooling off periods
3.1.1 We are committed to working with IFAC to find a sustainable solution to the perceived, and potentially real, independence weaknesses which may arise as a result of a member of the audit team joining the audit client as an employee.
3.1.2 Our initial reaction is that the SEC's proposed rule takes a sensible approach in putting the onus on preventing the accounting firm from acting as auditor in this situation. We also believe that the SEC approach is sensible in focusing on senior executive or senior financial positions in the audit client and on individuals who were engaged in the audit within a 1-year period prior to the initiation of the current audit.
3.1.3 However, we believe that the application of the proposed rule in relation to individuals who were engaged in any capacity in the audit is too wide. For example, it is unnecessary to apply this in relation to individuals in the accounting firm which could not be in a position to exercise significant influence on the audit opinion, because their work is subject to review by others, or because of the immateriality of their role in relation to the listed entity's group accounts or to the audit.
3.2 Non-audit services
3.2.1 We are strongly supportive of the principles on which the list of prohibited non-audit services is claimed to be based. That is:
3.2.2 However, we are concerned at the apparent lack of application of these principles in relation to the nine proposed prohibitions on non-audit services. A more robust approach would be to apply the broad principles and the specific prohibitions that the Sarbanes-Oxley Act requires, but not to extend those prohibitions or define them in excessive detail. In practice, and especially at the margins, audit committees and auditors should be left to consider whether non-audit services conflict with the underlying principles. See also our comments below on "Audit Committee Administration".
3.3 Partner Rotation
3.3.1 We have recently extended our ethical guidance to require that audit engagement partners should be subject to rotation every five years. We also require that other key audit principals (ie those individuals involved in the planning and control of the audit, and including partners other than the audit engagement partner where this is the case) should not have an involvement of more than seven years. However, we would not favour any requirement that all partners should be subject to a five-year rotation period.
3.3.2 SEC registrants are generally large and very complex organisations and auditors of these companies require a broad knowledge and deep understanding in order to undertake an effective audit. Such knowledge can only be built up by an individual partner over a period of time. Requiring rotation of all partners within a five-year period (even if such rotation is staggered) does not allow time for this knowledge and understanding to be built up and then used to maximise the effectiveness of the audit. Consequently, we have major concerns about imposing too short a rotation period and applying this to too many of the partners involved in the audit. We believe that this will reduce the overall auditor knowledge of the client company, significantly weaken audit effectiveness, and run counter to the underlying objective of the Sarbanes-Oxley Act, ie of increasing confidence in audit and in the capital markets.
3.3.3 Furthermore, we believe it is unnecessary for the proposed rule to be imposed upon individuals (including partners) who cannot be in a position to exercise significant influence on the audit opinion, for example because their work is subject to review by others, or because of the immateriality of their role in relation to the listed entity's group accounts or to the audit.
3.3.4 We support the SEC's analysis to support the proposed rule that, following rotation, a partner (or other individual) may not return to the audit engagement for a period of five years.
3.3.5 We would not support a requirement for a second audit firm to undertake a "forensic audit" to evaluate the work of the auditor. In our view, this would impose a cost burden wholly out of proportion to the likely benefits that would arise.
3.4 Audit Committee Administration
3.4.1 We accept that the provision of non-audit services may have an adverse effect on the perception of auditor independence in the UK, and we have suggested that this would be properly dealt with by enhancing the UK's corporate governance framework to require the audit committee to:
3.4.2 Subject to our concerns on the extra-territorial application of the SEC's proposed rules, we would therefore be comfortable with the SEC's proposed rules along these lines.
3.4.3 We would not support any de-minimis exemption under which engagements involving fees below a certain level are allowed to be awarded by management to the company's auditors. We commented above that there seemed to be little acknowledgement in the proposed rules of the concept of materiality. However, materiality needs to be considered in qualitative terms, and cannot be assessed purely in relation to monetary amounts. There may be non-audit services which generate insignificant fees for the accounting firm but represent, or may be perceived to represent, a significant threat to the auditors' independence and objectivity. We believe that the audit committee should consider each non-audit engagements on a case by case basis.
3.4.4 As noted above, we are concerned that legal and regulatory rules in the UK and in the rest of the EU may prevent compliance with some of the detailed requirements imposed by the SEC and which extend to foreign registrants and their auditors. In this case, the requirements imposed on audit committees need to be capable of being fulfilled by Supervisory Boards in two-tier board structures.
3.5.1 We agree that where an accounting firm offers members of its audit engagement teams cash bonuses and financial incentives to sell products or services other than audit to their audit clients, this is inconsistent with the actual (and perceived) independence and objectivity of the audit team. We therefore support the thrust of the proposed rule.
3.5.2 However, taking this principle further would suggest that audit partners cannot be independent or objective if their remuneration or profit share is dependent on the audit fees received from the SEC registrant. Ultimately, all partners' income depends on the profitability of the firm, and this could be construed to mean that no partner could be independent or objective. It would be helpful if the SEC could elaborate on the overall principle it is seeking to apply here - that members of the audit team should not benefit directly from the provision of non-audit services to audit clients.
3.6 Communication with Audit Committees
3.6.1 We do not favour any extension of the existing requirements on communication with audit committees. Whilst we agree that the audit committee needs to maintain a close working relationship with the auditors, many of the proposed areas of communication are matters which are primarily the responsibility of management, eg critical accounting policies and practices. It should therefore be management's responsibility to ensure that the audit committee is aware of these matters. Clearly, the audit committee would wish to discuss matters such as critical accounting policies with the auditors, but we do not see any need to require these to be formally communicated.
3.6.2 In our view, such matters should be left to Auditing Standards. UK auditing standards already require certain key matters to be communicated to audit committees.
3.7 Expanded Disclosure of Audit and Non-Audit Fees
3.7.1 In the interests of openness and transparency, we support the proposed disclosure requirements on audit and non-audit fees. The UK has required disclosure of audit and non-audit fees for some years. We have supported extending this disclosure, so as to analyse the different services supplied by nature of service, and we understand that this likely to be required shortly.
3.7.2 We agree that this is important to enable investors to be better able to evaluate the extent to which the audit firm provides services to the company and the nature of those services. The involvement of the audit committee in the awarding of non-audit engagements (see above) should also provide comfort that the audit firm remains fully objective and independent.
We hope that our comments are of assistance to you in the finalisation of these rules. If you wish to discuss any of these further, please do not hesitate to contact me.