COMMENT LETTER OF DELOITTE & TOUCHE LLP
ON THE COMMISSION'S PROPOSED RULE IMPLEMENTING
SECTIONS 201, 202, 203, 204, AND 206 OF THE
SARBANES-OXLEY ACT OF 2002
Deloitte & Touche LLP
10 Westport Road'
P.O> Box 820
Wilton, CT 06897-0820
January 10, 2003
Mr. Jonathan Katz
United States Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549-0609
Re: Release Nos. 33-8154; 34-46934; 35-27610; IC-25838; IA-2088
Strengthening the Commission's Requirements Regarding Auditor Independence
(File No. S7-49-02)
Dear Mr. Katz:
Deloitte & Touche LLP is pleased to respond to the request for comments from the Securities and Exchange Commission (the "Commission") on its proposed rule, Strengthening the Commission's Requirements Regarding Auditor Independence, File No. S7-49-02, (December 2, 2002) (the "Release"). 1
TABLE OF CONTENTS
TABLE OF CONTENTS
- General Comments
- The Commission's Task Is Aided By Recent Efforts To Strengthen Independence
- The Commission Should Track The Congressional Mandate
- The Commission Should Provide Issuers, Audit Committees, And Auditors With Clear Guidance
- The Commission Should Minimize The Harmful Unintended Consequences From The Rule
- The Proposal Is Inconsistent In Its Varied Applicability To "Issuers," "Audit Clients," And "Registrants"
- The Proposed Rule Poses Unique Problems For Foreign Firms
- The Proposed Rule Should Be Tailored To The Special Features Of Investment Companies
- The Costs Associated With The Proposed Rule Would Be Needlessly Excessive
- The Commission Must Provide For Appropriate Transition Periods In Order To Avoid Market Disruption
- Specific Comments
- Conflicts Of Interest Resulting From Employment Relationships
- Services Outside The Scope Of The Practice Of Auditors
- Tax Services
- Partner Rotation /A>
- Audit Committee Administration Of The Engagement
- Communication With Audit Committees
- Expanded Disclosure
- APPENDIX A-1
We strongly support the goals of the President of the United States, the United States Congress, and the Commission to improve the quality and transparency of financial reporting and corporate governance. Effective implementation of the Sarbanes-Oxley Act of 2002 (the "Act") will result in positive changes in governance and financial reporting, and we are committed to assisting the Commission in the adoption of responsible rules that improve the quality of financial reporting and help to restore investor confidence in our capital markets. One element of the Act's implementation that has great significance for investors, issuers, and the accounting profession is the Commission's proposed rule concerning auditor independence.
Following are our comments with respect to this proposal for your consideration in the final rulemaking process. We first set forth our general comments on some of the larger legal and policy issues raised by the proposed rule, and then provide a more detailed response to some of the specific aspects of the proposal and the Commission's specific questions contained in the Release. On several points, we suggest alternative approaches that we believe will serve the Commission's goals while avoiding costly or unwieldy implementation problems.
The aspects of the proposed rule that we consider to be the most important for us to comment on are those that relate to:
- partner rotation;
- restrictions on partner compensation;
- the ability to provide tax services;
- transition periods; and
- the breadth of entities to which the proposed rule would apply.
Although we consider our comments on these aspects of the proposed rule to be more critical than others, in providing our specific comments we have chosen to follow the order in which the various parts of the proposal are discussed in the Release, rather than commenting in an order that would more accurately reflect the importance that we place on each aspect of the proposed rule.
II. General Comments
A. The Commission's Task Is Aided By Recent Efforts To Strengthen Independence
The Release is issued in the wake of the recent adoption of the Act, wherein Congress addressed the issue of auditor independence across a broad front. Congress also has altered dramatically the regulatory regime for accounting firms, displacing existing professional self-regulation and imposing regulation and oversight by the independent Public Company Accounting Oversight Board, whose members are selected by the Commission. Congress thus has adapted, strengthened, and broadened the existing mechanisms designed to protect and enhance auditor independence. Informed investors will have increased confidence in the independence of auditors, as a result of the new, broader, multi-faceted regulatory regime crafted by Congress.
The Commission also recently addressed many of the issues covered by the Release. In its 2000 rulemaking, for example, the Commission extensively considered and adopted new scope of service restrictions, and in so doing considered the many existing safeguards - both within the profession, as part of the securities laws' disclosure regime, and within issuers themselves - to protect auditor independence. 2 The Commission thus returns to these issues with the benefit of the responses and knowledge obtained during the 2000 rulemaking.
It is against this background, and in light of the new statutory protections for auditor independence, that the Commission must determine its final rule.
B. The Commission Should Track The Congressional Mandate
We support the Commission's efforts to ensure auditor independence - such independence is a vital imperative for the accounting profession. We recognize that Title II of the Act provides congressional direction to maintain auditor independence and that much of the proposed rule tracks the course charted by Congress and focuses on explaining how the Commission proposes to implement the specific provisions set forth in Title II. Indeed, § 208 of the Act requires as much, providing that the Commission "shall issue final regulations to carry out" the provisions contained in Title II.
As drafted, the proposed rule in some instances would impose restrictions not contemplated by Congress. The impact of these more expansive restrictions will be felt by issuers, investors, and accounting firms. We respect the Commission's policy expertise and judgment, but we are especially concerned about the unintended, harmful consequences, including potential impacts on audit quality, of the Commission's proposed rule.
As a general principle, we believe the Commission should not adopt rules that go beyond the Act. The Act directs the Commission to act swiftly in its rulemaking - mandating that the final regulations be issued by January 26, 2003. 3 The proposed rule was published in the Federal Register on December 13, 2002. As a consequence, given the statutory deadline for issuing a final rule, the Commission was forced to provide only a 30-day comment period - a period that will obviously limit the ability of interested parties to provide meaningful, comprehensive comments on all aspects of the proposal. Indeed, 30 days is plainly not enough time for commenters to conduct the type of cost-benefit analyses that would assist the Commission in considering many of the questions that the Release poses. 4
In addition, the Commission will have a remarkably short time to consider the comments. The 30-day period will expire on Monday, January 13, 2003. The Commission must issue its final rule by January 26, 2003, at the latest. Thus, the final rule will be issued just 13 calendar days - and only eight business days - after the close of the comment period. We do not view 13 days to be an adequate amount of time for the Commission to assess concerns expressed by the public, or to respond to flaws in the proposed rule that the comment period is intended to highlight for the Commission.
We recognize that, in light of the statutory mandate concerning the timing of the final rule, the Commission could have done little to avoid having to implement the Act's specific provisions on this hurried timetable, and we applaud the Commission for the dedication and insight it has brought to its difficult task; but we believe the truncated time frame strongly counsels against attempts to "go beyond" the Act's specific provisions and to make policy judgments not endorsed by Congress. 5
We also believe that the Commission's recent comprehensive consideration of many of these same scope of service issues in 2000 further reduces the need to go beyond the congressional mandate. Initially, the Commission issued proposed independence rules in June 2000 that, as the Commission now describes them, were "more restrictive" than those ultimately adopted. 6 As noted in the Release, "[i]n the period between publication of the proposed rules and the adoption of the final rules, the Commission conducted public hearings at which over 100 persons testified, a congressional hearing was held, and over 3,000 comment letters were received." 7 After this thorough consideration of its proposal, the Commission settled upon the adopted scope of service requirements as the appropriate regulatory response.
Congress clearly used the 2000 rules in drafting and passing the Act and demonstrated its intent to codify the current auditor independence rules with respect to prohibited non-audit services contained in § 201 of the Act - even keeping the services in the same order as they appear in the 2000 rule. 8 Moreover, Congress's decision to follow the Commission's list of non-audit services set forth in the 2000 rulemaking, without providing its own set of definitions, further demonstrates Congress's intent to incorporate the defined terms of the Commission's rule. 9
The Supreme Court has concluded that when Congress enacts a statute and does not abrogate an agency's interpretation of terms used in that statute, Congress should be deemed to have concurred in the agency's interpretation of those terms. 10 "[C]ongressional failure to revise or repeal the agency's interpretation is persuasive evidence that the interpretation is the one intended by Congress." 11 That principle is directly applicable here. In addition, as the Supreme Court has explained, "[i]n the absence of contrary indication, we assume that when a statute uses . . . a term [of art], Congress intended it to have its established meaning." 12 Thus, by using the same terms of art that the Commission used, Congress reinforced its decision to adopt the definitional guidance that the Commission provided in its 2000 auditor independence rulemaking. 13
The Act's legislative history further supports this straightforward interpretation of the statutory text. Congress not only was aware of the Commission's existing definitions, but it also expressly considered - and rejected - any changes to them. The Sarbanes bill once contained a provision that would have required the Commission to adopt rules substantially similar to its proposed 2000 auditor independence rules (as distinct from the final rule), but that provision was deleted from the bill before it was reported out of the Senate Banking Committee. The Committee recognized that the result of deleting the provision was that "we will live under the current rules, not the July 2000 [proposed] rules." 14 A later proposed amendment that would have re-inserted that provision was not considered by Congress. 15 The Supreme Court has recognized that when "Congress repeatedly consider[s] and reject[s]" broader legislation, its intention to legislate narrowly is evident. 16 The Act's legislative history also makes clear that the prohibited group of non-audit services is intended to be "limited" in scope and to have the specific purpose of "assur[ing] the independence of the audit, not to put an end to the provision of non-audit services by accounting firms." 17 The legislative history as a whole thus demonstrates that Congress intended the existing 2000 rules to remain in effect. Moving beyond the Act's requirements as to scope of services - and the Commission's own recent regulatory conclusions in 2000 - is unnecessary in this rulemaking. 18
In light of the brief comment period, the time-intensive, rigorous consideration that the Commission gave to its 2000 rulemaking, the fact that the more restrictive provisions of the 2000 rulemaking just became effective on August 5, 2002, the outcome of the recent legislation in which Congress considered the 2000 rule, and the congressional judgment to reject many proposals during the course of the legislative process as being too rigid, extreme, or injurious to the public interest, we recommend that the Commission track the congressional mandate where possible. We recognize, however, that in some narrow instances the Commission may wish to adopt additional rules because it determines that such rules are necessary in order to apply the law effectively - and that the Commission has the authority to do so. In those narrow instances, we believe any extensions of the Act should be both judicious and strictly limited to those sections where any additional rules are necessary for the Commission to fulfill the intent of Congress. Otherwise, the Commission may find itself adopting unnecessary rules, based on an inadequate record, that will in practice prove injurious to investors and the public markets.
C. The Commission Should Provide Issuers, Audit Committees, And Auditors With Clear Guidance
We believe that the Commission should clarify the scope of its proposal, explain the intended meanings of several terms, and resolve questions left open by the proposal in a manner that will reduce the likelihood of unintended consequences and decrease the costs of compliance. Without such clarification, audit committees and accounting firms could face great difficulty in determining the appropriate precautions to take in order to ensure that they are acting consistently with the rule.
Consider one example: in discussing the scope of prohibited non-audit services, the proposed rule relies heavily on "three principles" of auditor independence. 19 Although we endorse the principles as general guidance, we are concerned that the reliance on the principles may be an inadequate substitute for the specific guidance needed by audit committees and auditors seeking to understand and comply with the prohibitions that the Act imposes and that the proposed rule seeks to implement. We recommend that the Commission clarify its proposed revisions to the scope-of-services restrictions to define with greater precision the Act's impact on the services that accounting firms offer their audit clients. 20
Providing more specific guidance would be consistent with the Act. Congress never lost sight of the need to offer auditors and their clients clear and precise guidance, as is demonstrated by the passages of legislative history that are quoted in the Release. The portion of the Banking Committee report quoted in the Release begins by stating, "The intention of this provision is to draw a clear line around a limited list of non-audit services that accounting firms may not provide to public company audit clients." 21 Senator Sarbanes, in the floor debate excerpted in the Commission's discussion, made precisely the same point, reiterating that it was a "fundamental objective of the conference report" to "draw a bright line around" the set of prohibited non-audit services. 22
We do not mean to suggest that the Commission should not consider the three principles in the course of its rulemaking. As the legislative history indicates, Congress referenced those principles in developing the list of services set forth in § 201(a) of the Act. 23 In evaluating future contingencies that may fall within the general ambit of Congress's prohibitions but which Congress and the Commission have not specifically contemplated, audit committees may derive guidance from the three principles (as well as other independence principles) in deciding how to address these unforeseen circumstances. 24 But we do not believe that Congress ever intended to leave auditors and audit committees to be guided only by these three general concepts, whose application can be highly debatable and counter-intuitive. As explained in the Senate Report to the Act, the pre-approval provision "does not require the audit committee to make a particular finding in order to pre-approve an activity. The members of the audit committee shall vote consistent with the standards they determine to be appropriate in light of their fiduciary responsibilities and such other considerations they deem to be relevant." 25 Indeed, the Release's emphasis on the "three principles" could create a degree of uncertainty for many audit committees that undercuts the certainty that Congress sought to provide issuers and audit firms in adopting a "limited list of non-audit services." 26
Issuers forced to speculate about what tasks they can and cannot ask their auditors to perform are not in a good position to obtain the services they need from their providers of choice. Similarly, regulatory uncertainty will drive audit committees and accounting firms to take unnecessarily risk-averse positions (thereby losing the ability to provide issuers with the best service available) in order to avoid even arguable or inadvertent violations of the Act. Such risk-averse decisions may actually keep audit committees from performing their assigned role and would come at a higher cost to investors. None of those outcomes is useful for the investing public, issuers, or accounting firms.
Other examples are found throughout the proposed rule. The timing of the "cooling-off" period, the application of the partner rotation proposal, and transition periods, all present implementation questions on which issuers, audit committees, and accounting firms will benefit from clear guidance by the Commission. Providing clear guidance to audit committees and auditors will enable them to avoid potential independence violations and to function more efficiently in the new regulatory environment.
We believe the Commission should clarify and resolve the ambiguities contained within the proposed rule. We have sought to identify many of our specific areas of concern below.
D. The Commission Should Minimize The Harmful Unintended Consequences From The Rule
Undoubtedly, the Commission intends the proposed rule to enhance the quality and effectiveness of audits, and the various aspects of the proposal were suggested with that goal in mind. We are concerned that some aspects of the proposal may result in unintended, adverse consequences for investors and the audit process. We believe that some parts of the proposed rule may ultimately lead to a decrease in audit quality by depriving the audit process of input from key specialists. The proposed rule's suggested restriction on compensation also could lead to the negative consequence that certain partners with a particular and necessary expertise will have regulatory reasons to withdraw from assisting in an audit. We are particularly concerned that partners who have expertise in tax, computer assurance, or internal control systems, among others, may be forced by overbroad rules to limit their involvement in the audit, thereby injuring the quality and effectiveness of the audit. We believe that effective audits require specialized expertise, and that firms must have the ability to apply their internal, collective expertise on a real time basis to assist the audit.
We also are concerned that, depending on the form of the final rule, service on audit committees may become less desirable, given the increased time, risk, and expense likely to be involved with such service. To the extent that the final rule's provisions require audit committees to meet more frequently, review more reports, and make more decisions than mandated by the Act, many otherwise qualified individuals may choose not to serve on these committees. Moreover, given the increased role of audit committees in the pre-approval process, there may be a real or perceived increase in liability risk for committee members. We believe that the Commission could minimize these unintended consequences by providing audit committees with appropriate flexibility in fulfilling their new regulatory obligations.
E. The Proposal Is Inconsistent In Its Varied Applicability To "Issuers," "Audit Clients," And "Registrants"
The proposed rule varies in its purported application to issuers, audit clients, and other entities. We seek below to address definitional issues in the specific proposals, but we recommend that the Commission revisit the use of these terms throughout the Release as a general matter. We are concerned that in some instances the reach of certain aspects of the proposed rule is greater than Congress intended and would impose more substantial costs on accounting firms and the entities they service. For example, although the Act's "cooling-off" provision applies to employees of "issuers," the proposed rule's comparable provision would apply to the much broader (and less certain) category of employees of "audit clients."
F. The Proposed Rule Poses Unique Problems For Foreign Firms
The Release does not comprehensively address the impact that the proposed rule could have on foreign issuers and foreign audit firms. 27 Many aspects of the proposed rule could be particularly problematic for foreign accounting firms, including individual firms that are members of international organizations or members of international associations of firms (hereinafter referred to as "foreign associated firms"). For example, the proposed partner rotation requirements could seriously impact foreign firms and potentially will reduce the quality of audits in many countries. In many foreign regions, there are a limited number of audit partners who have obtained the requisite level of knowledge of accounting principles generally accepted in the United States ("U.S. GAAP"), auditing principles generally accepted in the United States ("U.S. GAAS"), and Commission regulations to provide effective audit services to their clients that are registrants or affiliates of registrants. In most cases, these partners have developed their expertise over a long period of time and often partners spend several years in the United States on an expatriate assignment before they have transitioned into the role of lead partner for an issuer. In addition, most large multinational clients require several "line" partners to complete their audits. Developing "line" partners who can maintain the high level of expertise necessary to serve issuers is costly, difficult, and time consuming, and audit firms are limited in their ability to fill critical partner roles for these clients. In some countries, the number of audit partners that currently serve, or could serve, U.S. public companies is so limited that compliance with the proposed rotation rule is not currently possible. 28
By forcing the limited number of experienced partners to rotate off of certain engagements and be replaced by less experienced candidates, the proposed rule could reduce the quality and effectiveness of audits provided for foreign registrants or foreign affiliates of registrants. We urge the Commission to consider alternatives that would mitigate the potentially negative impact of the proposed rotation requirements on foreign issuers and foreign affiliates.
Also, in some areas of the world, only attorneys can perform certain tax services and thus the ability to complete a client's audit requires the services of both an audit firm and a law firm. The practical effect of the proposed rule, however, would be that in certain European countries, such as France and Spain, a tax specialist would be unable to provide tax/audit specialist services to an audit client because those services would be deemed legal services and prohibited by the proposed rule. The inability of a tax specialist to provide expertise to the audit partner, as part of the audit of a client's financial statements, could lead to a decrease in audit quality. The Commission's rulemaking should create an environment that will increase, not decrease, the quality of the audit.
Additionally, the application of the proposed "cooling-off" period should be carefully reconsidered because of the negative effects it is likely to have in many countries outside of the United States. In certain foreign countries, placing restrictions on an individual's future employment options may be deemed unlawful and not sustained by the courts. Some issuers and affiliates of issuers in these countries may not delay hiring of personnel in order to comply with the proposed rule. As a result, a foreign audit firm, whether or not affiliated with an international network of firms, may no longer be deemed independent under the Commission's definition. In addition, in certain countries, such as Belgium, France, and Germany, an audit firm may be prevented by law or regulatory action from resigning from its "statutory auditor" role, even if the foreign audit firm were deemed to be no longer independent under the Commission's rules. In such a circumstance, the issuer, or at least the affiliate, may be required to engage a second audit firm to perform an audit that complies with the Commission's regulations, while retaining the audit firm appointed or contracted for a multi-year period to perform the statutory audit. The proposed cooling-off period would thus not achieve its intended benefits, but rather would create confusion and unnecessarily require a significant duplication of audit costs that must be borne by foreign issuers.
We acknowledge and support the Commission's actions to garner insights into the international impact of the proposed rule. We encourage the Commission to continue to seek information from those outside the United States and to monitor the developments of independence standard setters and other regulators at national, regional, and global levels. With that backdrop, the Commission should take the above and similar considerations into account and craft particular rules for foreign firms where appropriate, including in the areas of legal/tax services, partner rotation, and cooling-off periods.
G. The Proposed Rule Should Be Tailored To The Special Features Of Investment Companies
As the Commission points out in the Release, many aspects of the proposed rule, if implemented as drafted, would apply to investment companies. 29 Because of the expansive definitions related to investment company complexes and the unique nature of the investment management industry, we believe that provisions in the proposed rule should be modified to address the unique situation of investment company complexes.
The investment management industry is highly specialized and has unique accounting, financial reporting, and regulatory requirements. The accounting and tax professionals who service investment companies must understand the technical issues associated with these companies and must have the experience and expertise necessary to assess the unique audit, tax, and business risks that these companies face. If the proposed rule is implemented as drafted, however, the ability to staff engagements for investment company clients with partners that possess the requisite level of expertise will be seriously jeopardized.
Many sponsors of investment companies have developed a large number of products for individual investment companies. Because each individual investment company is considered a separate registrant, each is subject to its own financial reporting and regulatory requirements. Many investment management clients sponsor more than one hundred funds. To address the large volume of work created by investment company clients, multiple audit partners are routinely dispatched to provide necessary audit services on each engagement. Given the highly technical nature of the investment management industry, many senior partners that practice in this area serve several different investment company complex clients. Thus, while there are many individual investment companies to service, the number of qualified partners to assist in these companies' audits is quite limited.
A number of safeguards currently exist to ensure that investment company complexes' financial reporting issues are being reviewed by a number of different parties with varied interests. Most investment companies utilize independent third parties to hold custody of their assets. The reconciliation performed between an investment company's accounting records and the custodian's record of assets as part of the audit process, provides third party confirmation of the existence of all assets of the investment company. In addition, many investment company organizations engage independent third parties to maintain the accounting and financial records for the funds. Because the accounting and financial reporting systems used by these third party organizations are consistent among a variety of different clients, the systems are subject to testing by various audit firms that serve each of these different clients. Further, many third party service providers engage an audit firm to attest to their control environment through the issuance of an internal control report most commonly referred to as a SAS (Statement of Auditing Standards) 70 report. Many of the investment company complexes also engage multiple audit firms to audit the many funds they offer. The engagement of multiple audit firms creates duplicate testing of the systems, which results in a continuous double-checking by each audit firm.
We suggest that a more industry-focused approach be taken - one that would provide accounting firms with more flexibility in ensuring that industry experienced partners are able to provide their expertise on investment company engagements, while not compromising the intent of the auditor independence requirements set forth in the Act. Specifically, auditor independence rules for investment companies should be tied to a registrant's audit committee structure. Congress and the Commission have both recognized the critical role played by audit committees in the financial reporting process and the unique position of audit committees in oversight of the audit firm's performance. 30 We share that view and believe that by limiting the investment company complex definition to all entities that utilize the same audit committee, the implementing regulations will fulfill the Act's requirements without creating the potential for simultaneously depriving investment companies, and the investing public, of effective audits.
Under this definitional approach, the investment company adviser and its related companies, such as affiliated transfer agents, would be separate from the investment companies because each would be subject to the oversight of a different audit committee. In addition, because some of the larger investment company complexes have multiple boards and audit committees for separate groups of investment companies, each group would be considered separately for partner rotation and pre-approval of non-audit services. This approach would meet the Commission's intended objectives for partner rotation and pre-approval and place the responsibility for evaluating the engagement partner's or the accounting firm's independence with the audit committee responsible for the relationship and the services provided. To the extent necessary, the definition of investment company complex could also be further refined to require that the funds not only have different audit committees, but also that they operate using different accounting and financial reporting systems unless these systems are being operated by independent third party administrators or record keepers. This refinement would address any perceived concern that over time a partner may become too familiar with a family of funds' common affiliated operating system and therefore lose objectivity.
H. The Costs Associated With The Proposed Rule Would Be Needlessly Excessive
The Release requests comments "on all aspects of" the potential costs and benefits of the proposed rule, and the Commission "encourage[s] commenters to identify and supply relevant data concerning the costs or benefits." 31 Although the time constraints within which we are forced to prepare our comment prevent us from providing the Commission with a detailed cost-benefit analysis, we have sought to address in our specific comments particular areas of the proposed rule that would create readily apparent cost burdens, with no countervailing benefit to investors.
As a more general matter, the Commission should be cautious in its regulatory approach. Congress has acted to restore investor confidence in the capital markets by enacting a number of specific provisions designed to strengthen auditor independence. The Act's specific provisions will undoubtedly impose significant costs on issuers and auditors alike.
We recognize that some of these costs are unavoidable, given the requirements dictated by the Act. For example, the Act requires lead audit and review partners on an audit engagement team to rotate after five consecutive years on an engagement. We have not had time to conduct a full, detailed analysis to determine the actual costs that the Act's rotation requirement will impose. Although we generally support this rotation proposal, it is evident that replacing experienced lead and reviewing audit partners for an issuer with partners who are not familiar with the issuer will result in lost efficiencies, increased costs, and possibly decreased audit quality.
Additional costs that result from rules that go beyond the Act's requirements and that would not result in appreciable improvements in audit quality, however, are avoidable. For example, a rotation requirement of five years imposed on all partners on an audit engagement team would greatly increase the anticipated costs described above and may not provide any increased benefit to investors. 32 On average, we have conservatively estimated that it costs $250,000 to relocate a partner within the United States. Expanding the rotation requirement beyond the lead audit and review partners significantly increases the number of partners being relocated, the frequency of relocation, and the cost of relocation. For example, on one of our largest engagements 25 partners would be forced to rotate, as opposed to the one partner that is required to rotate every seven years under current requirements and the two partners that would be required to rotate under the Act. In this example, 25 partners would be required to rotate off the engagement and another 25 partners would have to rotate on to the engagement, impacting a total of 50 partners. Assuming that half of the partners in this particular example would need to relocate, at an average cost of $250,000, the result would be $6,250,000 in estimated relocation costs over five years, and an average annual cost of $1,250,000. Such costs would likely be passed on to issuers, and could be even higher depending on the need to rotate partners to overseas locations.
The Commission should be careful not to implement regulations that will be extremely costly, that do not provide a clear and significant independence benefit in return, that may produce a lower quality audit, and that are not required by the Act.
I. The Commission Must Provide For Appropriate Transition Periods In Order To Avoid Market Disruption
Although neither the proposed rule nor the Release proposes any specific transition periods for any aspects of the proposed rule, the Release explains that the Commission is "considering whether the application of some [of the proposed rule's] provisions should be delayed to a later date." 33 The Release further states that the Commission is considering such transition provisions for the proposed rules related to "audit partner rotation, audit committee communications, disclosures of fees paid to auditors, and partner compensation." 34 We believe that it is essential to the effective implementation of the Act and the proposed regulations for the Commission to establish appropriate transition periods. We address below some of our specific recommendations with respect to transition periods for various aspects of the proposed rule, and we have attached detailed suggestions as an Appendix to this letter.
As a general matter, however, we suggest a tiered approach. First, we recommend that no regulation take effect until at least 90 days after publication of the final rule in the Federal Register. Indeed, a modest 90-day transition period is the minimum that we think would ever be appropriate in light of the abbreviated comment period and the speed with which the Commission must act. Second, because we believe that 90 days would not be sufficient in some circumstances, we have identified in the Appendix and in our specific comments below those aspects of the proposed rule that we believe require a longer transition period in order to ensure orderly and effective implementation. Consistent with our concerns in this area, we suggest that any aspects of the final rule that "go beyond" the specific provisions of the Act should have a delayed effective date. 35 Finally, we believe that in some cases a grandfathering provision would be appropriate. For example, it would be exceptionally difficult, cumbersome, and costly to our clients for us to withdraw from pre-existing assignments where it has been agreed that the auditor can be named as an expert witness for a client. Such withdrawals would typically require court approval and would be particularly problematic.
III. Specific Comments
A. Conflicts Of Interest Resulting From Employment Relationships
We support mechanisms to ensure auditor independence when certain employment relationships arise between an issuer and former personnel of an audit firm. Current independence standards, including those that were recently adopted by the ISB and Commission that became effective in 2000, require specific measures to be taken when an audit client offers employment to a member of the engagement team or when a member of the engagement team accepts employment with an audit client. The Act and the proposed rule would require an additional mechanism - a "cooling-off period" - to ensure auditor independence when an employment relationship arises. Specifically, the proposed rule would deem a registered public accounting firm's independence to be impaired if "[a] former partner, principal, shareholder, or professional employee of an accounting firm is in a financial reporting oversight role at an audit client, unless the individual . . . [w]as not a member of the audit engagement team of the audit client during the one year period preceding the date that audit procedures commenced." 36 This language in the proposed rule goes beyond the requirements of the Act.
Congress designed the employment restriction to apply to "issuers," a statutorily defined term that focuses on the readily identifiable entity whose financial statements are being audited. By contrast, the proposed rule would extend the restriction far more broadly, to "audit clients." 37 Because the proposed rule does not contain a definition of "audit clients," we must assume that the existing rule's definition would be left in place. The existing rule defines "audit clients" to include not only "the entity whose financial statements . . . is being audited," but also "any affiliates of the audit client." 38 The same rule defines "affiliate," among other things, as any entity that can exert "control" or "significant influence" over the audit client, or over which the audit client can exert "control" or "significant influence." 39 As a result, the Commission's proposed rule could have a far greater reach than the Act contemplates, making it overly burdensome and potentially unworkable. For example, the restrictions might apply to a junior engagement team member who accepts employment with a company that is remotely affiliated with or immaterial to an audit client, even though no reasonable investor would perceive this relationship as a threat to independence. Firms would possibly be faced with the need to establish expensive and burdensome systems for cross-checking employment opportunities being pursued by staff on a global basis with lists of audit client affiliates. These are not consequences intended by the Act. Given the seriousness of these consequences to the ability of individual accountants to pursue their profession and develop their careers, the Commission should craft a narrower, more easily applied restriction that follows the congressional decision and applies only to "issuers," as Congress intended.
Additionally, the proposal would affect a broader range of employment decisions than the Act contemplates. Specifically, the proposal would apply to the employment of anyone in a so-called "financial reporting oversight role." This term refers to "any individual who has direct responsibility for oversight over those who prepare the registrant's financial statements and related information." 40 This term sweeps more broadly than the Act, in which Congress designed the employment restriction to apply only to persons who serve in a senior management capacity, such as the "chief executive officer, controller, chief financial officer, chief accounting officer, or any person serving in an equivalent position." 41 To this list, the proposed rule adds members of the board of directors, president, chief operating officer, general counsel, director of internal audit, director of financial reporting, treasurer, and individuals in any equivalent positions. The Commission acknowledges that this proposal "go[es] beyond the specific provisions of the Act," 42 and we believe that such an expansion would be unwarranted and unnecessarily costly. The Commission ought not expand upon the Act in this manner, and should instead follow Congress's considered judgment by limiting the rule to the senior positions identified in the Act.
The proposed cooling-off period would also have a negative impact in certain foreign countries where such restrictions on future employment opportunities have been deemed unlawful. For example, in Chile, tribunals have struck down similar employment limitations as unconstitutional. 43 As a result of these, and perhaps future, foreign legal decisions, and because audit clients may not agree to delay in hiring former firm personnel, a foreign audit firm or foreign associated firm may not be able to avoid inadvertently violating the Commission's final rule. In addition, because foreign jurisdictions prohibit the resignation of the statutory auditor, except in very limited circumstances, an issuer may be required to engage a second firm to perform an audit that complies with Commission regulations. Rather than giving companies, and therefore accounting firms, some level of flexibility in maintaining their relationship by structuring a particular hire in a manner that resolves any independence concerns, the employment restriction would likely result in significantly increased costs for foreign private issuers and may require the de facto resignations of foreign associated firms whenever an employee subject to the proposed rule is hired by an audit client. That result would not improve the quality or effectiveness of audits, and would not serve the public's interest. Accordingly, we recommend that the Commission carefully reconsider the application of the cooling-off provision in the foreign context to avoid such consequences.
We also believe that an appropriate transition period is necessary before the cooling-off restriction takes effect. Such a transition period is particularly necessary if the final rule goes beyond the Act in any way. If the final rule's cooling-off provision applies to more positions than those set forth in the Act, the provision should not take effect until at least a year after the final rule is issued. In that case, the cooling-off provision should apply when a former partner, principal, shareholder, or professional employee of an accounting firm takes a financial reporting oversight role at an audit client at a date after the completion of the one-year transition period. If, on the other hand, the cooling-off period is limited to those employment positions that Congress set forth in the Act, we recommend that at a minimum the proposal should not take effect until 90 days after the final rule is published in the Federal Register. Such a transition period would allow issuers, accounting firms, and their partners and employees, adequate time to account for the new rule's impact on their various relationships, including those accountants and companies that may be in the midst of employment-related negotiations. Additionally, we do not believe that the cooling-off period should apply in situations in which a former partner, principal, shareholder, or professional employee of an accounting firm takes a financial reporting oversight role at a non-audit client, and the non-audit client subsequently merges with, or is otherwise acquired by or acquires, an audit client of the firm. Application of the cooling-off provision to the former partner, principal, shareholder, or professional employee in such circumstances could unfairly impact that person's new employment position, even though he or she never sought employment with an audit client.
* * *
With these comments as background, we turn to specific questions the Commission has posed.
Is the one-year cooling-off period sufficiently long to achieve an appearance of independence by the accounting firm? If not, what period would be appropriate? (67 Fed. Reg. at 76782)
The "appearance" of independence rests upon whether "a reasonable investor with knowledge of all relevant facts and circumstances would conclude that the accountant is not capable of exercising objective and impartial judgment on all issues encompassed within the accountant's engagement." 44 We believe that a one-year cooling-off period is appropriate to maintain the appearance of independence. Congress determined that a one-year period struck the appropriate balance between the burden on individuals and companies and the benefit to the appearance of independence. Indeed, in striking a similar balance with respect to other potential appearances of conflicts of interest, Congress has determined that a one-year cooling-off period is appropriate. 45
Is the term audit engagement team sufficiently clear? If not, what changes would improve the description to describe the group of accountants who would be covered? (67 Fed. Reg. at 76782); and
Are the appropriate officers covered by the proposed rule? If not, which additional individuals should be subject to the cooling-off period provision? For example, should national office personnel who would be excluded under the proposal be included? (67 Fed. Reg. at 76782)
The Act specifies that the employment restriction applies to any person who was "employed by [the] registered public accounting firm and participated in any capacity in the audit." 46 The proposed rule applies to any "member of the audit engagement team," which the current rule defines as "all partners, principals, shareholders, and professional employees participating in an audit, review, or attestation engagement of an audit client." 47 The proposed rule is thus substantially consistent with the Act on this point; however, we recommend that the Commission should also consider including a de minimis exception for those personnel of the accounting firm who were only marginally involved in an audit. An issuer's hiring of tax and other specialists that previously had minimal participation in planning and preparing the audit, for example, does not present the same threat to independence as other types of hiring. For the same reasons, those personnel in a firm's national office and other advisory roles should be generally excluded from "the audit engagement team" as they would not normally be involved in the planning or direct execution of the audit.
Is the phrase commencement of the audit sufficiently clear? If not, what changes would improve the description? Is that the appropriate time to mark the commencement of the period? Is there a better mark? (67 Fed. Reg. at 76782)
The Release states that "procedures associated with the planning of the engagement constitute the commencement of an audit." 48 Determining the point in time that an audit commences based on when "procedures associated with the planning of the engagement" have started is complicated. Planning activities for an upcoming audit may take place months, weeks, or merely days ahead of the actual commencement of an audit and may take place at the same time that a prior audit is concluding. This variance in planning times could introduce a high degree of uncertainty into determining the bounds of the cooling-off period. We support a 12-month cooling-off period as discussed above and recommend that the Commission consider adopting a "bright-line" rule for the sake of clarity, certainty, and effective application of the rule. For example, the Commission could construct the cooling-off requirement based on the beginning or end of the issuer's fiscal year.
Is the phrase commencement of review procedures sufficiently clear? If not, what changes would improve the description? (67 Fed. Reg. at 76782)
The phrase "commencement of review procedures" is subject to the same criticism as the term "commencement of audit procedures." We recommend that the Commission adopt a "bright-line" rule for the commencement date like the one that we suggest directly above.
Is it appropriate that the cooling-off period provisions apply to employment relationships involving audit engagement team members and their audit clients? Should the requirements be limited to audit clients who are issuers as defined in section 205 of the Act? (67 Fed. Reg. at 76782)
As discussed above, the Commission's proposed rule is broader than the Act in that it would apply not only to "issuers" but to "audit clients." As a result, the proposed rule's scope is greater than the Act contemplates, which we think will make it overly burdensome and potentially unworkable. The Commission should limit the reach of the rule to "issuers," consistent with Congress's intent as expressed in the Act.
Should the proposed rules apply equally to large firms/companies as small firms/companies? Would the proposed rules impose a cost on smaller issuers that is disproportionate to the benefits that would be achieved? Why or why not? Should there be an exemption to this requirement for smaller businesses? (67 Fed. Reg. at 76782)
The proposed rule should apply uniformly to all public companies and firms without differentiating between small and large businesses.
The "cooling off" period applies to all entities in the investment company complex. Is this too broad? Why or why not? (67 Fed. Reg. at 76782)
As discussed, the Commission's rule is broader than the Act in that it applies not only to "issuers" but to "audit clients." "Audit clients" includes "affiliates," which, in turn, includes all entities in the "investment company complex." We believe that the use of the current investment company complex definition is too broad in that it would apply to employment positions that have no direct connection to financial reporting of a mutual fund. For example, a professional with an accounting firm who has audited a mutual fund would be prohibited from taking a position as the chief financial officer of an affiliated transfer agent that provides shareholder services to the funds but has no direct role in the financial reporting process for the mutual fund. In order to avoid such consequences, the Commission should limit the reach of the rule with regard to organizations identified as being within the investment company complex to the employment positions with such organizations that would have a direct role in the financial reporting process for the mutual fund, consistent with Congress's intent as expressed in the Act.
B. Services Outside The Scope Of The Practice Of Auditors
Section 201 of the Act sets forth a list of eight non-audit services that a public accounting firm is prohibited from providing to an issuer contemporaneously with an audit: (1) bookkeeping; (2) financial information systems design and implementation; (3) appraisal or valuation services, fairness opinions, or contribution-in-kind reports; (4) actuarial services; (5) internal audit outsourcing services; (6) management functions or human resources; (7) broker-dealer, investment adviser, or investment banking services; and (8) legal services and expert services unrelated to the audit. The eight prohibited activities closely follow those set forth by the Commission in its final 2000 independence rulemaking. 49
As explained above in our general comments section, in legislating against the backdrop of the Commission's 2000 rule, Congress demonstrated its intent to codify the current auditor independence rules with respect to prohibited non-audit services contained in § 201 of the Act. Indeed, Congress tracked the scope of service section from the Commission's 2000 rule and even listed the prohibited services in the same order as they appear in the 2000 rule. Moreover, by codifying the Commission's list of non-audit services set forth in the 2000 rulemaking, without providing its own set of definitions, Congress demonstrated its intent to incorporate the defined terms of the Commission's rule. Accordingly, one should look to existing practices under the 2000 rule to determine those non-audit services that Congress intended to prohibit.
The Release's preamble suggests, however, that the "three principles" may be applied to prohibit a broader set of services:
Whether the provision of a non-audit service not specified in the proposed rule impairs an accountant's independence will be measured against the four general principles set forth in the preliminary note to Rule 2-01 and the [three] "simple principles" in the legislative history noted above. 50
Congress clearly did not intend for a broad application of the three principles to prohibit services beyond the eight services specifically prohibited in the Act. The Senate Report to the Act states:
The intention of this provision is to draw a clear line around a limited list of non-audit services that accounting firms may not provide to public company audit clients because their doing so creates a fundamental conflict of interest for the accounting firms. 51
The purpose of a limited list is to establish clarity. Application of the general principles to permitted services, by contrast, will create uncertainty and may lead to an effective prohibition on such services, even where independence is not impaired. Audit committee members will face a dilemma when determining whether to permit such services. Requiring audit committees broadly to apply the three principles will bring paralyzing uncertainty to the audit committee pre-approval process and potentially could expose audit committee members to liability. Moreover, Congress did not intend for audit committees "to make a particular finding in order to pre-approve an activity. The members of the audit committee shall vote consistent with the standards they determine to be appropriate in light of their fiduciary responsibilities and such other considerations they deem to be relevant." 52 Accordingly, rather than prohibiting services outside of those identified explicitly in the Act, we believe that the three principles should be applied to assist in the identification of services that may fall within one of the identified prohibited services.
Although we share the Commission's objective of ensuring auditor independence, the Release's proposed construction of the prohibited group of non-audit services listed in § 201 is unnecessary to achieve that objective and goes beyond the parameters of the 2000 rulemaking, and thus the Act. Specifically, the Release's statement that the Act requires it to abandon "exceptions and exemptions" contained in its 2000 scope of services rule is unjustified and has no basis in the statutory text or the legislative history.
Furthermore, the Release's formulations of definitions for prohibited non-audit services conflict with the Commission's own recent policy judgments. As we noted above, the Release acknowledges that the final 2000 rule, including its exceptions and exemptions, was the product of an extended rulemaking in which "over 100 persons testified, a congressional hearing was held, and over 3,000 comment letters were received." 53 In addition, the Commission's careful regulatory and policy conclusions as reflected in the 2000 rule have not yet been given sufficient time to work or be evaluated. Indeed, wholly apart from the conclusive evidence of congressional intent set forth above, it would be remarkable for the Commission to use a 30-day comment period and 13-day consideration period to abandon the established rule that was the product of 75 days of comment and nearly 60 days of consideration.
In light of these considerations, we believe it is clear that the Commission should construe the non-audit services listed in § 201 of the Act consistently with the Commission's guidance in its 2000 rulemaking. If, however, the Commission decides to go beyond the Act and further limit the services provided by auditors, we have several recommendations regarding the limits on non-audit services proposed in the scope of services section of the Release.
For example, the Commission proposes a "reasonably likely to be audited" standard in several instances to determine whether certain services would impair an auditor's independence. We believe that this is a useful standard, and we support the Commission's inclusion of this standard in the proposed rule regarding bookkeeping, valuation, and actuarial services. In addition to these services, however, the Act's legislative history also supports application of the "reasonably likely" standard to permit auditors to perform "financial information systems design and implementation" and "internal audit outsourcing" services when it is not "reasonably likely" that the work will be reviewed as part of the audit. 54 We therefore believe that the Commission should reflect that congressional intent in its final rule by including the "reasonably likely to be audited" standard for these two non-audit services as well.
In addition, we recognize that in the past the Commission has effectively addressed instances involving inadvertent or de minimis potential independence violations. Although we adhere to rigorous independence standards and devote substantial resources, training, oversight, and review procedures to ensure continued adherence to independence standards, we support the inclusion of these types of important protections that encourage identifying and promptly curing any potential innocent violations. Accordingly, we believe that the Commission's final rule should preserve existing mechanisms to address potential inadvertent or de minimis independence violations. 55
Our additional concerns and recommendations with respect to the specific non-audit services are described in the remainder of this section.
Current independence rules provide that an accountant is not independent if bookkeeping services are provided to the audit client, except in limited circumstances such as in emergency situations or where the services are provided in a foreign jurisdiction and certain conditions are met. 56 The proposed rule would eliminate the exceptions and prohibit bookkeeping services where it is "reasonably likely" that the results of these services will be subject to audit procedures during the course of an audit. 57 The Commission's proposed "reasonably likely" standard for determining whether bookkeeping and like services would impair independence is appropriate and should be adopted in the final rule.
We also believe that it would be consistent with the intention of Congress and the Commission's objectives to preserve the limited exceptions that were specifically identified in the 2000 rule, as discussed above. Indeed, the provision of bookkeeping services to immaterial subsidiaries or parent or sister companies of an audit client is not "reasonably likely" to be subjected to audit procedures during the course of the audit. Additionally, in the increasingly global marketplace, with the presence of sprawling multinational companies, the risk of providing insignificant bookkeeping services unwittingly to an immaterial subsidiary or acquired affiliate of an audit client is high. Therefore, at a minimum, an exception for inadvertent and insignificant occurrences of this sort should be included in the final rule. Also, in the event of an inadvertent and insignificant violation of the bookkeeping prohibition, the auditor should be given the opportunity to cure the violation, including through a "cleansing audit" performed by another auditor.
Is the standard of reasonably likely sufficiently clear? If not, should we use some other standard? If so, what standard should we use? (67 Fed. Reg. at 76785)
As noted above, the Commission's proposed "reasonably likely" to be audited standard is appropriate and sufficiently clear, and will prove to be an understandable standard in practice.
2. Financial Information Systems Design and Implementation
The Commission's proposed rule would prohibit an accountant from providing financial information systems design and implementation services to an audit client under two circumstances: (1) where the accountant directly or indirectly operates or supervises the operation of the audit client's information system or manages the audit client's local area network; or (2) where the accountant designs or implements a hardware or software system that aggregates source data underlying the financial statements or generates information that is significant to the audit client's financial statements taken as a whole. 58 Consistent with the existing independence rules, the Commission's proposal does not preclude an accountant from working on hardware or software systems that are unrelated to the audit client's financial statements. As stated previously, the "reasonably likely" to be audited standard should be applied to financial information systems design and implementation services, and is consistent with prior independence interpretations embraced by the Commission.
When the Independence Standards Board ("ISB") terminated its operations in July 2001, the Commission issued a statement confirming that it would continue to recognize ISB interpretations and guidance. In this context, the Commission should clarify that ISB Interpretation 99-1 (March 12, 1999) continues to be viable guidance for purposes of assessing whether certain advisory services relating to an audit client's financial systems used to account for derivatives will impair independence. 59 For example, ISB Interpretation 99-1 states that an "auditor may provide consulting services on the proper application of FAS 133, including assisting a client in gaining a general understanding of the methods, models, assumptions, and inputs used in computing a derivative's value," and that an auditor may "provide guidance or assist management in developing and adapting systems to account for derivative instruments and hedged items under [FAS 133]." 60
The Commission should clarify that accounting firms can continue to rely on ISB Interpretation 99-1 and, therefore, can continue to license and implement software products that simply provide an audit client the tools with which to perform certain mechanical calculations for FAS 133 or other purposes where management is responsible for reviewing the software's output (e.g., FAS 109 and tax compliance software).
3. Appraisal or Valuation Services, Fairness Opinions, or Contribution-in-Kind Reports
Current independence rules, with some exceptions, provide that an accountant is not independent if he or she provides appraisal or valuation services or any service involving a fairness opinion. In the 2000 rulemaking, the Commission expressly provided certain exceptions to the prohibition on appraisal and valuation services, including the determination that appraisal and valuation services for tax planning strategy or tax compliance can be provided without impairing independence. 61 There is no new evidence, research, or congressional finding that would serve as support for the Commission now to eliminate those limited exceptions to the prohibition on appraisal and valuation services that were carved out as part of the 2000 rulemaking.
We support the Commission's proposed "reasonably likely" standard for determining whether appraisal or valuation services, fairness opinions, or contribution-in-kind reports would impair independence. We believe that standard is appropriate and should be adopted in the final rule.
Does providing valuation or appraisal services for tax purposes impair an accountant's independence? (67 Fed. Reg. at 76786)
The 2000 auditor independence rules regarding appraisal and valuation services contain an exemption for tax purposes. Specifically, the rules permit the performance of tax services and appraisal and valuation services that are part of tax planning strategy or for tax compliance purposes. In its discussion of those final rules, the Commission stated:
As the rule text and this Release make clear, accountants will continue to be able to provide tax services to audit clients. A few commenters pointed out, however, that unless accountants can perform appraisal and valuation services that are part of a tax planning strategy or for tax compliance purposes, the client would not hire the accountant to provide tax services. The final rule makes clear that accountants can perform appraisal and valuation services for those purposes without impairing independence. 62
The proposed rule would erase the exception for the performance of appraisal or valuation services for tax purposes. There is no reason for the Commission now to abandon that tax services exception. As discussed above, Congress intended to codify the Commission's existing rules in the Act, including those exemptions for tax services provided in the context of appraisal or valuation services.
Moreover, the Release states that "[n]othing in these proposed rules is intended to prohibit an accounting firm from providing tax services to its audit clients when those services have been pre-approved by the client's audit committee." 63 This language tracks closely the language used by the Commission in the 2000 final rulemaking, making clear that tax services are permissible, even when such services may appear to fall within a prohibited non-audit service. 64 Accordingly, the Commission should confirm that tax services are permitted when they are performed in connection with appraisal and valuation services.
4. Actuarial Services
The proposed rule would needlessly broaden the scope of prohibited "actuarial services." 65 In 2000, the Commission's rule permitted audit firms to provide five categories of actuarial services because they do not impair auditor independence. As discussed above, Congress intended to preserve the 2000 rule, including the permissible categories of actuarial services.
The performance of currently-permitted actuarial services should not be prohibited. Under current law, the Commission allows actuaries to "value an audit client's pension, other post-employment benefit, or similar liabilities, provided that the audit client has determined and taken responsibility for all significant assumptions and data." 66 For example, actuaries are currently allowed to assist management in preparing calculations for FAS 87 and FAS 106, and the Commission should not alter that existing practice. The Commission also explained in the 2000 final release:
Another exception allows accountants to continue to value an audit client's pension, other post-employment benefit, or similar liabilities, so long as the audit client has determined and taken responsibility for all significant assumptions and data underlying the valuation. Accountants historically have provided pension assistance to their audit clients, and if appropriate persons at the audit client determine the underlying assumptions and data, we believe that independence is not impaired. 67
Indeed, when actuaries prepare calculations for FAS 87 and FAS 106, the actuary has no discretion with respect to the assumptions chosen by the client and, because the actuarial methodologies are prescribed (based on given assumptions) in this context, the actuary is only applying specified computations. Because the client, not the actuary, makes the critical discretionary decisions, the auditor is not auditing the work of the actuary, but rather considering management's decisions, as the auditor does in other areas. Again, these services that the Commission has previously determined not to impair independence should remain permissible.
The Commission also should clarify that the provision of actuarial advisory services, including those advisory services related to the assumptions, methodologies, and processes used by management to present the items in the financial reports, would not impair independence. In addition, the provision of many actuarial services would not run afoul of the Commission's "reasonably likely" to be audited standard, and should thus be permitted, including: (1) providing actuarial due diligence, including the identification of potential areas of risk, in a business acquisition; (2) assisting management with a profitability analysis of their current business; and (3) providing statutory actuarial opinions that opine on the reasonableness of the policy reserves recorded by management.
5. Internal Audit Outsourcing
Currently, auditors may perform up to 40% of an audit client's internal audit work if the audit client has $200 million or more in assets. The accounting profession recognizes that the proposed rule would reduce that 40% allowance to zero - the external audit firm will no longer be able to provide internal audit outsourcing services to an audit client. But it remains unclear what non-audit services that have characteristics similar to internal audit outsourcing services will be considered permissible.
Proposed Rule 2-01(c)(4)(v) contains a blanket prohibition that an auditor is not independent when he or she performs for an audit client "[a]ny internal audit services related to internal accounting controls, financial systems or financial statements." 68 This language is extremely vague and does not clearly proscribe only "internal audit outsourcing services," which the plain language of the Act demonstrates Congress intended. The Commission therefore should clarify in its final rule that this prohibition applies to "internal audit outsourcing services" rather than "any internal audit services." Additionally, we believe that the Commission should clearly define what is meant by "internal audit outsourcing services." Without such clarification, audit committees, issuers, and auditors will lack essential guidance to fulfill their responsibilities with respect to this provision.
The final rule also should clearly state that the independence of an audit firm would not be impaired if an engagement, regardless of purpose and scope, is performed in accordance with U.S. GAAS or the attestation standards established by the American Institute of Certified Public Accountants. The final rule should provide guidance as to what may happen in situations where there is more than one "nonrecurring evaluation" performed by the auditor, or at what point the provision of such services becomes tantamount to the outsourcing of the internal audit function. The final rule also should clarify that "nonrecurring evaluations" may include evaluations and recommendations regarding the audit client's internal control systems. Moreover, the final rule should contain guidance with respect to the "operational audit" exception to ensure that this concept is understood by issuers, audit committees, and audit firms, which, in turn, will ensure the efficient and cost effective performance of permissible services by auditors to both small and large clients. In addition, as discussed above, the final rule should adopt the "reasonably likely" to be audited standard to permit accounting firms to perform internal audit services that do not impair independence.
An orderly transition to the new requirements regarding internal audit outsourcing services also is imperative. Moving from allowing audit firms to provide up to 40% of the total hours expended on the audit client's internal audit activities to zero is a significant change that must be managed appropriately. Accordingly, we propose that the effective date be 90 days after the final rule is published in the Federal Register. Existing contracts should also be grandfathered so long as the terms are not materially modified or extended after the final rule is published in the Federal Register and such existing contracts comply with existing independence rules. We also propose that multi-year engagements should cease within 18 months of the effective date of the final rule to allow issuers time to identify new vendors and limit disruption to issuer operations. This will allow companies to plan for the impact that this elimination of services may have on their internal audit function in order to manage the many significant changes that will result.
6. Management Functions
The Commission states that it is not "proposing any significant change" to the current auditor independence rules regarding management functions adopted in 2000. 69 The Commission's position that follows in the Release, however, undermines that statement. Specifically, the Release states:
[W]e believe that design and implementation of internal accounting and risk management controls are fundamentally different from obtaining an understanding of the controls and testing the operation of the controls which is an integral part of any audit of the financial statements of a company. . . . Because of this fundamental difference, we believe that designing and implementing accounting and risk management controls impairs the auditor's independence because it places the auditor in the role of management. Conversely, obtaining an understanding of, assessing effectiveness of, and recommending improvements to the internal accounting and risk management controls is fundamental to the audit process and does not impair the auditor's independence. 70
That statement also appears to conflict with the statement in the release accompanying the 2000 rule, that the "rule expressly does not limit services in connection with the assessment, design, and implementation of internal accounting and risk management controls, provided that the auditor does not act as an employee or perform management functions." 71
The intentions of the Commission with respect to assessment, design, and implementation thus are not clear. For example, does the Commission propose a change to the permissibility of these services from 2000, to eliminate the ability to design and implement internal accounting and risk management controls even in situations when management is responsible for the engagement and makes all decisions in that regard?
The term "management functions" is defined as "[a]cting, temporarily or permanently, as a director, officer, or employee of an audit client, or performing any decision-making, supervisory, or ongoing monitoring function for the audit client." 72 We believe the auditor's independence is not impaired in performing services in connection with the assessment, design, and implementation of internal accounting and risk management controls as long as the following three overriding principles are satisfied:
- management actively participates in planning the engagement;
- management maintains meaningful and substantive involvement in the engagement, including making all management decisions; and
- management takes responsibility for the results of the engagement.
We thus recommend that the Commission affirm in the final rule that services related to the assessment, design, and implementation of internal controls do not impair independence, provided that the auditor does not act as an employee or perform management functions. The Commission should clarify that internal controls, as described by Committee of Sponsoring Organizations of the Treadway Commission ("COSO"), include control objectives relating to financial reporting; efficiency and effectiveness of operations; and compliance with applicable laws and regulations. Under the COSO framework controls within the control objectives are not mutually exclusive (e.g., controls over purchasing would be encompassed in both financial reporting controls and controls over the effectiveness and efficiency of operations, and in certain circumstances may also be a control regarding compliance with laws and regulations). While managements' responsibilities for monitoring such controls are clear, the Commission should seek to reduce any confusion on the part of audit committees as to the ability of the auditor to assist issuers in documenting controls and assessing effectiveness of controls.
If the above clarification is made, the final rule will be clear and workable. However, if the Commission maintains the current text of the proposed rule several issues will arise:
First, the difference between "recommending improvements" and "designing/implementing" controls is not clear. Issuers, audit committees, and auditors will have to determine the point at which "recommending improvements" becomes "designing" the internal accounting and risk management controls. If the client seeks to engage its accounting firm separately to provide assistance related to internal control matters, including recommendations on the controls outside of the external audit or attestation engagement, we believe that the firm should be allowed, in fact encouraged, to do so, so long as it is clear that management actively participates in planning the engagement, the client maintains meaningful and substantive involvement in the engagement, and management takes responsibility for the results of the engagement.
Additionally, an essential element of the external audit is an auditor's ability to advise an audit client with regard to internal controls. Auditors, so long as they are not performing management functions, should be permitted to provide such advice to assist management in implementing any recommendations. To limit the ability of the external auditor to provide such services would prevent issuers from receiving vital advice and assistance from those who can provide the most expertise with respect to internal controls. With the new requirements for management and auditors to report on internal controls, it will be particularly important on a going-forward basis that audit clients are able to rely on their accounting firms' expertise and assistance in developing and implementing internal control systems.
Second, the proposed rule appears to suggest that only those recommendations that are made as a result of the external audit or attestation process would not impair independence. The proposed rule does not take into account the possibility that the accountant may be hired in a separate engagement to make recommendations involving the client's internal accounting and risk management controls. As a result, the ability to provide services specifically designed to assist management in complying with the control requirements of the Act may be undercut. In connection with helping our clients meet the new internal control requirements for example, we perform the following types of services, among others:
- advising the company about the selection of the appropriate internal control framework by which the achievement of control objectives will be measured;
- providing training and education regarding the selected framework;
- assisting the company with the development and documentation of its control objectives;
- assisting the company with workshops, surveys, and interviews with process owners and subject matter specialists to understand and document the company's existing business processes, associated risks, and controls; and
- assisting the company in designing its initial assessment of control effectiveness and providing recommendations on ways that management may address control weaknesses and assisting the company with the development and implementation of an automated repository of control documentation.
Based on the language in the proposed rule, the above types of services may be interpreted as "design and implementation" services, and thus would be prohibited under the proposed rule. It is not in the public interest to limit the ability of auditors to assist issuers in the internal control arena. The suggestion that these design and implementation services will no longer be permissible is of particular concern in light of the increased importance that has been placed on issuers' internal controls in both the Act and other Commission-proposed rulemakings. Rather than prohibiting these services, the Commission should be encouraging issuers to seek as much assistance as possible from auditors in designing and implementing their internal control systems. This will help ensure that issuers comply with the expansive new requirements.
Accordingly, we recommend that the Commission affirm in the final rule that services in connection with the assessment, design, and implementation of internal accounting and risk management controls do not impair independence as long as appropriate safeguards are in place.
7. Human Resources
The Release states that it does not "propose any significant change" to the auditor independence rules regarding human resource services adopted in 2000. 73 We believe this is the appropriate approach and that certain types of human resource consulting services that are currently permissible, should continue to be permitted services.
However, we also believe that the statement in the Release that "[u]nder the proposed rule, an auditor's independence also is impaired when the auditor advises an audit client about the design of its management or organizational structure," 74 is contrary to the stated intention of the Commission and, as such, should be omitted or revised significantly in any discussion accompanying the final rule. Providing data, benchmarking, analysis of various organizational structures, and alternatives are appropriate advisory services. "Management" of human resources issues requires making and imposing decisions, which admittedly is not compatible with auditor independence. Equating advisory services with management functions creates ambiguity and confusion that will make compliance with the final rule more difficult.
Does it impair an auditor's independence if the auditor provides consultation with respect to the compensation arrangements of the company's executives? (67 Fed. Reg. at 76788)
The above question from the Release suggests that the Commission may be considering a potential ban on the ability of auditors to provide services with respect to executive compensation. This would be a significant change from the current rules. Auditors currently are not banned from advising an audit client with respect to various compensation arrangement options.
An auditor's independence should not be deemed compromised when it reviews with management the options regarding compensation arrangements for the company's executives. Contrary to the Release's suggestion, consultation regarding executive compensation is not a management function. 75 If an auditor generally consults on the various compensation packages, any of which is subject to the approval of management, the auditor is not functioning as management. For example, the auditor could provide management with a range of options to determine benchmarking, including third-party benchmarking, from which management could then choose. Management, and not the auditor, would be the decisionmaker. Accordingly, consistent with the 2000 rule, auditors should continue to be permitted to review various executive compensation options with audit clients.
In addition, the final rule and/or accompanying guidance to the final rule should clarify that auditors are permitted to provide tax services relating to compensation and compensation arrangements, including compensation of management. The provision of tax services in relation to compensation packages, like other tax services that the Act and the Release specifically state are not prohibited services, does not implicate auditor independence concerns. 76
8. Broker-Dealer, Investment Adviser Or Investment Banking Services
The Release indicates that no substantial change to the existing rule guidance regarding broker-dealer, investment adviser, or investment banking services is intended. 77 Accordingly, the Commission should also reaffirm previous Commission guidance, including guidance in the 2000 rule and subsequent interpretations, relating to the provision of broker-dealer, investment adviser, or investment banking services.
The Commission in 2000 recognized that certain services that could be deemed to be "investment adviser" services do not impair independence and should not be prohibited. The Commission also determined in 2000, and should now reaffirm, that an affiliated registered investment adviser of an accounting firm should be permitted to provide investment advisory services. 78 Moreover, in response to concerns that the proposed rule would have "preclud[ed] accountants from providing . . . personal financial planning services," the Commission in 2000 made it clear that certain investment advisory services would not be deemed to impair an auditor's independence. The Commission stated that accountants
can recommend the allocation of funds that an audit client should invest in various asset classes, based on the client's risk tolerance and other factors; provide a comparative analysis of the client's investments to third-party benchmarks; review the manner in which the audit client's portfolio is being managed by investment account managers; and transmit a client's investment selection to a broker-dealer, provided that the client has made the investment decision and has authorized the broker-dealer to execute the transaction. 79
When auditors act as "investment advisers" in such contexts, the Commission found after deliberation that they did not violate the four principles set forth in the preliminary note to Rule 2-01. There is no reason for the Commission now to depart from that earlier conclusion.
The Commission also should reaffirm its conclusion from the 2000 final rule that certain corporate finance consulting services do not impair independence.
9. Legal Services
The proposed rule includes a formulation for the definition of "legal services" that was expressly considered and rejected in the final 2000 rule. The proposed rule would forbid auditors from providing any service to an audit client or an affiliate of an audit client that, in the jurisdiction in which it is provided, could only be provided by someone licensed to practice law. 80 The proposed rule would lead to confusion and a lack of uniformity because it would be based on the laws of innumerable local jurisdictions rather than a U.S. law or international standard. The Commission should avoid such confusion by adopting a uniform definition of legal services as exists in the 2000 rule.
If the proposed rule is adopted as currently drafted, it will be more difficult for registered public accounting firms to serve their clients in an increasingly global marketplace and to compete with foreign firms that are allowed to offer multidisciplinary services. Perhaps for that reason, the Commission two years ago defined "legal services" in an unambiguous manner as those services that require one to be admitted to practice before U.S. courts. The final rule should keep the definition of "legal services" adopted in the 2000 rulemaking. Not only did Congress intend to codify existing prohibitions on non-audit services in the Act, and expressly reject the 2000 proposal, but the definition adopted in 2000 is a better definition than the one currently proposed because it avoids difficulties inherent in the reconciliation of foreign laws.
Should there be any exception for legal services provided in foreign jurisdictions? For example, in some countries only a law firm may provide tax services. Should a foreign accounting firm be permitted to provide, through an affiliated law firm, tax or other services that a U.S. accounting firm could provide to a U.S. audit client without impairing the firm's independence? Why or why not? (67 Fed. Reg. at 76789)
The Act and proposed rule contemplate a system where tax/audit specialist services are provided by the accounting firm performing the audit, as is the practice in the United States. However, in countries such as France and Spain, among others, the provision of tax services is considered to be a subset of the legal profession. Accordingly, the provision of tax services in each of those jurisdictions is considered a "legal service." The proposed rule would therefore prohibit an auditor from providing tax services in those jurisdictions, even though it would paradoxically be permissible for an accounting firm to provide such services in the United States. Consequently, the final rule should clarify that it is permissible for the foreign associated firm to provide tax or other services through a foreign associated law firm to an audit client anywhere in the world to the same extent that such services are provided in the United States.
10. Expert Services
The Act prohibits "expert services." "Expert services," although considered by the Commission during its 2000 auditor independence rulemaking, were not included among the prohibited non-audit services contained in the final 2000 rule. Nonetheless, the Commission's 2000 rule does provide some useful guidance with respect to the definition of the term "expert services." Specifically, the Commission's guidance outlines specific services that could be deemed to be "expert services," but that should not be prohibited. Because any of the services that auditors provide can be labeled as "expert services," it is important that the final rule clearly and narrowly define what are considered to be prohibited "expert services."
The Release states that an accountant's independence is impaired if the accountant provides an audit client with expert opinions in connection with legal, administrative or regulatory proceedings, or acts as an advocate for the audit client in such proceedings. 81 Indeed, the legislative history of the Act as it relates to expert services is focused on whether the auditor serves as an advocate of the audit client when performing such services. Advocacy may be perceived by the public and investors to impair the auditor's independence. Because advocacy is a perception issue, we believe that for purposes of the rule, "advocacy" should equate to advocacy in a public forum, such as a court of law.
The definition of "expert services," as contained in the proposed rule, is ambiguous because it does not clearly establish which services will be prohibited. The definition is also problematic because it does not explicitly exempt certain services that clearly do not constitute "advocacy" and/or compromise auditor independence. We believe that, given the "appearance" concern, focusing on whether advocacy is provided in a public forum should be the guiding principle as to whether such advocacy impairs an auditor's independence. Also, as discussed below, several of the services listed as "expert services" in the Release do not constitute advocacy and should not be prohibited, such as acting as a fact witness.
Are there circumstances in which providing audit clients with expert serves in legal, administrative, or regulatory filings or proceedings should not be deemed to impair independence? (67 Fed. Reg. at 76790)
There are many circumstances in which "expert services" can be performed by auditors without impairing independence.
First, any ban on the performance of "expert services" should not include any prohibitions on the provision of tax services. The Commission concluded at the time it issued its 2000 final rule that "accountants may need to act as experts in defending work they have done for audit clients before such bodies as the Internal Revenue Service, and indeed, this Commission." 82 This statement, along with the Release's position that tax services should not be banned, means that any ban on "expert services" should not translate into a ban on tax services, including, but not limited to, representing a client in Internal Revenue Service examinations and administrative appeals, as well as drafting technical advice memoranda and private letter ruling requests. 83
Second, there are other situations in the legal, administrative, and regulatory contexts where non-audit services should not be classified as prohibited "expert services." As the above quotation suggests, where auditors are required to defend their work before administrative, regulatory, or legislative bodies both including and beyond the Commission, or are ordered to do so by a court, they should not be deemed to be providing "expert services" that compromise independence. For example, an auditor could be subpoenaed to testify in court by a non-client third party regarding an audit client, which logically should not result in the impairment of that auditor's independence. In other words, any time an auditor is required to provide services or act as a witness before an administrative or regulatory body or court, that appearance as a witness should not be deemed to defeat the auditor's independence.
Also, a client's filing for protection under the Federal Bankruptcy Code is a legal proceeding. We do not believe that the Commission intends to suggest that being retained to provide otherwise permissible non-audit services to bankrupt debtor clients would impair the independence of the auditor. Clarification on this point would be very useful.
Additionally, auditors often need to consult with members of the Commission staff on behalf of their clients. It should not be the intention of the Commission to prevent auditors from speaking with Commission staff members on such occasions, where the motivation is for the issuer to comply with the Commission's rules and regulations, even though auditors in the course of these discussions may urge or defend certain conclusions or analyses.
Third, and finally, the Release also states that consultation and other services provided to a client's legal counsel in connection with litigation should be prohibited. 84 With regard to situations in which we provide litigation support services, however, the characterization of our role as an advocate is not correct. The Release states as follows:
Our prohibition on the provision of expert services would include providing consultation and other services to an audit client's legal counsel in connection with litigation, administrative or regulatory proceedings. . . . [I]n the context of the provision of legal services, legal counsel have an ethical duty to "represent a client zealously and diligently within the bounds of the law" and "take whatever lawful and ethical measures are required to vindicate a client's cause or endeavor." An auditor who takes on such duties, either directly or by being
engaged by the audit client's legal counsel, takes on a role as an advocate for the client. 85
When we provide litigation services, however, we believe that our role does not constitute advocacy. As an initial matter, auditors' provision of litigation services is significantly different from that of the attorneys who represent our audit clients and who are required to become their "advocate." This position is supported by AICPA Consulting Services Special Report 93-2, Conflicts of Interest in Litigation Services Engagements:
.23 In effect, the requirement for objectivity and integrity for a CPA cannot readily be equated with the undivided loyalty to a client required of a lawyer. Accordingly, many relationships that would result in a conflict of interest for a lawyer may not result in a conflict for the CPA expert.
The proposed rule's contrary presumption - that based on legal counsel's ethical obligation to
"represent a client zealously and diligently within the bounds of the law," accountants similarly serve as advocates - is mistaken.
The Commission presumes that in every instance counsel is asking the accountant or consultant it engages to advocate the client's position. As it is counsel's job to represent his or her client, many engagements through counsel that involve legal, administrative, or regulatory proceedings do not involve the accountant in the role of an advocate for the client. In many cases, the accountant's or consultant's job is to find facts or provide advice.
These engagements may be forensic or remedial in nature, or both. In a purely forensic engagement, the accountant is engaged to find facts, whether those facts strengthen or weaken the client's case. Thus, we do not believe that a pure forensic assignment involves acting as an advocate. It assists counsel's defense by providing counsel with information regarding the client's potential wrongdoing. Armed with the facts, it is then the counsel's job to advocate for his or her client.
Remedial engagements involve determining the cause of what happened and recommending improvements in processes and procedures to make it less likely that the problem will recur. Remedial engagements are frequently done through counsel at the request of the client. In these engagements, the accountant's role is not to advocate but rather to recommend improvements. As previously expressed by the Commission, remedial actions by registrants to address regulatory problems should be promoted and not impeded by the Commission. 86
Many remedial, and some forensic, engagements involve the appointment of an independent consultant as the result of a court order or otherwise. Sometimes the accountant is engaged by a law firm that was appointed as the independent consultant. Other times, the accountant is selected as the independent consultant, but is again formally engaged by outside counsel to preserve the attorney-client privilege. Although these engagements involve counsel, neither counsel nor the accountant acts as an advocate for the client. By definition, the independent consultant must be independent.
In sum, contrary to the Release's statement that consultation and other services provided to a client's legal counsel in connection with litigation should be broadly prohibited, 87 it is possible for an auditor to consult in such circumstances without compromising or appearing to compromise independence. Lawyers often need to consult with a company's auditor to prepare a proper defense in securities actions. To limit an auditor's cooperation with an audit client's lawyers because of ill-defined independence concerns would harm the ability of companies to defend themselves effectively.
Based on the above, we recommend that the final rule clarify that only an auditor's advocacy in a public forum is prohibited, with the exception that appearances as a fact witness would be permissible. Our recommended approach is consistent with the rule proposed by the Commission with respect to services provided to the audit committee, even if engaged by the audit committee's legal counsel. It states that "the auditor's independence would not be impaired if it were assisting the audit committee in fulfilling its responsibility to conduct its own investigation of a potential accounting impropriety, so long as the auditor did not take on the role of an advocate in such an investigation." 88 We believe that the Commission should adopt this approach for all engagements involving legal, administrative, or regulatory actions where counsel is involved.
Should an auditor be permitted to serve as a non-testifying expert for an audit client in connection with a proceeding? (67 Fed. Reg. at 76790)
Consultation with the client, the client's attorney, or others in a non-testifying role should not be limited. Clients and their attorneys must be able to seek expert advice on accounting or audit matters from their audit firm; to suggest otherwise is contrary to the responsibilities of the accounting profession. Accounting professionals are valued by their clients as expert advisers. As long as these experts are consulting with and assisting clients without serving as advocates in a public forum, these services do not impair the appearance of auditor independence and should not be prohibited.
Auditors are often required to act as non-testifying experts in litigation so that the lawyers may gain an understanding of underlying facts and accounting principles applicable in a particular case. In such situations, professional standards require an auditor to maintain objectivity. As discussed above, the auditor's role may be solely fact-based, which, under any definition, should not constitute advocacy. Also, to the degree that an auditor serves as a non-testifying rather than a testifying expert, there will be no appearance that the auditor is acting as an advocate. Requiring a different accountant to provide consultative services to a lawyer in connection with a proceeding would often be inefficient and would increase costs for issuers, including smaller clients, which would need to spend resources to educate new accountants.
C. Tax Services
The provision of "tax services" by audit firms has never been considered an independence issue. Tax services were not prohibited under the 2000 rulemaking, and Congress affirmed that policy in the Act. Indeed, the Act itself specifically allows an audit firm to provide tax services to its public clients. The Act states that a registered public accounting firm "may engage in any non-audit service, including tax services," that is not expressly prohibited, so long as that service is pre-approved by the audit committee. 89
The Release similarly acknowledges that because tax services are "unique," auditor independence is not impaired by the traditional provision of tax services. 90 Tax services are unique because there are "detailed tax laws that must be consistently applied" and "because the Internal Revenue Service has discretion to audit any tax return." 91 The Act's legislative history reinforces that point. 92 Representative Michael Oxley - one of the Act's chief sponsors - recently confirmed that Congress did not intend for the Act to restrict accounting firms from providing tax services to audit clients. Representative Oxley stated "that tax issues were part and parcel of the traditional audit function," and that "[t]here was no evidence in [Congress's] hearings that indicated that the tax function was untoward or somehow led to fraud." 93
The Release states that "[n]othing in these proposed rules is intended to prohibit an accounting firm from providing tax services to its audit clients when those services have been pre-approved by the client's audit committee." 94 The Release further acknowledges that "the Congressional intent behind . . . `tax services' would appear to be that auditor independence is not impaired by an accountant providing traditional tax preparation services to an audit client or an affiliate of an audit client." 95
Despite the clear intent of Congress and the Commission to permit accounting firms to provide pre-approved tax services, the Release seemingly undermines that intention and introduces uncertainty with respect to tax services by suggesting that audit committees and accounting firms consider the three principles to determine whether the rendering of a particular tax service impairs independence. This proposed application of the three principles has already generated much confusion surrounding the impact of the proposed rule on tax services. 96
Whatever applicability the three principles may have generally, the three principles should not be interpreted to prohibit tax services in light of the statutory text granting a special status to tax services. The Commission must state in the final rule that tax services are deemed not to violate the three principles. Otherwise, audit committees will be faced with the dilemma of determining whether tax services, which Congress intended to permit, should nevertheless be prohibited through a literal interpretation of the three principles. If there are particular tax services that the Commission is concerned about, such services should be well-defined and explicitly prohibited in the final rule.
The Commission also states in the Release that auditor independence may be compromised where an auditor provides the "the formulation of tax strategies (e.g. tax shelters)." 97 We are concerned that this statement could be construed in a manner at odds with the Act's and the Release's clearly articulated position that the provision of tax services is permissible. The language in the proposed rule would put the audit committee in the difficult, if not impossible, position of determining what constitutes an allowable "traditional tax service" versus a prohibited "tax strategy." Therefore, the "formulation of tax strategies" language should be removed.
Similarly, the term "tax shelter" has no commonly understood definition and would confound audit committees. Despite their best and repeated efforts, both the Department of Treasury and Congress have been unsuccessful in developing a workable definition of the term "tax shelter" for tax administration purposes. In fact, Congress and the Department of Treasury have effectively abandoned their attempts to define "tax shelter" and now focus instead on disclosure and transparency. Whereas, the goal of tax administration is now transparency, the goal of the Commission is independence. Accordingly, reference to the tax system for a definition of "tax shelter" is inappropriate and in our view not good policy.
Given the damaging public attention that the Release has already received, the Commission must clearly and emphatically correct the misconceptions that have resulted from the Release to avoid further confusion. We do not believe it is necessary to include a nonexclusive list or definition of permitted tax services. However, if the Commission were to conclude that such a list is necessary, we would suggest the list reads as follows:
Examples of tax services include, but are not limited to, compliance; consultation; planning and implementation assistance with respect to taxes and similar items; assistance and representation in connection with tax audits and administrative proceedings and appeals before federal, state, local and non-U.S. taxing authorities; practice before state, local, and similar foreign administrative review boards; tax advice related to mergers, acquisitions, other business transactions, employee benefit plans, and compensation arrangements; requests for rulings and technical advice from taxing authorities; advice and assistance regarding trade and customs duties; advice and assistance on pending or proposed tax legislation; tax services related to economic development incentives; tax opinions; and valuation, appraisal or actuarial services that are a reasonable and necessary part of the performance of tax services. This list of tax services is intended to demonstrate the broad range of allowable tax services and in no way should be construed as all-inclusive nor should a service be considered impermissible solely as a result of its omission.
As noted by Congress, prohibiting the provision of some tax services to audit clients could lead to adverse consequences for the accounting profession. Such a ban could impose a serious limitation on the ability of tax professionals to provide the types of tax services that fall within their professional expertise and that they are qualified to provide. In the accounting firm setting, in particular, imposing that unnecessary limitation could hinder our ability to retain many of our most competent tax partners and professionals and could deter many of our brightest prospects from entering into a profession burdened with such restrictions. 98 Depriving tax professionals of some of the varied professional opportunities that they currently enjoy - and carry out without any risk to their or their firm's independence - could be an unfortunate consequence of a vague prohibition on tax services. Additionally, depriving an audit of the breadth and depth of tax expertise will risk significantly damaging the quality of audits as tax experts are better equipped to determine the appropriateness of clients' tax positions and exposures.
We request comment on whether providing tax opinions, including tax opinions for tax shelters, to an audit client or affiliate of an audit client under the circumstances described above would impair, or would appear to reasonable investors to impair, an auditor's independence? (67 Fed. Reg. at 76790)
We believe that tax opinions furnished for the client should not be prohibited. We provide daily tax advice to our clients in the form of oral discussions and written communications. In all of these communications, we are expressing our opinion on some aspect of the tax law. Accordingly, we believe the final release should specify that rendering of tax advice, including the expression of an opinion to the client on some aspect of the tax law, is not prohibited.
Moreover, we do not believe that there should be a prohibition on third party opinions. Third party opinions are commonplace in business transactions, including mergers, acquisitions, and other business restructurings. These opinions are typically not written for purposes of attracting third parties to enter into a particular transaction, nor are the authors of these documents generally viewed as an advocate of the client for whom the opinion is written.
Are there tax services that should be prohibited by the Commission's independence rules? (67 Fed. Reg. at 76790)
As a general matter, the Commission should not prohibit any bona fide tax service. By the phrase "bona fide tax service," we mean to underscore that we agree with the Commission that otherwise prohibited services cannot be transformed by improperly re-labeling them as tax services. 99 Congress has already conclusively determined that the provision of tax services does not threaten independence. Currently, audit firms are prohibited from representing an audit client before a tax court. This prohibition should be retained, but otherwise the final rule should not ban any tax services.
D. Partner Rotation
We fundamentally agree that an effective system of audit partner rotation is vital to maintain the objectivity needed to complete an effective and high-quality audit. Our firm's experience, culture, and policies have demonstrated the value of audit partner rotation. Effective audit partner rotation requirements strike an appropriate balance between continuity of experience and knowledge, and the benefits of a "fresh perspective." We believe that an appropriately designed and executed policy on partner rotation benefits issuers and the investing public. We applaud the Commission for its efforts to explore and seek public comment on issues posed by partner rotation, including aspects of rotation that were not specifically required by the Act. We view partner rotation as one of the areas that may lend itself to the Commission's consideration of rules that build on the specific requirements of the Act. We are in agreement with the Commission's objectives and many elements of the proposed rule. We observe that the challenge for the Commission is to develop a final rule that represents good regulatory policy, that can be reasonably implemented, and that serves the public interest in quality audits while permitting effective and orderly transition.
The ultimate goal of audit partner rotation, as mandated by § 203 of the Act, should be to improve the quality and effectiveness of public company audits. The impartiality of the external audit is a critical component of the function auditors perform for issuers, their investors, and their potential investors, and measures that militate against complacency and reinforce the external auditor's professional skepticism can protect that impartiality.
We begin with the plain language of the statutory text and the backdrop against which it was enacted. Pre-existing professional guidance provides that after the "partner-in-charge" of an issuer's audit has served in that role for a period of seven consecutive years, a new lead audit partner must be assigned, and the incumbent partner-in-charge cannot return to that position on the engagement for at least two years. 100 In the Act, Congress intended primarily to give the force of federal law to the AICPA's existing rotation rule, with two additional requirements: the shortening of the seven-year rotation period to five years, and the application of the rule to two clearly delineated categories of audit partners. 101 Section 203 specifically identifies "the lead (or coordinating) audit partner (having primary responsibility for the audit), or the audit partner responsible for reviewing the audit," as those subject to its rotation requirement. 102 The addition of review partner to the pre-existing AICPA rule represents Congress's determination to build upon the AICPA rule.
The legislative history of the Senate bill confirms that the Banking Committee understood § 203's five-year limit as applying only to time spent in the capacity of supervisor or reviewer. 103 The Committee's report explains that the Act's partner rotation requirement is meant to ensure that "no partner performs an audit of the same issuer as a lead partner or review partner for more than five consecutive years." 104 The report further states that the Act "requires a registered public accounting firm to rotate its lead partner and its review partner on audits so that neither role is performed by the same accountant for the same issuer for more than five consecutive years." 105
As Congress acknowledged, partner rotation must be set against other competing considerations, such as the expertise that comes from experience with a particular issuer or industry, and the high value that issuers place on informed competence and consistency. 106 In creating a statutory mandate for audit partner rotation, Congress undertook to balance these competing considerations, with the goal of preserving expertise and maintaining audit quality, while reinforcing independence.
We note the Commission's discussion states that "the proposed rules would go beyond the minimum specified by the Act." 107 We respectfully disagree with the Commission's apparent presumption that Congress intended to establish only a floor of minimal regulation and to leave entirely to the Commission the decision of how high to set the regulatory barrier.
Section 203 of the Act embodies Congress's decision to strike a balance between competing concerns. Both the scope and the duration of the rotation requirement imposed are crafted to ensure that partner rotation would be a meaningful aid to independence without imposing an unjustified burden. Congress chose to sharpen and strengthen the profession's existing rotation rules while resisting, pending further examination of the costs and benefits, the suggestion that it depart more dramatically from current practice. 108 Therefore, we recommend that the Commission respect the balance of burden and benefit that Congress struck in the Act.
To the extent that the Commission determines that it must go beyond the rotation requirements imposed by the Act in order to carry out Congress's intent, we urge the Commission to do so in a judicious and limited fashion, and to remain cognizant of the significant costs, in terms of both audit quality and out-of-pocket costs, that such departures from the Act's text would impose. For example, while we believe that a five-year moratorium may be appropriate for the lead audit partner (because as a practical matter it is unusual for a partner to return to the same lead partner role on a public company), we also believe that a five-year moratorium is not warranted with respect to review and other partners who have limited, or in some cases no, contact with management or the audit committee - in contrast to the frequent contact that lead partners typically have with such individuals.
Similarly, we believe that extending the rotation requirements to specialists (who are not serving in a lead partner role and are generally not involved in the setting of the audit scope) would not be necessary. Specialist partners provide critical services that are essential to audits, but that also are discrete, task-oriented and do not raise the potential independence concerns implicit in the lead audit partner position.
Further, if the Commission determines that it is necessary to go beyond the Act in some fashion, the rotation requirements could be applied to certain subsidiaries or sub-components of issuers. The Act's purposes may theoretically be furthered by applying the rotation principle to subsidiaries of issuers as well as to the issuers that the Act specifically mentions. We do not believe that basing the rotation requirement on the pre-existing significant-subsidiary regulation (as the proposed rule does) draws the best dividing line in those situations. 109 Instead, we would suggest an approach in which the Commission could apply rotation requirements to major subsidiaries of an issuer and, recognizing that extending rotation to subsidiaries is a departure from the Act's terms, limit the impact of that departure (i.e., allowing such partners to serve for a period up to ten years 110 with a two-year cooling off period). The Commission should consider whether the requirement to extend to sub-components of the issuer would be better based on a concept of a business unit or reporting segment if the external audit is staffed using a structure that charges an audit partner with responsibility for such a component and thereby lends itself to a carefully crafted rotation regime. We acknowledge that clear definitions for such an approach may be difficult to achieve. If clarity of such a requirement is not achievable, we prefer limiting the rotation requirement to a major subsidiary approach.
In summary, we recommend the following with regard to auditor rotation:
- Require rotation for the lead audit partner and concurring review partner. If the Commission determines to go beyond the Act with regard to auditor rotation requirements, consider applying the rotation requirements to audit partners for truly major subsidiaries (as defined below), or alternatively, to business units, provided a clear definition can be developed.
- Adopt a tiered approach for the time-out period (i.e., five years for the lead audit partner and two years for other partners subject to the requirements).
- Allow the incoming lead audit partner a one year phase-in/training period that does not count against his or her rotation period.
- Permit an orderly transition by applying the rotation requirements to audit services for lead audit partners in calendar year 2004.
- Give special consideration to the unique implications of partner rotation for foreign issuers and subsidiaries.
* * *
With these general comments as background, the following provides more detailed discussion regarding the above recommendations and answers to specific questions the Commission has posed.
Should the Commission adopt rules requiring that issuers engage forensic auditors periodically to evaluate the work of the financial statement auditors? If so, how often should the forensic auditors be engaged? What should be the scope of the forensic auditors' work? Would doing so obviate the need to require partner rotation for the audit firm? Alternatively, could the company obtain the necessary expertise by engaging other outside consultants? If so, what type of consultants should it engage? (67 Fed. Reg. at 76792); and
Would the establishment of rules requiring companies to engage forensic auditors periodically provide an opportunity to other firms to enter the market to provide these services? (67 Fed. Reg. at 76792); and
Should the Commission establish requirements for firms conducting forensic audits? If so, what should those requirements be? (67 Fed. Reg. at 76792); and
Should issuers be given a choice between engaging forensic auditors periodically and having the audit partners on their engagement team be subject to the rotation requirements? Why or why not? (67 Fed. Reg. at 76792); and
What are the costs and benefits of engaging forensic auditors to evaluate the work of the financial statement audit firm? (67 Fed. Reg. at 76792)
Without offering any specific proposal concerning forensic audits, the Release raises the question of whether such audits should be instituted, possibly as an alternative to the proposed rotation rules. The primary goal of the auditor independence rules is to ensure that auditors are independent, and are perceived to be independent by informed investors. Audit partner rotation is intended to serve both aspects of this primary goal, and the Commission's task is to implement that goal in a way that is consistent with the decisions reached by Congress to balance the attendant benefits and burdens.
We believe forensic audits can play a highly important role in maintaining investor confidence. As a device for uncovering fraud or other misconduct, or even for achieving a definitive resolution to disputed questions of corporate finance, the forensic audit is invaluable. However, we do not believe that periodic forensic audits should be required as a matter of course, but rather should remain a specialized tool used to dispel, or substantiate, substantial fears of fraud. Forensic audits serve a fundamentally different function than audits generally. Requiring the performance of periodic forensic audits would be needlessly duplicative. Forensic audits duplicate the work of the financial statement audit and produce limited benefits absent some reason to doubt the accuracy of the financial statement audit. Instituting a new forensic audit requirement in addition to - or in lieu of - the rotation requirements would be an unduly expensive and labor-intensive response and would require the creation of a whole new body of professional standards for conducting and reporting on such forensic audits, as such standards do not currently exist.
Moreover, the likely effect on the perception of audits' reliability would probably not be a salutary one: forensic audits would likely become the sine qua non of investor confidence, an expensive outcome and one not contemplated by Congress or justified by the current state of conventional auditing. Forensic audits would become, in effect, the seal of approval that investors seek, and investors accordingly would develop unfounded doubts about the accuracy of financial statement audits that have not been subjected to a forensic audit. Such a result would be contrary to Congress's intent in adopting the Act to restore confidence in, among other things, both auditors and the work they produce, by further protecting their independence and providing visible guarantees of trustworthiness.
Forensic audits are not contemplated by the Act, and the Commission has neither set forth proposed parameters for such audits nor established a need for such audits. In light of the lack of either a congressional or administrative record concerning the propriety of any forensic audit requirement, we recommend that the Commission not seek to include forensic audit regulations as part of its rulemaking. Again, given the short time period for issuing final rules, the Commission should take care to implement the Act's specific provisions and not seek to go beyond the Act's requirements.
This proposed rule would apply to the audits of the financial statements of "issuers." Should the Commission consider applying this rule to a broader population such as audits of the financial statements of "audit clients" as defined in 2-01(f)(6) of Regulation S-X? Why or why not? (67 Fed. Reg. at 76792)
As noted above, we urge the Commission to maintain the proposed rule's focus on clients who are "issuers," a focus that fidelity to the text and intent of the Act demands. Congress explicitly directed that firms undertake to rotate their audit partners after five years' service auditing clients who are issuers. 111 Like the remainder of Title II of the Act, § 203 focuses on "issuers," and the legislative history reveals an identical focus; these repeated references make it clear that Congress intended "issuers" to define the scope of the new rotation requirement. 112 The rotation requirement, like the Act's other auditor independence provisions, is aimed most particularly at preserving and promoting "[p]ublic confidence in the integrity of financial statements of publicly-traded companies." 113
Congress plainly intended not to impose rotation upon every audit partner at every audit firm, but rather to target its reform efforts at the segments of the marketplace where they could most directly benefit public investors. Focusing its regulatory efforts on firms that audit issuers was a rational policy choice, because improved auditor objectivity with respect to issuers' financial statements would be more likely to benefit a relatively large portion of the marketplace and impose a relatively small burden compared to the alternative that the Commission's question presents.
Moreover, preserving the distinction between issuer and non-issuer clients may help to moderate some of the burdens of audit partner rotation on foreign firms and foreign associated firms. Foreign firms and foreign associated firms are more likely to have fewer clients and, therefore, fewer available work options for partners who become subject to the rule's "time-out" provisions. Permitting a safe harbor for work on non-issuer clients permits those foreign firms and foreign associated firms to regain some of the crucial flexibility in partner assignment that the rule as written largely denies them. Small firms would also benefit from such a result.
For organizations other than investment companies, the rotation requirements would apply to significant subsidiaries of issuers. Should a different approach be considered? If so, what approach would be appropriate? (67 Fed. Reg. at 76792)
As discussed in more detail below, we do not support the proposed rule's expansion of the application of the rotation requirements to all partners on an audit engagement team. When coupled together, the application of the rotation requirements to significant subsidiaries and to all partners on an audit engagement team would have serious adverse effects on audit quality and the ability of accounting firms to service their clients. This is particularly true in geographical areas where there are few optimal candidates to fill the critical partner roles on an audit engagement team for an issuer.
Moreover, subjecting even lead and review partners of significant subsidiaries to mandatory rotation represents a departure from the prescriptions of the Act, which were written to apply only to audits of "issuers." Expanding the requirement to subsidiaries thus calls for a cautious and restrained approach, to which the pre-existing regulatory definition of "significant subsidiary" may not be appropriate. If the Commission does decide to expand the rotation requirements to apply to subsidiaries of issuers, we recommend limiting the requirement to "major subsidiaries." Specifically, we propose that the Commission define a "major subsidiary" for purposes of audit partner rotation as a subsidiary in which either the subsidiary's assets exceed 20% of the parent's consolidated assets or the subsidiary's revenues on a consolidated basis after excluding intercompany revenues, exceed 20% of the parent's consolidated revenues. As net income of both subsidiaries and parents can fluctuate greatly from year to year, net income should not be used in determining a "major subsidiary."
We also suggest that if the Commission chooses to impose rotation requirements on audit partners serving "major subsidiaries," the Commission should limit audit partners on audits of a major subsidiary to serving up to ten years, followed by a two-year time-out period. 114 We also recommend that such a rotation requirement be narrowly drawn to apply only to work within a given subsidiary. Subsidiary audit partners do not make final decisions concerning the issuer's consolidated financial statements, nor do the subsidiary audit partners develop significant relationships with senior management of the issuer. Applying the rotation requirement as outlined above would allow auditors to move from subsidiary to parent, in recognition that those who supervise the audit of a subsidiary often gain expertise that makes them well suited to work on an audit of the parent company, without presenting the independence problem that a lead audit partner or concurring review partner who works at the parent company for the same length of time might pose. Applying a ten-year rotation requirement to audit positions at subsidiaries, while allowing an auditor who moves vertically or horizontally to a new position on the team auditing the parent corporation or another subsidiary, would codify and reinforce the sensible practice of preventing a lead audit partner from becoming ensconced in his or her role on a given audit engagement team, while retaining for the parent issuer - in whose financial statements investors have the more direct stake - the benefit of that auditor's industry-specific expertise without compromising his or her independence.
Should the rotation requirements apply to all partners on the audit engagement team? If not, which partners should be subject to the requirements? (67 Fed. Reg. at 76792); and
Is the proposed guidance sufficiently clear as to which audit engagement team partners would be covered by the rule? Is the proposed approach appropriate? If not, how can it be improved? (67 Fed. Reg. at 76792); and
Should certain partners performing non-audit services for the client in connection with the audit engagement be excluded from the rotation requirements? (67 Fed. Reg. at 76792); and
Should additional personnel (such as senior managers) be included within the mandatory rotation requirements? (67 Fed. Reg. at 76792)
Congress spoke directly to these issues in the Act and, we believe, arrived at a sensible outcome given the competing considerations at stake. Section 203 expressly provides that mandatory partner rotation is appropriate for lead partners (those in charge of an audit engagement) and concurring partners (those with responsibility for independently reviewing an engagement's results). Extending the five-year rotation requirement to cover every partner who performs audit services threatens to upset this careful balance and require audit firms - and, as the Commission recognizes, their clients - to bear burdens that Congress considered and rejected. 115 The proposed expansion of partners required to rotate after five years also underestimates the importance of deep, client-specific, experience and knowledge in conducting an effective audit. We urge the Commission to reconsider the course that the proposed rules would take in light of the considerations outlined here, considerations that influenced Congress's policy decision.
Section 203 strikes a balance between two competing considerations: the effectiveness that an experienced auditor can provide, and the detachment that a pair of "`fresh and skeptical eyes'" may "periodically" bring. 116 To require rotation not only from lead and review partners, but also from any partner who worked on the audit of an issuer in any capacity, would disrupt the balance between knowledge and freshness that Congress sought to strike. Indeed, after seriously considering whether or not to require periodic rotation of audit firms, Congress decided that further study was warranted and commissioned a year-long examination of the issue by the Comptroller General. 117 The Commission should be similarly cautious of departing dramatically from the rotation framework that Congress has now examined, strengthened, and codified.
The scope of the Commission's proposed rule, moreover, is truly sweeping. Based on a limited internal study that we have conducted concerning our audit engagement teams for five of our larger clients, it appears that dozens of partners would be affected on any given engagement team. Rotation is not simply a matter of exchanging one client for a neighboring one; due to such considerations as firms' client lists, staffing needs, and specialized expertise, it will frequently involve relocation and retraining, with relocation expenses conservatively estimated at approximately $250,000 per rotation per partner. Moreover, as will be discussed further below, applying the rotation requirement indiscriminately to any partner providing audit services promises to be particularly burdensome to small population centers, specialized sectors of industry, and clients of smaller audit firms.
Indeed, the examples presented in the Commission's discussion acknowledge how deeply into the structure of the audit engagement team the proposed rule would reach. At one point, the Commission states that even "an actuarial specialist who assists in auditing the loss reserves for an insurance company would be subject to the rotation requirement." 118 The proposed rule has in effect opted to focus only on whether a given partner's involvement is "on a continuous basis," regardless of the substance of his or her involvement with the issuer, and regardless of the substantive justifications for imposing a rotation requirement on individual auditors. 119 The Commission's own example - a partner acting in a non-supervisory capacity and offering specialized knowledge and expertise important to a single aspect of the overall audit - illustrates the danger of extending the regulatory burden beyond the parameters that Congress drew. Audit and non-audit partners who are able to offer such specialized knowledge targeted to a particular client or type of client are among the most severely impacted by the imposition of a rotation requirement, and they are among the most difficult to replace once rotation removes them. Indeed, in many cases, there is a limited number of qualified partners with the necessary specialized skills; for example, internal control experts for certain software packages or experts who specialize in narrow, industry-specific matters. Moreover, the narrow role in which they operate, and their supervision by partners who are subject to the rotation requirement, suggest that only minimal objectivity benefits can be expected from imposing an inflexible five-year period and an equally inflexible five-year "time out" upon such partners. We accordingly recommend that the Commission reconsider the aspect of the proposed rule that would subject specialist partners operating in non-supervisory capacities to mandatory rotation.
A further expansion of the scope of the rotation requirement to include partners or managers not already covered would similarly impose massive disruption on any audit engagement team and could compromise audit quality. Such an expansion would also fail to address the danger to which the rotation provision is primarily targeted, i.e., that lead audit engagement partners and review partners are those who are in particular danger of developing the kind of personal and professional relationship with the issuer that may be perceived to compromise their independence and judgment in performing their audit services, in a setting where their skeptical perspective is necessary to the entire audit. Indeed, the Commission appears to recognize that the proposed partner rotation rule is intended to protect against the perceived impairment of independence caused by close interaction with the issuer, as the Release explains that national office personnel are exempted from the rotation requirements because they "are not involved in the audit per se and do not routinely interact or develop relationships with the audit client." 120 That undoubtedly is true and demonstrates that it may not be appropriate to include others within the rotation rule's reach who "do not routinely interact or develop relationships with the audit client." Rotation of lead partners or review partners is more directly tailored to the danger the rotation provision seeks to address, both because it tells the lead partner that his or her work will be scrutinized by fresh eyes in relatively short order, and because it brings the incoming auditor's fresh perspective to bear on the entire engagement.
Is the exclusion of certain "national office partner" personnel from the rotation requirements appropriate? (67 Fed. Reg. at 76792); and
Is the guidance on national office partners who are exempted from the rotation requirements sufficiently clear? (67 Fed. Reg. at 76792); and
Is the distinction between a member of the engagement team and a national office partner who consults regularly (or even continually) on client matters sufficiently clear? (67 Fed. Reg. at 76792)
We agree with the Commission's determination that requiring rotation of national office personnel would not be warranted. National office personnel primarily consult with others in the firm rather than the client and do not develop relationships with client personnel. Consequently, and given the functions such partners perform, the desirability from a public policy viewpoint of enlisting the national office's consultation, and the decreased likelihood of their developing relationships or familiarity with individual clients that could be perceived to threaten their independence, the distinction that the proposed regulations draw is a sound one.
Is it appropriate to provide transitional relief where the proposed rules are more restrictive that the provisions of the Sarbanes-Oxley Act? (67 Fed. Reg. at 76792)
Changes to the audit partner rotation requirements beyond lead audit partners and review partners will require significant adjustments by accounting firms and issuers globally. Ensuring compliance will add a new level of complexity to audit firms' staffing decisions, and adjusting to the new requirements will require a transition period. Moreover, such a transition should take into account the dates these implementing regulations were proposed and finalized, rather than merely the date of enactment of the Act itself, because the possible contours of the rotation requirement are only now becoming known.
Further, as discussed above, the Commission's proposed partner rotation rule "go[es] beyond the provisions of the Act" in both of its essential elements: its coverage and its duration. 121 Accordingly, to the extent that the Commission determines that the final rulemaking should reflect this "more restrictive" approach, a phased-in transition rule would be particularly appropriate in light of the additional burden for which audit firms and issuers must begin planning.
The most straightforward approach to providing transitional relief would be to omit from the proposed rules' coverage audit, review, or attest services that were performed in fiscal years prior to the rules' promulgation and were not at that time the subject of rotation requirements. Such a prospective approach would be faithful to the text, structure, and intent of the Act, and would avoid the unnecessarily disruptive effects that would arise from immediate, retroactive application of the rotation requirement.
Accordingly, we propose that the Commission phase in its rotation requirements as follows. First, we believe that the timing of the requirements should be set so as to allow for meaningful preparation and an efficient transfer of responsibility. In particular, the rotation requirement should not apply to services performed during a fiscal year that had already begun before the Commission adopts the final rule. Accordingly, because the final rule will be issued in 2003, we recommend that the rotation requirements apply to audit services provided during issuers' fiscal years beginning on or after December 15, 2003.
Second, with respect to any audit partners who have not previously been subject to a rotation requirement, audit services performed before the effective date of the newly applicable rotation requirements should not be retroactively counted toward the rotation limit. For example, review partners should not be subject to immediate rotation, i.e., their rotation period should begin running with the effective date of the rotation requirement.
Under the proposal, some lead partners - those who have already spent five years in that role - would be compelled to leave their current clients as soon as the rotation requirements take effect. We accordingly reiterate the importance of minimizing the disruption that replacing these partners will involve, and reiterate our first recommendation that the rotation rule take effect for fiscal years beginning on or after December 15, 2003.
Planning for and undertaking such a gradual transition would promote the preservation of institutional knowledge within an audit team, without significantly delaying any new requirements. Indeed, the Commission's discussion notes the disruption that a quinquennial exodus of audit partners would cause. As the Release states, "we would expect that firms would stagger the rotation of partners to ensure that the engagement team continues to have appropriate expertise to allow the audit engagement to be conducted in accordance with GAAS." 122 Promulgating a transition rule permitting staggered departures once the rule takes effect would foster precisely this sort of salutary staggered rotation.
Moreover, phasing in the implementation of the rotation requirement through staggered departures will permit auditing firms and individual auditors to take into account the personnel considerations involved in staffing decisions. The Commission has recognized that the proposed rules might force partners subject to the rotation requirement "to relocate from one part of the country to another." 123 With the exception of a small number of larger offices, we do not have sufficient partner resources in any one office to deal effectively with partner rotation without relocation. In a number of smaller markets, the limited number of firm clients and the interrelatedness of those clients may require the replacement of all partners serving a particular engagement with partners from outside the area, if the Commission's rule, as proposed, takes effect. Requiring that replacement, and the attendant relocation process, to take place immediately upon the final rule's promulgation would dramatically impact many issuers, as well as small-firm auditors, and large-firm auditors who work primarily in smaller markets. Allowing their individual circumstances to be taken into account in making staffing decisions during a limited transition, with the benefit of full advance knowledge of the rule's final rotation requirement, would come at no cost to auditor independence.
Additionally, in order to preserve audit quality, the Commission should consider allowing an audit partner who has been designated to assume a lead audit partner role a one-year overlap with the current lead audit partner. Such an overlap year should not count against the rotation requirements. This overlap year should be considered a training period essential to effective transition and audit quality. Lead audit partners should also be able to consult with prior partners who have rotated off the engagement regarding transactions that took place or issues that arose during the prior partners' assignment.
We also ask the Commission to provide implementation guidance in the final rule regarding how the rotation rules would apply in a re-audit situation or initial public offering situation. With respect to re-audits, such engagements are generally performed as one engagement simultaneously with the audit of the current year. As such, we believe re-audits combined with the audit of the current year should count as one year of service, even if multiple years have been re-audited. With respect to initial public offerings, we believe that because these partners were not previously subject to rotation requirements, the limitation on the years of service should begin at the point the client becomes an issuer.
Are there situations in foreign jurisdictions that extended partner rotation could be modified with additional safeguards or limitations that would recognize the jurisdictional requirements as well as logistical limitations that may exist? (67 Fed. Reg. at 76792)
Most foreign jurisdictions do not maintain a large number of foreign private issuers, and as such, the number of audit clients of foreign audit firms and foreign associated firms is substantially less than the number in the United States. 124 The Commission's question recognizes the logistical challenge faced in those countries and offices that do not have a sufficiently large base of foreign private issuers to facilitate the rotation of qualified audit partners in a manner that complies with the proposed rule. Some foreign audit firms and foreign associated firms will have difficulty conforming to the proposed rotation requirements because the number of qualified audit partners needed to serve foreign private issuers is greater than the number of qualified audit partners currently within the firm in that country. 125
Foreign audit firms and foreign associated firms in smaller countries have a smaller number of foreign private issuers, and a smaller number of audit partners. The concerns regarding the size of the number of qualified audit partners available to serve foreign private issuers is exacerbated when one considers the nature of many foreign private issuers. Excluding certain Canadian filers, foreign private issuers are often the largest multinational companies resident in the issuer's local jurisdiction. As is typical of multinational companies, regardless of their country of domicile, several "line" audit partners are required to serve the issuer, as those companies typically operate in various industries, and in some instances, in very specialized industries.
For those foreign private issuers, the qualifications needed for "line" audit partners are not easily attained and are developed through several years of training and experience: they must obtain the requisite knowledge of U.S. GAAP, U.S. GAAS, and Commission regulations, in addition to their knowledge of local accounting and auditing standards; they must attain, in some instances, highly specialized accounting expertise for a particular industry; and they must maintain a requisite level of skill in the English language, as well as in their local language. As such, the difficulties associated with obtaining the required number of qualified audit partners within a foreign audit firm or a foreign associated firm are not obviated by simply relocating partners, en mass, from a U.S. audit firm into foreign countries.
Many of the difficulties that would be posed by applying the partner rotation rules to work performed in foreign jurisdictions as described above would be obviated by restricting the rotation requirement to audits of "issuers." Conversely, these difficulties would be compounded by expanding the requirement to all audit clients, a step that would apply partner rotation even in situations farther afield from the "`public watchdog' function" that the Act aimed primarily to strengthen. 126
If the Commission decides to go beyond the Act, a benefit of applying the rotation rules only to audits of issuers' major subsidiaries, as we suggest above, would be that such an approach would avoid many of the difficulties associated with applying the rotation rules to audit partners working in foreign jurisdictions. Still, the threshold we propose would include audit partners serving the largest subsidiaries whether foreign or domestic, which we believe meets the objective of the Commission. This approach would save many of the costs associated with wholesale application of the rotation requirement to foreign private issuers or even to their significant subsidiaries, while ensuring that U.S. investors reviewing the financial statements of domestic and foreign issuers with major foreign subsidiaries would still receive the benefits associated with a "periodic fresh look at the accounting and auditing issues" of the issuer. 127
Should the rotation requirements be different for small firms? What changes would be appropriate and why? If so, how should small firms be defined? (67 Fed. Reg. at 76792)
Would the proposed rules impose a cost on smaller firms that is disproportionate to the benefits that would be achieved? (67 Fed. Reg. at 76792)
The Commission's question appropriately recognizes that its broad interpretation of the Act's mandate risks imposing burdens that outweigh the potential benefits, for large and small firms alike. However, the danger is particularly acute for smaller firms, and arguably for smaller practice units within larger firms.
Smaller firms, with smaller numbers of partners and correspondingly smaller client lists, risk losing partners, losing clients, or both if the Commission's interpretation of the rotation requirement prevails. Audit partner rotation serves twin purposes - not only allowing a client to benefit from fresh eyes, but also allowing the audit partners who rotate out of engagements to bring their experience to new situations and new clients. Small firms may find themselves unable to serve either goal, because the rotation requirement and ensuing five-year moratorium on returning may leave their experienced partners without an available client and their clients without an available audit engagement team. Similarly, the application of the rotation requirement to review partners may leave a partner who takes on reviewing responsibility for multiple clients' audits completely barred from working in that capacity once the five-year period of assignment expires. 128
We also urge the Commission to take into consideration that larger firms may face similar problems in implementing this rule, particularly in regional offices, geographically smaller markets, and smaller market sectors. As the Commission's cost-benefit analysis correctly recognized, "[s]maller firms that do not have sufficient partners to replace the partners on an audit engagement team may be particularly affected by the proposed rules in that they would have to accept more partners into the firm or lose the audit engagement." 129 In certain markets, either the number of firms or the number of issuer clients whose engagements trigger the rotation requirement will exhaust the local supply of eligible partners. Addressing this problem by simply "accept[ing] more partners into the firm" runs counter to the basic principles - promoting audit quality and reliability and securing investor confidence - that underlie the Act and the rotation requirement. It is essential that the partners who perform audit duties for issuer clients meet the highest standard of professional qualification. The proposed rule risks requiring audit firms, particularly regional offices and smaller firms, to expand their partnerships to a degree that could require those firms to dilute their professional standards. The necessary personnel simply may not be available in regional markets, particularly if the "time-out" period proposed in the rule is adopted.
Is the five-year "time out" period necessary or appropriate? Would some shorter time period be sufficient, such as two, three or four years? Should there be different "time out" periods based on a partner's role in the audit process? (67 Fed. Reg. at 76792)
The five-year "time out" period is one of the more significant ways in which the proposed rule goes beyond the prescriptions of the Act. Under existing AICPA requirements at the time the Act was adopted, lead partners who rotated out of that role were required to wait two years before resuming their lead role.130 We support the Commission's decision to extend that "time-out" period to five years for lead audit partners. With regard to other partners to whom the rotation requirements may be applied, we believe a two-year time-out period is appropriate. These other partners have very little interaction with management and the audit committee, and as such, a shorter time-out period is appropriate.
Establishing a longer time-out period than Congress evidently contemplated across-the-board will impose significant costs on audit firms, issuers, and investors alike, while decreasing the number of qualified candidates for a given audit engagement position, particularly in smaller markets. Audit partners face an increased likelihood that they will be forced to give up clients to preserve their post-rotation options, relocate to markets with more client options, or both. Audit clients, particularly those in small markets or specialized industries, will be faced with increased costs as firms must move personnel or incur substantial additional expense to complete their audit engagement teams with qualified personnel. Investors will be deprived of the expertise of many of the most qualified audit personnel, many of whom will be diverted from the markets or industries on which their talents and expertise are best brought to bear. Investors will not gain an appreciable offsetting benefit in the form of increased auditor independence.
The effect is likely to be particularly pronounced with respect to review partners, who frequently perform quality control reviews for many issuer clients. Rotation is thus likely to disqualify a given review partner from not just one client, but several. Because the review partner position frequently requires industry-specific expertise, the number of qualified candidates to perform that role for a given engagement is frequently quite limited - a problem that is exacerbated in smaller markets. The independence concerns that underlie the rotation requirement offer less justification for five years' separation in the case of review partners, who rarely have the sort of direct, regular, personal contact with clients' managers that some believe can dull the skepticism required of an outside auditor.
If a partner rotates off an engagement after fewer than five years, should the "time out" period also be reduced? Why or why not? If so, how much should the reduction in the time out period be? (67 Fed. Reg. at 76792)
Under the terms of the rule as presently drafted, it appears that a partner who rotates off an engagement after fewer than five years would not be subject to the "time-out" period. Many situations may arise that could require a lead audit partner to rotate off of an engagement prior to serving five continuous years on the engagement, such as instances in which an individual goes on medical or maternity leave. To address these types of situations, we believe it would be appropriate for the Commission to allow a lead audit partner to serve a particular engagement for any five years within a ten-year period. For example, if a lead partner served a particular client for two years, then went on an extended medical or maternity leave for one year, that lead partner should be able to return to the engagement immediately upon returning to work; a five-year time-out period does not seem appropriate in such circumstances. Using this convention of five years out of ten years is within the spirit of the Act and would address situations in which partners leave an engagement prior to serving five years. Such a convention should also be considered for other partners that are required to rotate under the final rule.
Are the partner rotation requirements, as proposed, for investment company issuers or other entities in the investment company complex too broad? (67 Fed. Reg. at 76792)
We believe that the investment company complex definition does not need to be incorporated into the partner rotation requirements. Instead, a rotation policy determined on an issuer basis, with each individual fund considered a separate issuer, would be appropriate and sufficient. For many of our investment company complex clients, multiple audit partners are assigned to the investment company audits to ensure the large volume of work is completed in an effective manner. Each audit partner is responsible for the issuance of the audit opinion for the funds he or she is assigned. To the extent there are common accounting, financial reporting, or auditing issues that apply throughout the investment company complex, assigning multiple partners provides a safeguard by ensuring that multiple individuals are constantly challenging the issues independent of each other. The most compelling evidence of the success of following this approach is the historical lack of audit failures in the investment company industry.
However, to the extent that the Commission determines to apply its rotation rules across an investment company complex, the Commission, as noted above, should recognize the importance of the audit committee. We believe that auditor independence rules for investment companies would be better driven by a registrant's audit committee structure. Under such an approach, a partner could perform audit, review, or attest services for an investment company only if he or she had not performed such services during the previous five consecutive fiscal years for that company or any sister investment company with a common audit committee. By formulating the rules in this fashion, the Commission's stated goal in requiring auditor rotation - "to [assure] investors that there will be a periodic fresh look at the accounting and auditing issues confronting the company" 131 - will be met. We recognize that for this process to be effective in the investment company context each audit committee must be independent of the others. Accordingly, we would propose that audit committees within a group of sister investment companies be deemed independent for purposes of the five-year auditor rotation requirement if a majority of the independent directors on each audit committee is different. 132 As an alternative, the investment company complex definition could be refined to require that the funds not only have different audit committees but also either (1) employ independent third party administrators or recordkeepers who maintain the accounting or financial reporting records for the funds, or (2) if the funds' accounting and financial reporting records are being maintained by affiliated organizations, only those funds operating on the same accounting or financial reporting system would be included in the investment company complex definition for this purpose. This refinement would address a perceived concern that a partner may become too familiar with a family of funds' operating system over the course of time and therefore lose an objective view.
Should we only prohibit a partner from rotating between investment company issuers within the same investment company complex? Why or why not? (67 Fed. Reg. at 76792)
In order to manage the volume of work associated with the audits of a large number of funds within an investment company complex, many firms assign multiple audit partners to the engagement. Although any one partner is assigned signing responsibilities to discrete investment companies within the complex, there is often one partner who is designated the "lead audit partner." Some of the common areas of responsibility assigned to the lead audit partner include: (1) establishing the audit approach followed throughout the complex; (2) ensuring consistent policies and audit quality are followed for all audits within the fund family; (3) oversight of the audit process for testing the internal control environment that is common to all of the funds in the fund family; and (4) being the main point of the contact for communication of audit issues with the investment companies' audit committee. This role is analogous to the lead audit partner role for a parent-subsidiary audit client where the lead audit partner at the parent establishes the approach executed by each of the partners at the subsidiary level. We believe the rotation requirements for partners in an investment company audit team organized in this manner are consistent with the rotation requirements established for partners in audit teams serving parent-subsidiary clients.
We further believe that the definition of the entities included in the group subject to complex wide rotation be limited to those investment companies that share a common audit committee. To the extent that investment companies share a common audit committee the lead audit partners should be prohibited from rotating between them; to the extent that the investment companies do not share a common audit committee, the lead audit partners should not be prohibited from rotating between the companies. Because the audit committee has the responsibility for engaging the public accounting firm, the audit committee would be the critical group that would supervise the "fresh look" by a different audit partner every five years. To the extent that a separate audit committee oversees a separate group of funds then the audit partner may rotate to serve the separate group of investment companies operating under that different audit committee. For those investment company complexes that do not engage independent third party service providers to perform financial reporting and record-keeping services, the definition could be further refined to require different financial reporting and record-keeping systems for each group of investment companies. Several factors would need to be considered, including (1) separate accounting organizations maintaining the funds' records managed by discrete management teams, (2) distinct general ledger and portfolio accounting systems, and (3) different fund management and investment advisory organizations that are operated by separate corporate organizations.
The proposed rules would not require all partners on the audit engagement team to rotate at the same time. Should it? Why or why not? (67 Fed. Reg. at 76792)
The Commission's own discussion more than adequately explains why requiring simultaneous rotation of all audit engagement partners would be both unnecessary and unwise.
Indeed, we urge the Commission to be cognizant of the disruption and negative impact on audit quality that the simultaneous departure of all audit engagement partners would cause. As noted above, a phased-in transition would allow firms and clients to prepare for and execute an orderly transfer of responsibilities rather than require the sudden departure of much of their audit engagement team, including the team's leadership.
E. Audit Committee Administration Of The Engagement
The Commission's proposed rule provides that an accountant is not independent of an issuer unless the issuer's audit committee pre-approves all engagements "[i]n connection with audit, review and attest reports required under the securities laws." 133 The proposed rule would also require the audit committee to pre-approve the provision of permitted non-audit services. For purposes of the proposed rule, pre-approval occurs whenever the audit committee meets and votes in favor of a particular engagement, as well as when "[t]he engagement . . . is entered into pursuant to pre-approval policies and procedures established by the audit committee . . . provided the audit committee is informed of each service." 134 As the Release makes clear, the policies and procedures permitted by the rule must be "detailed as to the particular service and designed to safeguard the continued independence of the auditor." 135
We support the Commission's proposal to approve this "policies and procedures" mechanism for the pre-approval of non-audit services. This provision will provide needed flexibility to issuers to obtain permitted non-audit services from their independent auditors, without undue inefficiencies or administrative burden. At the same time, the requirement that issuers disclose their pre-approval policies and procedures will give investors a chance to consider and evaluate them, providing audit committees with the direct incentive to develop policies that meet investors' desire for "best practices" to preserve auditor independence.
We are concerned, however, that the effectiveness of the pre-approval provisions may be compromised by other aspects of the proposal. The Release notes that the pre-approval provisions are "supplemented as a result of the proposed proxy disclosure requirements." 136 Specifically, the proposed rule requires disclosure not only of the policies and procedures that an audit committee uses to pre-approve non-audit services in the issuer's proxy statement and annual report, but also the percentage of fees for non-audit services that were pre-approved, by category of approval mechanism: that is, (1) by audit committee vote for individual non-audit services, (2) pursuant to established policies and procedures, or (3) prior to completion of the audit engagement (where the criteria for waiver of the pre-approval requirement are met). 137 Requiring this level of disclosure would serve to confuse investors and expose audit committee decision-making to retrospective criticism, which may minimize the appropriate flexibility that the "policies and procedures" mechanism is intended to provide. Thus, we believe that the proposed changes to the Commission's proxy disclosure rules should be revised to require disclosures regarding the pre-approval policies that audit committees utilize, but not disclosures concerning the percentage of fees pre-approved by each possible pre-approval mechanism. 138
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With these general comments as background, we turn to specific questions posed by the Commission.
Should the Commission create other exceptions (beyond the de minimis exception) that would allow an audit committee to adopt a policy that contracts that are recurring (e.g., due diligence engagements in connection with a series of insignificant acquisitions) and less than a stated dollar amount (such as $25,000) or less than a stated percentage of annual revenues (such as 1% or 5%) could be entered into by management and would be reviewed by the audit committee at its next periodic meeting? (67 Fed. Reg. at 76793)
The Release acknowledges that the proposed pre-approval rule is not without its costs, among which are "more frequent committee meetings, an increased workload on audit committee members, and having legal counsel review the audit committee's draft policies and procedures. . . . The increased burden on audit committee members might [also] result in the need to increase their compensation." 139 To these costs, we would add, at a minimum, the increased difficulty of identifying individuals to serve on audit committees, given the burden and potential liability exposure. 140 The proposed rule, as drafted, reflects the Commission's judgment that these incremental costs are outweighed by the potential benefit of the rule. However, requiring the audit committee to turn its attention to relatively small, recurring non-audit engagements relating to "a series of insignificant acquisitions" (to use the example in the Release) imposes a cost with little corresponding benefit. 141 We believe that this requirement may actually undermine the objectives of pre-approval rules, by distracting audit committee members from scrutinizing more significant non-audit engagements. The Commission should ensure that the expertise of the audit committee is best employed by excepting from the pre-approval rules, in addition to the statutory de minimis exception, recurring engagements that contribute less than 5% of the fees paid by the issuer to the accountant during the fiscal year in which the services are provided. Providing audit committees with such flexibility would be consistent with the approach reflected in the proposed rule's provision allowing audit committees to adopt pre-approval policies and procedures to govern engagement decisions.
Is allowing the audit committee to engage an auditor to perform non-audit services by policies and procedures, rather than a separate vote for each service, appropriate? If so, how do we ensure that audit committees have rigorous, detailed procedures and do not, in essence, delegate that authority to management? (67 Fed. Reg. at 76793)
As discussed above, we support the Commission's adoption of the "policies and procedures" mechanism, because it provides needed flexibility to issuers to obtain certain non-audit services from their independent auditors without undue administrative burden. We understand the Commission's concern that audit committee members not use the flexibility inherent in the proposed rule to delegate their authority to management; however, the proposed rule addresses these concerns. We believe that the requirement to disclose pre-approval policies and procedures will give investors a chance to consider and evaluate the "detail" and "rigor" of the audit committee's policies and procedures. Thus, audit committees have a strong incentive to adopt "best practices" that will demonstrate their clear commitment to the goal of auditor independence.
Are there specific matters that should be communicated to or considered by the audit committee prior to its engaging the auditor? (67 Fed. Reg. at 76793)
Certainly, audit committees may find it useful to consider particular factors in their consideration of a potential auditor; however, the relevant factors might vary from one issuer to another, and even from one audit committee member to another. Congress appears to have recognized the audit committee's need for flexibility in this regard. The Senate Report explains that § 202 "does not require the audit committee to make a particular finding in order to pre-approve an activity. The members of the audit committee shall vote consistent with the standards they determine to be appropriate in light of their fiduciary responsibilities and such other considerations they deem to be relevant." 142 Embodied in this language is the broader understanding that flexibility is appropriate to assure the effectiveness of the audit committee in the context of the audit committee's oversight of the audit. By leaving the development of policies and procedures to the audit committee, the proposed rule also respects the congressional judgment. The Commission should not overlook congressional intent in an effort to standardize the policies and procedures for engaging independent auditors. Moreover, it is not at all clear what policies and procedures would be effective if standardized. The Commission should not rush to establish mandated policies and procedures without evidence as to which will be most effective in the new auditor independence regime established by the Act.
What, if any, audit committee policies and procedures should be mandated to enhance auditor independence, interaction between auditors and the audit committee, and communications between and among audit committee members, internal audit staff, senior management and the outside auditor? (67 Fed. Reg. at 76793)
Congress clearly intended to preserve the flexibility of the audit committee. The proposed rule also reflects this priority. The Commission should not attempt to impose standardized policies and procedures, beyond the requirements of the Act. Moreover, it is clear that standardized policies and procedures would not be effective for every issuer in every circumstance.
Should the Commission provide additional specific guidance to assist audit committees when deliberating auditor independence issues? What topics would be helpful? (67 Fed. Reg. at 76794)
We appreciate the Commission's attempt to provide additional guidance to assist audit committees to review auditor independence issues and to comply with the securities laws. However, we are concerned that such informal guidance could be interpreted not merely as suggesting areas to examine and consider, but as establishing actual legal requirements. This could undermine the Act's goal of audit committee responsibility and flexibility.
Our proposed rules would require the audit committee of an investment company to pre-approve the non-auditing services provided by the accountant of the investment company to the investment company's investment adviser and any entity controlling, controlled by, or under common control with the investment adviser that provides services to the investment company. Should the audit committee of an investment company registrant be required to approve any non-auditing services provided to the investment adviser and any entity controlled, controlled by, or under common control with the investment adviser that provides services to the fund? Should the scope of the pre-approval requirement be expanded or narrowed? Why or why not? (67 Fed. Reg. at 76794)
We believe that the audit committee of an investment company registrant should be required to pre-approve any non-audit services provided to or paid by the investment company or any "sister" investment company for which such audit committee also has responsibility. Any other non-audit services provided to the investment adviser and any entity controlling, controlled by, or under common control with the investment adviser that provides services to the investment company or sister investment company would be subject to pre-approval, but only to the extent such services are not already subject to a pre-approval process by the audit committee of the entity for which the services are being performed. The Commission's proposed rule would put an audit committee for an investment company in the difficult position of approving non-audit services for an entity for which it may not have any responsibility and for which it may not have the knowledge required to make an informed decision. We believe that the audit committee should pre-approve any non-audit services provided to and paid for by the investment company or any sister investment company for which that audit committee also has responsibility. Further, in order to avoid multiple audit committee approvals of the same services and ensure that the audit committee is well informed and understands the audit firm's relationship with affiliated entities, we believe that non-audit services provided to the investment adviser and any entity controlling, controlled by, or under common control with the investment adviser that provides services to the fund should be communicated to the investment company audit committee in a timely manner.
Under the proposed rules, the pre-approval of non-auditing services would permit, for purposes of determining whether a non-auditing service meets the de minimis exception, the investment company's audit committee to aggregate total revenues paid to the investment company's accountant by the investment company, its investment adviser and any entity controlled, controlled by, or under common control with the investment adviser that provides services to the fund. Should the de minimis exception be determined separately based on the total revenues paid to the investment company's accountant by each entity? (67 Fed. Reg. at 76794)
The de minimis exception should be determined based on total revenues paid for services provided to the group of organizations included in the disclosure requirement.
This proposed rule would apply to "issuers." Should the Commission consider applying this rule to a broader population such as "audit clients" as defined in 2-01(f)(6) of Regulation S-X? Why or why not? (67 Fed. Reg. at 76794)
Congress specified in the Act that the pre-approval requirement was designed to apply to "issuers," and the Commission should not seek to apply the rule to a broader category of companies. 143 The Act's legislative history repeatedly confirms this focus by stating that "the bill applies only to the auditing of public companies," and emphasizing that independence is required to permit "[p]ublic confidence in the integrity of financial statements of publicly-traded companies." 144 Indeed, it is the need to restore investor confidence in the public markets that is at the heart of the recent desire to strengthen auditor independence, and applying the proposed rule more broadly is unnecessary and unjustified.
Moreover, the definition of "audit clients" in the 2000 rulemaking is exceptionally broad and poorly defined, including within its meaning "affiliates" of audit clients. Given the lack of clarity that results from application of provisions to "audit clients" because of the far-reaching scope of that term, the Commission should adhere to the legislative mandate and apply its rulemaking to "issuers" only. 145
In addition to the requirement that a majority of the directors who are not interested persons of the registered investment company appoint the independent accountant of a registered investment company under the Investment Company Act of 1940, the proposed rules would also require the audit committee of an investment company to separately approve the accountant. For registered investment companies, who should approve the selection of the accountant, i.e. independent directors, the audit committee, or both? If both, should the audit committee nominate the independent accountant with the independent directors making the selection? (67 Fed. Reg. at 76794)
The audit committee for an investment company should approve the independent accountants, as this would be consistent with the rule for other companies and place responsibility with the group that has responsibility for oversight of the audit process. We note, however, that in its recent release relating to implementing the audit committee requirements of § 301 of the Act, the Commission proposes to exempt investment companies from the requirement that the audit committee be responsible for the selection of the independent auditor because Section 32(a) of the Investment Company Act already addresses the concerns behind the requirement. 146 If the Commission determines to proceed with this alternative course outlined in its § 301 proposal, we believe this approach would also be acceptable.
The Commission is considering imposing a new restriction - not contemplated in the Act - that would restrict the manner in which accounting firms may compensate their partners, principals, and shareholders who are members of the audit engagement team. As noted previously, due to the truncated time period in which the Commission is required to consider comments and finalize the rule, we believe the Commission should track the congressional mandate whenever possible. Because this new restriction is not required by the Act, and because the objective of this provision (to prevent audit partners from being biased in making audit judgments as a result of receiving financial incentives based on the audit client's purchase of non-audit services) is addressed through other provisions in the Act - including § 303's protection against improperly influencing the conduct of audits, § 201's limitation on the scope of services an accounting firm can provide to an audit client, and § 202's requirement that audit committees pre-approve all audit and permissible non-audit services - this additional restriction on partner compensation is unnecessary. If, however, the Commission determines that a restriction on audit partner compensation is necessary to the Act's effective implementation, we urge the Commission to construct the regulation in a judicious manner so as to meet the limited objective described above.
As currently proposed, the new provision would state:
An accountant is not independent of an audit client if, at any point during the audit and professional engagement period, any partner, principal or shareholder who is a member of the audit engagement team earns or receives compensation based on the performance of, or procuring of, engagements with that audit client to provide any products or services other than audit, review or attest services. 147
We agree with the Commission that audit partners should not be directly incentivized to cross-sell or promote non-audit services to their audit clients. As the Commission recognizes, such "cross-selling" may raise questions about the appearance of independence. 148 By its terms, however, the proposed rule would go beyond prohibiting audit partners from receiving direct incentive compensation for "cross-selling" non-audit services to audit clients, or prohibiting the use of cross-selling as a specific criterion in partner reviews. Indeed, under the terms of the proposed rule, the limitation is neither tied directly to affirmative acts of promotion or cross-selling nor solely to audit partners. Rather, the proposed rule imposes a broad ban on the receipt of compensation that is drawn in any way from the provision of non-audit services to an audit client, even if the partner on the audit engagement team had no involvement with either the provision or the procurement of those non-audit services to the audit client - indeed, even if the audit client seeks out the accounting firm to provide a needed and lawful non-audit service. Thus, the prohibition is extremely broad.
We believe this broad prohibition could have several unintended consequences, including preventing partners from participating in the overall success of their firm and potentially threatening the very structure of accounting firms as partnerships. The compensation proposal could also hinder the ability of firms to provide audit clients with the most effective audits. For example, under the proposed rule, a tax partner serving on an audit engagement team to provide specialized assistance in a supporting role could not be compensated for his or her separate provision of authorized non-audit services, such as tax compliance services, to the client. Given that prohibition, the tax partner responsible for tax compliance services for the client may be precluded from participating in the audit, and the quality of the audit would suffer from the loss of the partner's tax expertise and judgment. Indeed, our experience has been that the breadth and depth of specialized expertise that we can bring to an audit helps to assure the highest quality audit for our clients. Any regulation that unnecessarily interferes with the ability to bring any expertise to bear could negatively impact audit quality and should be avoided.
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With that general background, we now turn to specific questions posed in the Release.
What economic impact will our proposal have on the current system of partnership compensation in accounting firms? (67 Fed. Reg. at 76794)
If implemented as drafted, the compensation proposal could significantly impact partnership compensation in accounting firms. Creating an internal accounting system that could keep the ultimate distribution of monies collected from the performance of non-audit services separate from those collected from audit services on a client-by-client basis would be both cumbersome and impractical in the partnership setting. Partnerships are formed when persons decide to pool their resources to carry on a business with each of the partners sharing in the resultant profits (or losses). 149 One of the primary benefits of a partnership that includes both providers of non-audit services and providers of audit services (as many partnerships currently do) is that the financial performance of the firm is not overly reliant on the provision of one type of service. Partners agree to join together because they believe they will be able to reap greater financial rewards collectively than individually. However, because the proposed addition to the current independence regulations could be read as preventing auditors from sharing in the success of the firm as a collective unit, we believe that the Commission is unintentionally creating a financial disincentive for broad-based, cross-expertise partnerships to exist at all, because the value of partnering with a somewhat diversified group of service providers would be curtailed by the proposed limitation on compensation. The result may be accounting firms with only narrow expertise, potentially resulting in less effective and less efficient audits, to the detriment of the investing public.
In addition, because of the breadth of the proposed prohibition on receiving compensation drawn from the performance of non-audit services for an audit client, partners on the audit engagement team could be forbidden from receiving total compensation that is based on the accounting firm's overall profits. Given that some of those profits may have come from the performance of non-audit services to an audit client, the entire profit pool could be "tainted," and thus the receipt of any distribution of overall profits by a member of an audit engagement team would violate the rule. The compensation proposal thus may not permit partners to participate in the overall success of the firm. Such a result is not necessary to ensure auditor independence, and it would not rationally promote investor confidence.
Given the innumerable practical costs of the Commission's proposal regarding the limitation on compensation, and the lack of a congressional directive to implement such a limitation, we recommend that the Commission reconsider its proposal. We suggest that the limitation on compensation be crafted to prevent audit partners on an audit engagement team from receiving bonuses or other forms of direct incentive compensation as a direct result of any cross-selling. 150 To the extent, however, that revenue from both audit and non-audit services merges in the general partnership pool, such audit partners should be able to share in the undifferentiated success of the firm. Again, the independence standard is designed to ensure independence in fact, and independence in appearance to "a reasonable investor with knowledge of all relevant facts and circumstances." 151 Given all the other restraints and regulation designed to protect auditor independence, no one could rationally conclude that an auditor's independence would be undermined by his or her indirect, attenuated, pro-rata participation in the success of the firm as a whole.
Are there other approaches that should be considered with respect to compensation packages that pose a concern about auditor independence? If so, what are they? (67 Fed. Reg. at 76794)
As noted above, we believe that any limitation on compensation should be carefully crafted to prevent audit partners on an audit engagement team from receiving bonuses or other forms of direct incentive compensation as a direct result of any cross-selling.
Would the proposed rule change be difficult to put into practice? If so, why? How could it be changed to be more effectively applied? (67 Fed. Reg. at 76794)
The proposed language will result in unintended consequences and create requirements that will be extremely difficult to implement and manage.
If the proposed rule change were limited to preventing an audit partner, principal or shareholder on an audit engagement team from reaping financial rewards as a direct result of attempting to cross-sell the firm's provision of non-audit services to an audit client, many of the practical difficulties of putting the proposed rule change into practice would be eliminated.
Should managers, supervisors or staff accountants who are members of the audit engagement team also be covered by this proposal? (67 Fed. Reg. at 76794)
Managers, supervisors, and staff do not have responsibility to make final decisions with regard to the audit. A limitation on the compensation of managers, supervisors, or staff would not meet the objectives of the Commission.
Does this proposal cover the appropriate time period or should a measure other than the audit and professional engagement period be considered? (67 Fed. Reg. at 76794)
The time period covered by the Commission's compensation proposal is overly broad. The Commission states that the "[a]udit and professional engagement period" referenced in its compensation proposal "includes both the period covered by the financial statements being audited or reviewed and the period of engagement to audit or review the client's financial statements or to prepare a report filed with the Commission." 152 Thus, it would appear that partners would be prohibited from participating as members of an audit engagement team asked to re-audit or review a client's financial statements from 2001, for example, if they had previously earned any compensation that was partially drawn from non-audit services provided to that client in 2001. Additionally, as the rule is currently written, if an accounting firm provided only non-attest services to a client in 2002 and the firm's compensation structure distributed the profits generated from those services throughout the entire partnership - as would typically be expected - it would appear that if that client asked the accounting firm in 2004 to audit or review its 2002 financial statements, any partner who had received compensation from the firm in 2002 would be prohibited from serving on the engagement team. We fear that such de facto disqualifications would not be infrequent and could have a profoundly negative impact on audit quality and effectiveness, as partners are disqualified for unforeseen reasons.
We recommend that the time period covered by the proposed rule change be limited to the "professional engagement period," as defined in 17 C.F.R. § 210.2-01(f)(5)(ii), and not include the "audit period," as defined in 17 C.F.R. § 210.2-01(f)(5)(i). We believe that prohibiting audit partners, principals, and shareholders from receiving direct financial incentives for their attempts to promote or cross-sell non-audit services to current audit clients during the professional engagement period would satisfy the stated purpose behind the Commission's proposed restriction on compensation.
Does the proposed rule cover the entire component of an audit partner's compensation that gives rise to independence concerns? (67 Fed. Reg. at 76794)
We believe that the proposed rule is broader than necessary to address any potential independence concerns as a result of audit partner compensation. Our suggested approach as described above would more than adequately address the potential independence concerns.
Will this compensation limitation disproportionately affect some firms because of their size or compensation structure? If so, how may we accomplish our goal while taking these differences into account? (67 Fed. Reg. at 76794)
Because of the extraordinary breadth of the proposed rule change, its negative impact will be felt throughout the accounting profession. We believe that these unnecessary consequences could be largely avoided by limiting the proposed rule change to preventing an audit partner, principal, or shareholder on an audit engagement team from receiving direct compensation as a result of his or her affirmative attempts to promote or cross-sell non-audit services to an audit client. Eliminating the financial incentives available in such situations would directly address the problem that the Commission has identified and maintain that auditor's independence, without causing serious, unintended consequences to firms or the accounting profession as a whole.
Our proposal references compensation based on the performance or sale of non-audit services. Is there a better test that permits partners to participate in the overall success of the firm while addressing the influence that such services might have on a particular auditor-client relationship? (67 Fed. Reg. at 76794)
The proposed rule should limit application of the compensation restriction to audit partners, principals, and shareholders on an audit engagement team who receive direct compensation for their affirmative attempts to promote or cross-sell non-audit services to an audit client.
The Commission has specifically discussed and requested comment on four proposed definitions: (1) "accountant"; (2) "accounting role"; (3) "financial reporting oversight role"; and (4) "audit committee."
We support the addition of the phrase "a registered public accounting firm" to the definition of "accountant" found in 17 C.F.R. § 210.2-01(f)(1) as being consistent with the Act's important goal of strengthening auditor independence.
2. Accounting Role
The definition of "accounting role" should remain consistent with the pre-existing rules and should not be changed. According to the Release, the definition of "accounting role" would be expanded from existing practice to include those in clerical positions. 153 We do not believe such a change in the definition is appropriate or necessary.
3. Financial Reporting Oversight Role
As a general matter, we would not object to separating the terms "accounting role" and "financial reporting oversight role" in the manner suggested in the proposed rule. We recognize that the proposed definition of a "financial reporting oversight role" does not expand upon the positions that currently fall within the definition of this phrase under existing practice, and that clerical positions would not fall within this definition. We do not believe, however, that the term "financial reporting oversight rule" should be used to identify those employees that are subject to the cooling-off period that Congress adopted in § 206 of the Act. Instead, the proposed rule should adhere to Congress's intent as plainly expressed in § 206 and limit the employment positions subject to the cooling-off provision to those that Congress has specified in the Act.
4. Audit Committee
The Commission is proposing to define "audit committee" in the rule as "a committee (or equivalent body) as defined in section 3(a)(58) of the Securities Exchange Act of 1934 (15 U.S.C. § 78c(a)(58))." 154 In turn, 15 U.S.C. § 78c(a)(58) provides: "The term `audit committee' means - (A) a committee (or equivalent body) established by and amongst the board of directors of an issuer for the purpose of overseeing the accounting and financial reporting processes of the issuer and audits of the financial statements of the issuer; and (B) if no such committee exists with respect to an issuer, the entire board of directors of the issuer." In § 205 of the Act, Congress required the addition of this definition to the Securities Exchange Act of 1934, and we therefore believe that this is an appropriate definition for the term "audit committee."
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We now turn to specific questions posed in the Release.
Some registrants may not have designated boards of directors or audit committees (e.g., benefit plans required to file Form 11-K). Does the definition of audit committee sufficiently describe who should serve in this capacity where such situations exist? If not, what additional guidance would be appropriate? (67 Fed. Reg. at 76795)
In its discussion of its proposed definitions, the Commission states that in cases in which a company does not have a board of directors - and thus no audit committee within the meaning of the proposed rule - the company is not thereby automatically exempted from the proposed requirements. 155 The Commission notes as an example that "some limited liability companies and limited partnerships that do not have a corporate general partner may not have an oversight body that is the equivalent of an audit committee." 156 In such instances, the Commission suggests that the
issuers should look through each general partner of the limited partnerships acting as general partner until a corporate general partner or an individual general partner is reached. With respect to a corporate general partner, the registrant should look to the audit committee of the corporate general partner or to the full board of directors as fulfilling the role of the audit committee. With respect to an individual general partner, the registrant should look to the individual as fulfilling the role of the audit committee. 157
We believe that this is appropriate guidance to fill any gap created in those circumstances in which a registrant does not have a board of directors, and is consistent with Congress's directive in § 205 of the Act. We remain of the view, however, that the existence of these types of situations where there is not a board of directors requires giving increased attention to other aspects of the proposed rule. For example, the pre-approval requirements imposed on audit committees could be particularly burdensome for audit committees of the corporate general partner, if the audit committee were not permitted to pre-approve the provision of permitted non-audit services pursuant to established pre-approval policies and procedures.
Our proposed rules exempt unit investment trusts and asset-backed issuers from the rule requiring the audit committee to approve auditing and non-auditing services. Should unit investment trusts and asset-backed issuers be subject to these requirements? If so, given that unit investment trusts and asset-backed issuers are not actively managed, who should be responsible for approving the auditing and non-auditing services? Are there other, similar entities that should be exempt from the pre-approval requirements? (67 Fed. Reg. at 76795)
Unit investment trusts and asset-backed issuers should not be subject to the rule. To the extent that the Commission has historically determined that there are no corporate governance abuses existing that would require these entities to form a board of directors, the implementation of the Act should not alter that long-standing judgment.
Are the existing definitions in Regulation S-X and Rule 2-01 of Regulation S-X of audit client, issuer, and subsidiary sufficiently clear? (67 Fed. Reg. at 76795)
Although the profession and issuers have been living with the existing definition of "audit client," the definition under the 2000 rulemaking is exceptionally broad and vague. The term "audit client" is defined to include "any affiliates of the audit client." 158 In turn, "affiliates of the audit client" is defined as: "(i) An entity that has control over the audit client, or over which the audit client has control, or which is under common control with the audit client, including the audit client's parents and subsidiaries; (ii) An entity over which the audit client has significant influence, unless the entity is not material to the audit client; (iii) An entity that has significant influence over the audit client, unless the audit client is not material to the entity; and (iv) Each entity in the investment company complex when the audit client is an entity that is part of an investment company complex." 159 The scope of the term "audit client" is thus both overly broad and unclear as to its reach. As discussed above, the breadth of this definition has important implications for several aspects of the proposed rule, and in these instances the term "audit client" should be replaced by the term "issuer," both to remain faithful to the intent of Congress, and to avoid the problems associated with the overly-broad definition of "audit client."
H. Communication With Audit Committees
Section 204 of the Act requires registered public accounting firms that perform audits for any issuer to provide the audit committee with timely reports on certain matters related to the audit. To implement this section, the Commission proposes adding § 210.2-07, which would require the accounting firm to report to the audit committee, prior to the filing of the audit report:
(1) All critical accounting policies and practices to be used; (2) All alternative treatments of financial information within Generally Accepted Accounting Principles that have been discussed with management of the issuer or registered investment company, including: (i) Ramifications of the use of such alternative disclosures and treatments; and (ii) The treatment preferred by the registered public accounting firm; (3) Other material written communications between the registered public accounting firm and the management of the issuer or registered investment company, such as any management letter or schedule of unadjusted differences. 160
The text of the proposed rule flows from the Act. In addition, as the Commission notes in its discussion of this proposal, § 204 of the Act and the proposed rules implementing it "largely codify the requirements under" U.S. GAAS. 161 We support the codification of the current requirements under U.S. GAAS. The U.S. GAAS requirements were previously crafted in consultation with the Commission and subjected to appropriate notice and comment procedures. The proposed rule change will cause little disruption or confusion, so long as it is implemented consistently with current U.S. GAAS requirements. The Commission should clarify that disclosures made consistent with current U.S. GAAS requirements will satisfy the Act and implementing regulations.
In light of the requirements for the CEO and CFO to certify information in the company's periodic filings, should the auditor be required to communicate information on critical accounting policies and practices and alternative accounting treatments to management as well as to the audit committee? (67 Fed. Reg. at 76796)
Management is responsible for developing and selecting critical accounting policies as well as evaluating alternative accounting treatments. Therefore, it is unnecessary to require the auditor to communicate such matters to management and actually runs counter to the limitations on auditors performing management functions.
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We now turn to addressing the various aspects of the proposed required communications with audit committees in the manner and order set forth in the Release.
1. Critical Accounting Policies and Practices
In discussing the types of matters that should be communicated to the audit committee under this proposed rule, the Commission directs auditors to the Commission's May 2002 proposed rules and its December 2001 cautionary advice regarding issuer disclosures in the Management's Discussion and Analysis ("MD&A") Section of the annual report. 162 The Commission notes that it "do[es] not propose to require that those discussions follow a specific form or manner, but [it] expect[s], at a minimum, that the discussion of critical accounting estimates and the selection of initial accounting policies will include the reasons why certain estimates or policies are or are not considered critical and how current and anticipated future events impact those determinations." 163 The Commission also expresses its "anticipat[ion] that the communications regarding critical accounting policies will include an assessment of management's disclosures along with any significant proposed modifications by the auditors that were not included." 164
We support the Commission's intention to require communications with audit committees that would track its prior proposed rules related to MD&A disclosures. We believe that such communications will assist audit committees in carrying out their duties. We also believe that this approach is a reasonable interim measure for the Commission to implement, before it is able to implement fully its previously proposed rules in this area.
When should the communication take place? (67 Fed. Reg. at 76796)
The proposed rule would require the disclosure to be made "prior to the filing of [the] audit report with the Commission." 165 We support such a timing requirement. As a matter of current practice, auditors often have these required communications with the audit committee prior to the issuance of the audit report. Accordingly, this aspect of the proposed rule is appropriate.
Should the auditor be required to provide the communication in writing? (67 Fed. Reg. at 76796)
The Release states that communications made by auditors to audit committees concerning critical accounting policies and practices pursuant to § 204 of the Act can be oral or written. 166 We support giving auditors the flexibility to communicate with their clients in the manner which those parties deem most useful, whether oral or written.
Is it appropriate that investment companies would be subject to the rules regarding critical accounting policies? (67 Fed. Reg. at 76796)
Yes. Communications to audit committees of investment companies should mirror those required communications to audit committees of other types of companies. However, because many investment complexes include investment companies with fiscal periods ending throughout the year, a communication of critical accounting policies for all the funds for which the audit committee serves on an annual basis should be sufficient. Communication of any significant modifications to the critical accounting policies should be made prior to the filing of the financial statements first impacted by the change.
2. Alternative Accounting Treatments
Section 204 of the Act provides in part that "all alternative treatments of financial information within generally accepted accounting principles that have been discussed with management officials of the issuer" must be reported to the audit committee. 167 The proposed rule provides the same. The Release also provides that auditors should communicate with the issuer's audit committee consistently with Statements on Auditing Standards, "Communication with Audit Committees" ("AU § 380"). We support the Commission's intention to codify the requirements under U.S. GAAS and believe that AU § 380 should serve as a guide for the appropriate communications to be made to an issuer's audit committee under the proposed rule.
Is the discussion of which accounting policies require communication with the audit committee sufficiently clear? (67 Fed. Reg. at 76797)
We recommend that the Commission clarify the scope of the reporting requirement for alternative accounting treatments to apply only to alternative treatments that were the subject of serious consideration and debate by the auditor and the management of the issuer. We endorse the principle that informed audit committees will better be able to fulfill their oversight role. To perform those responsibilities effectively, audit committees should be informed about those alternative accounting treatments that were the subject of significant debate or disagreement between the auditors and management, and not be burdened by receiving unnecessary communications concerning every possible alternative treatment that might have been mentioned at some point in the audit process. We recommend that the Commission clarify the proposal to reflect that principle.
Should additional matters be required to be communicated to the audit committee? If so, which matters? (67 Fed. Reg. at 76797)
As written, the proposed rule is consistent with the Act's directive, and we do not believe that any additional matters should be required to be communicated to audit committees.
Is it appropriate that investment companies would be subject to the proposed rules regarding alternative accounting treatments? (67 Fed. Reg. at 76797)
Yes. As noted above, communications to audit committees of investment companies should mirror those required communications to audit committees of other types of companies. However, as also noted above the communication should only be required on an annual basis for all the funds for which the audit committee serves.
3. Other Material Written Communications
The Act provides that auditors should report to audit committees "other material written communications between the registered public accounting firm and the management of the issuer, such as any management letter or schedule of unadjusted differences." 168 The Commission's proposed rule repeats this language, but its discussion adds additional examples of material written communications. These additional written communications include: management representation letters; reports on observations and recommendations on internal controls; schedule of material adjustments and reclassifications proposed, and a listing of adjustments and reclassifications not recorded, if any; engagement letters; and independence letters. 169 We support this proposed reporting requirement for other material written communications.
4. Timing of Communications
The proposed rule requires that these communications be made to the audit committee prior to the filing of the audit report. We support such timing. As a matter of current practice, auditors often have these required communications with the audit committee prior to the issuance of the audit report. Accordingly, this aspect of the proposed rule is appropriate.
Should these communications regarding critical accounting policies be required to be in writing? If so, why? (67 Fed. Reg. at 76798); and
Should these communications regarding alternative accounting treatments be required to be in writing? If so, why? (67 Fed. Reg. at 76798)
As noted above, we support the Commission's proposal to allow auditors and audit committees flexibility in choosing the form in which to communicate about these issues. Permitting the communications to be handled orally will support the Commission's goal of "facilitat[ing] more open dialogue between auditors and audit committees." 170
Are the appropriate entities included under the term "issuer" appropriate? If not, what entities should be included or excluded? (67 Fed. Reg. at 76798); and
This proposed rule would apply to "issuers." Should the Commission consider applying this rule to a broader population such as "audit clients" as defined in 2-01(f)(6) of Regulation S-X? Why or why not? (67 Fed. Reg. at 76798)
We believe that the entities included under the term "issuer" represent the appropriate group to which this aspect of the proposed rule should apply. As noted throughout this comment, Congress intended Title II of the Act to apply to issuers, and we support that considered judgment. Expanding beyond the definition of "issuer" would be inappropriate.
Is it appropriate that investment companies are required to make these communications to their audit committees? Why or why not? (67 Fed. Reg. at 76798)
Yes. Communications to audit committees of investment companies should mirror those required communications to audit committees of other types of companies.
I. Expanded Disclosure
1. Fees for Services Provided by the External Auditor
The Commission's proposals would increase the categories of professional fees that must be disclosed in the proxy statement to four, redefine those categories to encompass "Audit Fees," "Audit-Related Fees," "Tax Fees," and "All Other Fees," and increase the years of service covered by the disclosure from the most recent fiscal year to the two most recent fiscal years. Companies also would be required to describe the subcategories of services for which fees are disclosed under the captions "Audit-Related Fees" and "All Other Fees." 171
We support enhancing disclosure about audit and non-audit fees and we support the Commission's proposals to expand the categories of required fee disclosure to four, which would include two new categories - for "Audit-Related Fees" and "Tax Fees." We also support the Commission's proposal to expand the category of "Audit Fees" to cover services beyond those necessary to complete a financial statement audit or render an opinion or review report on a company's financial statements. We believe that investors should have access to useful, understandable information about services provided by a company's external auditor. Expanding the definition of "Audit Fees" to encompass services related to the issuance of comfort letters, and to statutory audits and other services that, as the Commission acknowledges in the Release, "generally only the independent accountant can reasonably provide," will make fee disclosure more meaningful and useful to investors. Removing these services from the "All Other Fees" category, where they must currently be disclosed along with non-audit services that are more likely to raise independence issues, will result in more accurate disclosure about the amount of non-audit services that companies obtain from their external auditors and provide a clearer picture about the provision of services that may implicate the auditor's independence.
As currently written, the proposal would require routine accounting advice provided to a client to be included in the "Audit-Related Fees" category. This type of service is rendered in direct connection with the audit and is often indiscernible from an audit service. As such, we believe that routine accounting advice should be disclosed in the "Audit Fees" category. Additionally, the final rule should clarify that services performed in connection with the report on internal controls as required under §§ 103 and 404 of the Act should be classified as "Audit Fees." Fees related to mergers and acquisitions as well as other completed transactions should also arguably be included in the "Audit Fees" category as they directly relate to the issues considered in the audit of the financial statements.
We also believe that fees for services related to the audit of a client's tax accrual work should be classified as "Audit Fees" rather than "Tax Fees." In discussing the types of fees that should be disclosed under the new "Tax Fees" category, the Commission suggests in the Release that fees for review of a company's tax accruals would constitute "Tax Fees" because, like other tax services, such as those relating to tax compliance, consultation and planning, "[t]he review of a registrant's tax accruals and reserves is a task that requires extensive knowledge about the audit client - knowledge that has already been assimilated by the audit and tax professionals." 172 The Commission explicitly states earlier in the Release, however, that "many engagements will require that an auditor review the tax accrual that is included in the financial statements. Reviewing tax accruals is part of audit services and is not, in and of itself, deemed to be a tax compliance service." 173 Consistent with the Commission's view that tax accrual work constitutes a part of audit services, we believe that fees for such work are more appropriately categorized as "Audit Fees" than "Tax Fees."
2. Audit Committee Approvals
The Commission also proposes to require disclosure of audit committee policies and procedures concerning pre-approval of audit and non-audit services to be provided by a company's external auditor; and of the percentage of fees in each of the Commission's proposed fee categories, other than "Audit Fees," that have been approved by the audit committee, disaggregated according to the mechanism used to obtain approval.
We support requiring detailed disclosure about pre-approval policies to afford investors insight into the factors that the audit committee considers in determining whether to engage the company's external auditor to perform particular services. This type of disclosure will provide investors with useful information that can assist them in assessing the quality of the audit committee's processes for, and the committee's diligence in, monitoring the independence of the external auditor.
We do not believe, however, that it would enhance the quality of disclosure available to investors to require additional detail about what percentage of the fees reported in each of the "Audit-Related Fees," "Tax Fees" and "All Other Fees" categories have been: (1) pre-approved under the audit committee's policies and procedures; (2) expressly approved by the audit committee in advance of engagements; and (3) (in those circumstances where the criteria for waiver of the pre-approval requirement have been met) approved prior to the completion of the audit engagement. We believe that percentage disclosures are inappropriate, whether in the aggregate or by category of fees, because these disclosures may have the unintended consequence of erroneously implying that audit committees that rely on permissible pre-approval policies are not monitoring independence issues as diligently as they should be.
In its rule proposal to implement the pre-approval requirement in § 202 of the Act, the Commission gives audit committees alternatives with respect to authorizing in advance the external auditor's performance of permissible non-audit services. The audit committee may expressly approve the engagement of the external auditor to perform a particular non-audit service prior to the engagement, or the audit committee can establish pre-approval policies and procedures and rely on those to the extent they cover a particular service, provided that the audit committee is informed on a timely basis of each such service.
The Commission nonetheless proposes to require disclosure about the percentage of fees approved pursuant to such policies, on the theory that this disclosure will "provide insight into the extent to which the audit committee takes an active, direct role in considering each category of non-audit fee engagements." 174 This rationale is inconsistent with the Commission's apparent policy determination, expressed in the alternative mechanisms that it has proposed for pre-approving non-audit services, that pre-approval policies and case-by-case pre-approvals of particular services are equally acceptable means of satisfying the statutory requirement. Mandating disclosure about how particular types of non-audit services and fees are approved may imply, and create the misimpression in the minds of investors, that audit committees relying on pre-approval policies have somehow been remiss in their duties for not considering and explicitly approving in advance each engagement of the external auditor to provide non-audit services. If a company discloses that 70% of the fees included under the "All Other Fees" caption in its proxy statement were approved pursuant to the audit committee's policies and procedures, for example, we do not believe that would necessarily support the conclusion that the audit committee is not taking an "active, direct role" in monitoring independence issues and considering the provision of non-audit services by the external auditor. To the contrary, reliance on a pre-approval policy may simply reflect the existence of a carefully crafted policy that is appropriately tailored to a company's business needs. Furthermore, in an environment where audit committees are expected to assume increasing responsibilities, it is entirely understandable that they would seek to use their resources prudently by developing policies and procedures to address recurring issues.
For these reasons, we believe that the Commission's proposals to require percentage disclosures of fees tied to different audit committee pre-approval mechanisms could result in disclosure that is affirmatively misleading to investors and that will foreseeably undermine the goal of audit committee flexibility that other parts of the Commission's rule are designed to serve.
* * *
With these general comments as background, we turn now to specific questions posed in the Release.
Would expansion of the proxy disclosure of professional fees paid to the independent auditor from three categories to four provide more useful information to investors? (67 Fed. Reg. at 76800)
We support the Commission's proposal to expand the current proxy disclosure to four categories of professional fees and to create two new fee categories, consisting of "Audit-Related Fees" and "Tax Fees." We believe that the use of additional categories and subcategories will provide more useful information to investors by giving them more detailed data presented in a more organized fashion, making it easier for investors to understand the amounts and kinds of services, other than audit services, that a company obtains from its external auditor.
Are the new categories of disclosure appropriate? Are they well defined, or should they be more accurately defined? Should there be additional (or fewer) categories? (67 Fed. Reg. at 76800)
Although we support the Commission's proposal to institute four categories of fee disclosures, we believe that the Commission should provide further guidance on the types of fees to be included in each of the four categories. As an initial matter, we believe that fees for tax accrual work should be classified as "Audit Fees" rather than "Tax Fees." As discussed above, the Commission states explicitly in the Release that reviewing tax accruals is part of audit services and acknowledges that such services are part of audit engagements. Because reviewing the tax accrual included in the financial statements is closely related to the audit of the financial statements and is often part of the audit engagement, we believe that fees for tax accrual work are more appropriately considered part of "Audit Fees."
We also believe that companies would benefit from additional interpretive guidance on when services are "reasonably related to the performance of the audit or the audit or review of the registrant's financial statements" such that they should be disclosed under the category of "Audit-Related Fees." Although the Commission does offer some guidance in the Release, additional examples and guidance may be appropriate for services that arguably fall into more than one category.
Is disclosure of two years of fees appropriate? Should the proposed additional fee disclosures be expanded to three years or remain at one year? (67 Fed. Reg. at 76800)
We support disclosure of two years of fees. However, we believe that it is imperative that the requirement be prospective only and that the Commission, here as elsewhere, provide for necessary transition periods.
Audit committees should be given sufficient time to establish carefully considered policies, and companies should have sufficient time to craft appropriate disclosure about those policies and to address the Commission's new requirements in their disclosure controls and procedures.
Should companies be required to provide the information in their quarterly reports? Should it be required that the information be included in other filings such as Form 10-Q or 10-QSB? (67 Fed. Reg. at 76800)
We do not believe that companies should be required to provide disclosure about audit and other fees paid to the external auditor in quarterly reports. Such disclosures would be most meaningful when they include fees related to the entire fiscal year due to the fact that the timing in which audit services and non-audit services are performed may by chance distort the relationships among the fees. Information on a quarterly basis would not be meaningful or helpful to investors.
Should registered investment companies be required to provide the information in their semi-annual report to shareholders on proposed Form N-CSR? (67 Fed. Reg. at 76800)
As discussed above, we believe that disclosure about fees paid for audit and other services provided by a company's external auditor would be most meaningful if provided on an annual basis. We do not believe that there is any significant benefit to requiring fee disclosure by investment companies on a semi-annual basis, particularly given the volume of information that shareholders receive throughout the year.
Registered investment companies are required to provide disclosure of audit fees billed for the registrant only, but are required to disclose other types of fees in the aggregate for the registrant, its investment adviser, and certain other parties. Is this appropriate, or should we also require disclosure of audit fees on an aggregate basis? In the alternative, should we require disclosure of audit-related fees or any other fees for the registrant only and not on an aggregate basis? (67 Fed. Reg. at 76800)
We believe that the most meaningful information for investors would result from requiring disclosure about "Audit-Related Fees" and any other fees paid to the external auditor by: (1) an investment company; (2) any sister investment companies with the same audit committee as the investment company; (3) the investment adviser to the investment company; and (4) any entity controlled by, or under common control with, the investment adviser to the investment company. Because the audit committee is responsible for engaging the external auditor, disclosure about fees paid by the entities listed above would provide the most meaningful information to investors on the services provided by the external auditor.
If we adopt such a requirement, should we require or permit registrants to recalculate and report fees already disclosed for more than two years so that all fee information is consistently reported and available? (67 Fed. Reg. at 76800)
Registrants should be permitted but not required to recalculate and report previously disclosed fees under the new method of disclosure.
We endorse the shared goal of Congress, the President, and the Commission ensuring that auditors maintain appropriate independence. We also share the goals of maintaining and enhancing investor confidence in the integrity of issuers' financial statements and of reducing the risk of audit failures. In that spirit, we applaud the considered judgment embodied in the proposed rule. Some aspects of the proposed rule require revision and additional attention from the Commission. The Act imposes an expedited rulemaking environment that is unfortunately not conducive to detailed comment and analysis, or deliberate consideration of comments by the Commission. The issues raised in this comment should be addressed, and the Commission should achieve greater clarity in implementing the congressional policy judgments, and refrain - at least in this rulemaking - from exceeding the congressional mandate embodied in the Act.
If you have any questions, please contact Robert J. Kueppers at (203) 761-3579.
Very truly yours,
/s/ Deloitte & Touche LLP
cc: The Honorable Harvey L. Pitt, Chairman of the Securities and Exchange Commission
The Honorable Paul S. Atkins, Commissioner
The Honorable Roel C. Campos, Commissioner
The Honorable Cynthia A. Glassman, Commissioner
The Honorable Harvey J. Goldschmid, Commissioner
Proposed Transition/Effective Dates for Independence Rules
The Sarbanes-Oxley Act of 2002 requires that the Commission finalize rules relating to Title II on or before January 26, 2003. The implementation provisions and effective dates of the finalized rules are to be determined by the Commission. The choice of effective dates should serve to implement the Act while allowing issuers, audit committees, and audit firms sufficient time to implement the changes in an orderly fashion. We suggest a tiered approach for transition and implementation of new rules, as follows:
- As a general effective date, we recommend 90 days after the final rule is published in the Federal Register, as modified for the following:
- Certain elements of the rule should be given more time for completion of engagements in process;
- Specific elements of the rule will need additional time given their unique nature or implementation complexity.
The table below sets forth our specific recommendations, including some alternatives:
|Section or Element of the Rule
||Recommended Effective Date(s)
|Conflict of Interest - Act, § 206
||Effective 90 days after publication in the Federal Register, for positions taken after that date. If the final rule applies the cooling-off provision to more professionals than those set forth in the Act, however, a one-year transition period would be appropriate.
Would apply to partners and employees who have already left the firm as of the effective date of the rule and may seek employment with a client at a later date.
Former firm personnel already employed as of the effective date are grandfathered even if they are promoted into a position covered by the rule after the effective date of the new rule.
Former firm personnel who assume a financial reporting oversight role of an issuer as a result of an issuer merger are grandfathered.
|Services Outside the Scope of Practice of Auditors - Act, § 201
||Effective 90 days after publication in the Federal Register.
The Commission should allow for completion of engagements/contracts in process as of the date the rules relating to all permissible non-audit services are published, provided they are not materially modified. This permitted completion should in no event exceed 18 months, even for multi-year arrangements in existence upon publication of the rule, except for grandfathered expert services.
|Partner Rotation - Act, § 203
||For the lead audit partner, new shorter rotation requirements should take effect for client fiscal years beginning on or after December 15, 2003.
For concurring reviewers, the five-year clock should begin with any concurring reviews performed in client fiscal years beginning on or after December 15, 2003.
For additional partners, if any, subject to rotation (beyond the two positions described in the Act), the five-year clock should begin with services performed in connection with audits in client fiscal years beginning on or after December 15, 2003.
Special transition rule for lead audit partner and concurring reviewer in the foreign private issuer context.
|Audit Committee Administration of the Engagement (pre-approval) - Act, § 202
||For new services only, effective 90 days after publication of the final rule in the Federal Register. Services in process are grandfathered.
||Effective with the firm's first full fiscal year that begins more than 90 days after publication of the final rule in the Federal Register.
|Communication with Audit Committees - Act, § 204
||Should be required beginning with audit reports relating to audits of financial statements for fiscal periods ending after December 15, 2003.
|Expanded Proxy Disclosure
||Encourage, but do not require, application of the new format in proxy statements filed after the final rule is published. Require application of the new format for proxy statements (or periodic reports for those who do not file proxy statements - e.g., foreign private issuers) for periods with fiscal year ends of June 30, 2003 and thereafter. If the Commission retains pre-approval percentage breakdowns, provide another year for that requirement, given that the data would need a year of experience with pre-approval to permit the disclosure.
|1|| The Release can be found in the Federal Register at 67 Fed. Reg. 76780 (Dec. 13, 2002).
|2|| In the 2000 rule, the Commission defined independence as: (1) independence in fact - or when an "accountant is not . . . capable of exercising objective and impartial judgment on all issues encompassed within the accountant's engagement"; and (2) independence in appearance - or when "a reasonable investor with knowledge of all relevant facts and circumstances would conclude that the accountant is not capable of exercising objective and impartial judgment on all issues encompassed within the accountant's engagement." 17 C.F.R. § 210.2-01(b). The definition of independence set forth in the 2000 rule remains unchanged by the proposed rule.
|3|| See Act, § 208.
|4|| See, e.g., 67 Fed. Reg. at 76803 ("We request comments on all aspects of this cost-benefit analysis, including the identification of any additional costs or benefits. We encourage commenters to identify and supply relevant data concerning the costs or benefits of the proposed amendments.").
|5|| Compare id. at 76804 ("certain of these proposals would go beyond the specific provisions of the Act").
|6|| Id. at 76783.
|7|| Id. at 76783-84.
|8|| See also Speech by SEC Commissioner Paul S. Atkins: Remarks Before the Investment Company Institute 2002 Securities Law Developments Conference (Dec. 9, 2002) ("Congress in Sarbanes-Oxley endorsed the SEC's rules in this area.").
|9|| Although the Commission has apparently concluded that "Congress did not intend to codify unchanged the current auditor independence rules," that conclusion is based upon a floor statement, and does not address the substantial contrary evidence that we raise here. 67 Fed. Reg. at 76784. Indeed, the Release broadly relies on a statement from Senator Sarbanes to conclude that Congress intended "to eliminate categorical exceptions and exemptions" from the non-audit services prohibited by the Act. Senator Sarbanes' statement, however, was actually a narrow response directed at Senator Gramm's argument that the Act should have allowed the Public Company Accounting Oversight Board, with the agreement of the Commission, to grant firms blanket waivers from the application of § 201's ban on certain services (as opposed to allowing such exemptions on a case-by-case basis). See 148 Cong. Rec. S7353 (daily ed. July 25, 2002) (Statement of Sen. Gramm); 148 Cong. Rec. S7363 (Statement of Sen. Sarbanes). Senator Sarbanes was not addressing the issue of whether Congress intended to change the current auditor independence rules, and did not suggest that those existing standards (including their exceptions) should be altered.
|10|| Young v. Community Nutrition Inst., 476 U.S. 974, 983 (1986) (Congress's failure to alter existing FDA regulatory scheme ratified FDA interpretation).
|11|| Id. (quoting NLRB v. Bell Aerospace Co., 416 U.S. 267, 275 (1974)).
|12|| McDermott Int'l, Inc. v. Wilander, 498 U.S. 337, 342 (1991).
|13|| Indeed, the Commission justified its 2000 rule in part on its power to define "accounting, technical and trade terms" under 15 U.S.C. §§ 77s(a), 78c(b), 79t(a), and 80a-37(a), and thus the services were clearly terms of art that now embody an accepted meaning. 65 Fed. Reg. 76008, 76012 n.34 (Dec. 5, 2000).
|14|| Markup on the Public Company Accounting Reform and Investor Protection Act of 2002 Before the S. Comm. on Banking, Housing and Urban Affairs, 107th Cong. 34 (2002) (unofficial transcript dated June 18, 2002) (statement of Sen. Bunning) (emphasis added).
|15|| See Sen. Amend. No. 4216 (2002).
|16|| See Crosby v. National Foreign Trade Council, 530 U.S. 363, 378 n.13 (2000).
|17|| S. Rep. No. 107-205, at 18.
|18|| Notably, the congressional directive in § 208 that the Commission "carry out" the subsections added by Title II stands in marked contrast to the directive contained in § 307 of the Act. In § 307, Congress directs the Commission to "issue rules . . . setting forth minimum standards of professional conduct for attorneys . . ., including a rule" prescribed by Congress. With the exception of the one rule prescribed by Congress, the Commission is otherwise open to establish the proper minimum standards that reflect its policy choices because of the general grant of rulemaking power found in § 307. Thus, had Congress intended that the Commission "go beyond" aspects of Title II, Congress could have written § 208 more like § 307. The fact that it chose not to do so strongly counsels in favor of the Commission's limiting its final rule on auditor independence to regulations that "carry out" Congress's considered legislative judgments contained in Title II.
|19|| The "three principles" are "that an auditor cannot (1) audit his or her own work, (2) perform management functions, or (3) act as an advocate for the client." 67 Fed. Reg. at 76783. The proposed rule's invocation of these three principles should not be used to depart from prior practice under the 2000 rule. Although the Commission did not include them as part of the final 2000 rule, the Commission identified four principles in a preliminary note to Rule 2-01 that are intended to serve as guidance for independence analysis. As acknowledged in the Release, those "four principles" are substantively the same as the "three principles" proposed by the Release. See 67 Fed. Reg. 76790 n.64. Thus, services that satisfy the "four principles" should be deemed to satisfy the "three principles."
|20|| Proposed Rule, 17 C.F.R. § 210.2-01(c)(4).
|21|| S. Rep. No. 107-205, at 18 (2002) (emphases added), quoted in 67 Fed. Reg. at 76783.
|22|| 148 Cong. Rec. S7363 (daily ed. July 25, 2002) (statement of Sen. Sarbanes) (emphasis added), quoted in 67 Fed. Reg. at 76783.
|23|| Congress's own use of the "three principles" can be overstated, however. For example, and as noted above, the list of prohibited non-audit services that Congress included in the Act tracks the 2000 rule and even follows the same order used in the 2000 rule, and thus does not seem to be the product of an independent consideration of the "three principles."
|24|| See SEC Codification of Financial Reporting Policies (CCH) § 601.03, ¶3853 (listing factors for audit committee consideration of non-audit services including: (1) whether the service is being performed principally for the audit committee; (2) the effects of the service, if any, on audit effectiveness or on the quality and timeliness of the entity's financial reporting process; (3) whether the service would be performed by a specialist who ordinarily also provides recurring audit support; (4) whether the service would be performed by audit personnel and, if so, whether it will enhance their knowledge of the entity's business and operations; (5) whether the role of those performing the service would be inconsistent with the auditor's role; (6) whether the audit firm's personnel would be assuming a management role or creating a mutuality of interest with management; (7) whether the auditors, in effect, would be auditing their own numbers; (8) whether the project must be started and completed very quickly; (9) whether the audit firm has unique expertise in the service; (10) the size of the fees for the non-audit services).
|25|| S. Rep. No. 107-205, at 19-20 (emphases added).
|26|| Id. at 18; 148 Cong. Rec. S7363 (daily ed. July 25, 2002) (statement of Sen. Sarbanes), quoted in 67 Fed. Reg. at 76783. In this connection, as developed above, it is significant that Congress legislated against the backdrop of the 2000 rule, which (to the considerable extent that it overlaps with the list in the Act) serves as a definitive guide for determining those non-audit services that are prohibited.
|27|| See, e.g., 67 Fed. Reg. at 76788 ("We recognize that there may be implications for some foreign registrants from this proposal. . . . Accordingly, we are interested in understanding the implications of this proposal on foreign private issuers.").
|28|| A foreign associated firm of Deloitte & Touche LLP in a small European country currently has eight partners that serve a large, multinational conglomerate, all of whom would be required to rotate under the Commission's proposed rule. There are four other partners with the foreign associated firm that maintain, or could attain through training, the requisite industry expertise, technical expertise, and language skill. Therefore, even if these four partners were reassigned, at least four partners would have to transfer into the office.
|29|| See, e.g., id. at 76792 (partner rotation).
|30|| See, e.g., Act § 301 (specifying that audit committees have the responsibility for appointment, compensation, and oversight of the work of the company's audit firm).
|31|| 67 Fed. Reg. at 76808.
|32|| In other areas where the proposed rule would impose costs not required by the Act, the Release appears to underestimate the amount of such costs. For example, the Release estimates that the proposed enhanced disclosures about the services provided by auditors to registrants would result in only an additional 30 minutes per issuer for outside legal work. See 67 Fed. Reg. at 76807, 76808 (estimating that, "on average," the additional costs imposed on each issuer in connection with the proposed disclosure of fees, audit committee policies and procedures, and percentage of fees pre-approved by the audit committee would be "two additional burden hours," of which only 25%, or 30 minutes, are expected to be the result of increased outside legal work in reviewing the proposed disclosures). Based on our experience, we believe that estimate is unrealistically low.
|33|| 67 Fed. Reg. at 76800.
|35|| See id. at 76804. Moreover, Congress has required the Commission to "issue final regulations to carry out" Title II by January 26, 2003. Act, § 208 (emphasis added). Because the areas in which the Commission has proposed to "go beyond" the Act's requirements are not efforts to "carry out" Title II, we do not believe that the 180-day rulemaking period would apply to those aspects of the proposed rule. In short, there should be no hurry to implement rules that do more than what the Act requires, and a longer transition period in such instances is eminently reasonable.
|36|| Proposed Rule, 17 C.F.R. § 210.2-01(c)(2).
|37|| Compare Act, § 206, with Proposed Rule, 17 C.F.R. § 210.2-01(c)(2)(iii).
|38|| 17 C.F.R. § 210.2-01(f)(6).
|39|| Id. § 210.2-01(f)(4).
|40|| 67 Fed. Reg. at 76781-82; see also Proposed Rule, 17 C.F.R. § 210.2-01(f)(3)(ii).
|41|| Act, § 206; see S. Rep. No. 107-205, at 22.
|42|| 67 Fed. Reg. at 76804.
|43|| E.g., Ord. N_ 5.620/300, Sept. 9, 1997, issued by the Chilean Labor Office.
|44|| 17 C.F.R. § 210.2-01(b).
|45|| Compare 18 U.S.C. § 207(e)(1) (prohibiting former Members of Congress from making, with the intent to influence, any communication to current Members, employees, or legislative staff of Congress within one year of leaving office).
|46|| Act, § 206.
|47|| 17 C.F.R. § 210.2-01(f)(7).
|48|| 67 Fed. Reg. at 76782.
|49|| See Act, § 201(a). The Act also includes a category for other services that the Public Company Accounting Oversight Board determines are impermissible.
|50|| 67 Fed. Reg. at 76784.
|51|| S. Rep. No. 107-205, at 18 (emphases added), quoted in 67 Fed. Reg. at 76783.
|52|| S. Rep. No. 107-205, at 19-20.
|53|| 67 Fed. Reg. at 76784.
|54|| See S. Rep. No. 107-205, at 18 (explaining that the potential for an auditor to audit its own work exists when an auditor "provid[es] bookkeeping services, financial information systems design, appraisal or valuation services, actuarial services, and internal audit outsourcing services to an audit client") (emphases added).
|55|| See, e.g., 17 C.F.R. § 210.2-01(d) (providing the ability to cure potential independence violations in certain limited circumstances where an appropriate quality control system is in place).
|56|| See 17 C.F.R. § 210.2-01(c)(4)(i).
|57|| 67 Fed. Reg. at 76784-85.
|58|| Id. at 76785.
|59|| See Policy Statement: Establishment and Improvement of Standards Related to Auditor Independence, Release Nos. 33-7993, 34-44557, 66 Fed. Reg. 38149, 38151 (July 23, 2001) ("The Commission will continue to consider . . . ISB Interpretation . . . 99-1 to have substantial authoritative support for the resolution of auditor independence issues.").
|60|| ISB Interpretation 99-1, at 2-3.
|61|| See 65 Fed. Reg. 76008, 76085.
|62|| Id. at 76046 (footnote omitted).
|63|| 67 Fed. Reg. at 76790.
|64|| See 65 Fed. Reg. at 76046 ("As the rule text and this Release make clear, accountants will continue to be able to provide tax services to audit clients.").
|65|| 67 Fed. Reg. at 76786.
|66|| 17 C.F.R. § 210.2-01(c)(4)(iii)(B)(2).
|67|| 65 Fed. Reg. at 76046 (footnote omitted).
|68|| 67 Fed. Reg. at 76813.
|69|| Id. at 76787.
|71|| 65 Fed. Reg. at 76045.
|72|| 67 Fed. Reg. at 76813.
|73|| Id. at 76787.
|75|| See id. at 76787-88.
|76|| See id. at 76790.
|77|| Id. at 76788 ("The proposed rule is substantially the same as the Commission's existing rule related to the provision of these types of services to audit clients.").
|78|| See 65 Fed. Reg. at 76049-50 n.415 ("[The staff decided against] an enforcement action under the Investment Advisers Act where an accounting firm did not register as an investment adviser but an affiliated registered investment adviser provided investment advisory services. The staff permitted the affiliate to publish a newsletter with financial planning information, provided the newsletter does not recommend any specific industry sectors or securities, to identify categories of mutual funds that satisfy an advisory client's investment objectives, and to recommend two or more mutual funds in each category. When an advisory client wants more specific advice, the investment advisory affiliate accountant will provide a client with a list of two or more investment advisers or broker-dealers that meet certain predetermined criteria, provided that the accountant does not receive any fee or other economic benefit from the mutual funds, investment advisers or broker-dealers recommended. The advisory affiliate will disclose to advisory clients that the recommended mutual funds, investment advisers, or broker dealers may include audit clients.").
|79|| Id. at 76049-50.
|80|| See 67 Fed. Reg. at 76788.
|81|| See id. at 76789.
|82|| 65 Fed. Reg. at 76051.
|83|| See id; 67 Fed. Reg. at 76784 (stating that "tax services would seem to be among the services that are provided by an `expert.' However, it is clear that Congress did not wish to ban . . . tax services, if the audit committee approves them in advance.").
|84|| Id. at 76789.
|85|| Id. (footnote omitted).
|86|| See Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934 and Commission Statement on the Relationship of Cooperation to Agency Enforcement Decisions, Accounting and Auditing Enforcement Release No. 1470 (Oct. 23, 2001).
|87|| 67 Fed. Reg. at 76789.
|88|| Id. at 76788.
|89|| Act, § 201 (emphases added).
|90|| 67 Fed. Reg. at 76790.
|92|| See S. Rep. No. 107-205, at 51 ("A registered public accounting firm would be permitted to perform for a public company audit client any other non-audit service, including tax services, that the public company's Audit Committee pre-approves in accordance with the requirements adopted in Section 202.").
|93|| Bloomberg News Service, Oxley Says Governance Law Does Not Seek to Ban Tax Services (Dec. 9, 2002); see also Judith Burns, Rep. Oxley Hails Snow Appointment As `Strong Signal,' Dow Jones News Service (Dec. 9, 2002).
|94|| 67 Fed. Reg. at 76790.
|96|| See, e.g., Cassell Bryan-Low, Audit Firms May Face Tax-Service Sales Ban-SEC Proposal to Curtail Business to Some Clients Would Hurt Revenue Line, Wall St. J., at A2 (Dec. 4, 2002).
|97|| 67 Fed. Reg. at 76790.
|98|| See, e.g., H.R. Rep. No. 107-414, at 17 (2002) ("[A] broader ban on nonaudit services could undermine rather than improve audit quality, since certain such services can improve the auditor's understanding of the audit client's business activities. Likewise, a broader ban could reduce corporate efficiencies and impair auditing firms' ability to attract and retain tax and other nonaudit personnel who are essential to the audit process.").
|99|| 67 Fed. Reg. at 76790.
|100|| See Am. Inst. of Certified Pub. Accountants, SEC Practice Section Reference Manual § 1000.08(e)(1), at 1005 (2001) (hereinafter "Reference Manual").
|101|| See, e.g., 148 Cong. Rec. S6694-95 (daily ed. July 12, 2002) (statement of Sen. Carper).
|102|| Although the text contains the disjunctive "or," it appears that Congress intended to require the rotation of both "the lead partner and [the] review partner." S. Rep. No. 107-205, at 21 (emphasis added).
|103|| The committee report is a particularly authoritative indication of legislative intent in this instance, as neither the full Senate nor the conference committee made any substantive change in the text of § 203 as written by the Banking Committee; the committee report analyzes essentially the same language that was ultimately enacted. See S. 2673, 107th Cong. § 203 (2002); 148 Cong. Rec. S6786 (daily ed. July 15, 2002). The conference committee struck some repetitive text from § 203 and added a parenthetical clarifying that the requirements applicable to "lead" partners also cover "coordinating" partners.
|104|| S. Rep. No. 107-205, at 51 (emphasis added).
|105|| Id. at 21 (emphasis added).
|106|| See id.
|107|| 67 Fed. Reg. at 76791.
|108|| See S. Rep. No. 107-205, at 21.
|109|| See Proposed Rule, 17 C.F.R. § 210.2-01(c)(6)(1).
|110|| The appropriate period for rotation of these partners should be in the range of seven to ten years. As a practical matter, facts and circumstances, such as the significance of the subsidiary, the level of interaction with senior management and other factors, should dictate the appropriate period within this range. We believe that firms are capable of applying the appropriate period in these circumstances, which may often result in rotation in the low end of the range.
|111|| Act, § 203.
|112|| E.g., S. Rep. No. 107-205, at 21, 51.
|113|| Id. at 14 (emphasis added).
|114|| Significantly, audit partners serving major subsidiaries were not subject to the seven-year rotation requirement under pre-existing professional practice, which applied only to lead partners.
|115|| See 67 Fed. Reg. at 76806.
|116|| S. Rep. No. 107-205, at 21 (quoting former SEC chairman Arthur Levitt).
|117|| See id.; Act, § 207.
|118|| 67 Fed. Reg. at 76791 n.72.
|120|| Id. at 76791.
|121|| Id. at 76800.
|122|| Id. at 76791.
|123|| Id. at 76806.
|124|| As of December 31, 2001, the Commission reported 1344 companies were foreign private issuers, of which 503 were registrants from Canada. The two countries with the next largest number of foreign private issuers are the United Kingdom and Israel, with 143 and 91 foreign private issuers, respectively. The remaining 56 countries average 10.8 foreign private issuers per country. See Report: SEC, Office of Int'l Corporate Finance, Div. of Corporate Finance, Foreign Companies Registered and Reporting with the U.S. Securities and Exchange Commission December 31, 2001.
|125|| In some smaller foreign jurisdictions, one result of the lack of qualified audit partners in any single foreign audit firm or foreign associated firm will likely be the aggregation of qualified audit partners into a single firm via an acquisition or merger. Such consolidations may be an unintended consequence of the proposed rule, which may in turn reduce competition and the ability to cure independence conflicts.
|126|| S. Rep. No. 107-205, at 14.
|127|| 67 Fed. Reg. at 76791.
|128|| Two readily foreseeable scenarios are that some smaller accounting firms, with only a few issuer clients, will cease to audit public issuers; or that smaller firms may form loose associations with other similarly sized firms to manage the burden of rotation. Either scenario would impose dramatic changes on the accounting profession and on issuers.
|129|| 67 Fed. Reg. at 76806.
|130|| Reference Manual § 1000.08(e), at 1004-05.
|131|| 67 Fed. Reg. at 76791.
|132|| Under the Act, audit committee members must be independent directors, except as exempted by the Commission. See Act, § 301.
|133|| Proposed Rule, 17 C.F.R. § 210.2-01(c)(7)(i).
|134|| Proposed Rule, 17 C.F.R. § 210.2-01(c)(7)(ii)(B).
|135|| 67 Fed. Reg. at 76793.
|137|| See, e.g., Proposed Rule, 17 C.F.R. § 210.14a-101(9)(e).
|138|| See also, infra, Section III.H ("Expanded Disclosure").
|139|| 67 Fed. Reg. at 76806.
|140|| See "Audit Committees: Milstein Agrees Sarbanes-Oxley Raises Potential Liability of Audit Committees," 34 BNA Securities Regulation & Law Report 47, at 1968 (Dec. 9, 2002) (reporting statements of a "well-known plaintiffs' attorney" that the pre-approval requirements leave audit committees more exposed to liability than in the past and quoting him as saying, "I don't know who in his right mind is going to go on an audit committee").
|141|| 67 Fed. Reg. at 76793.
|142|| S. Rep. No. 107-205, at 19-20.
|143|| See Act, § 202.
|144|| S. Rep. No. 107-205, at 2, 14 (emphasis added).
|145|| We note that this would require at least one change in the proposed pre-approval rules: Proposed Rule 17 C.F.R. § 210.2-01(c)(7)(ii)(C)(1) provides that a non-audit service falls within the proposed rule's de minimis exception based on "the total amount of revenues paid by the audit client to its accountant." Id. (emphasis added). It should refer, instead, to the revenues paid by the issuer.
|146|| See Proposed Rule: Standards Relating to Listed Company Audit Committees (Jan 8, 2003), http://www.sec.gov/rules/proposed/34-47137.htm.
|147|| Proposed Rule, 17 C.F.R. § 210.2-01(c)(8).
|148|| See 67 Fed. Reg. at 76794, 76811.
|149|| See, e.g., C.I.R. v. Tower, 327 U.S. 280, 286 (1946) (explaining that "a `partnership' is generally said to be created when persons join together their money, goods, labor, or skill for purpose of carrying on a trade, profession, or business, and when there is community of interest in profits and losses"); Black's Law Dictionary 1142 (7th ed. 1999).
|150|| That approach would be consistent with the suggested intention of the proposal. See, e.g., 67 Fed. Reg. at 76780 ("The proposed rules also address the possibility of any partner, principal or shareholder who is a member of the audit engagement team being unduly influenced by financial incentives to sell non-audit services to the audit client." (emphasis added)).
|151|| 17 C.F.R. § 210.2-01(b).
|152|| 67 Fed. Reg. at 76794 n.80 (emphasis added).
|153|| See id. at 76795.
|154|| Proposed Rule, 17 C.F.R. § 210.2-01(f)(17).
|155|| See 67 Fed. Reg. at 76795.
|158|| 17 C.F.R. § 210.2-01(f)(6).
|159|| Id. at § 210.2-01(f)(4).
|160|| Proposed Rule, 17 C.F.R. § 210.2-07(a).
|161|| 67 Fed. Reg. at 76796.
|162|| See 67 Fed. Reg. at 76796. The Commission's May 2002 proposed rulemaking is located at 67 Fed. Reg. 35620 (May 20, 2002). The Commission's December 2001 Cautionary Advice Regarding Disclosure is located at 66 Fed. Reg. 65013 (Dec. 17, 2001).
|163|| 67 Fed. Reg. at 76796.
|165|| Proposed Rule, 17 C.F.R. § 210.2-07(a).
|166|| See 67 Fed. Reg. at 76797.
|167|| Act, § 204.
|169|| See 67 Fed. Reg. at 76797.
|170|| Id. at 76796.
|171|| See 67 Fed. Reg. at 76798.
|172|| 67 Fed. Reg. at 76798.
|173|| 67 Fed. Reg. at 76790 (emphasis added).
|174|| 67 Fed. Reg. at 76799.