Ernst & Young LLP
5 Times Square
New York, New York 10036
Phone: 212 773 3000
VIA HAND-DELIVERY AND ELECTRONIC FILING
January 6, 2003
Jonathan G. Katz, Secretary
United States Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549-0609
File No. S7-49-02 Proposed Rule: Strengthening the Commission's Requirements Regarding Auditor Independence
Dear Mr. Katz:
Ernst & Young LLP ("Ernst & Young") is pleased to submit its comments on the SEC's proposed rule implementing Title II of the Sarbanes-Oxley Act ("the Act").1
As a general matter, Ernst & Young supports the rule proposal. We believe that the rule will significantly help restore investor trust and confidence in the capital markets.
Ernst & Young supported the imposition of significant restrictions on consulting services when the SEC proposed new auditor independence rules in 2000. We continue to back such rulemaking efforts because it is important for investor confidence to eliminate the risk of both an actual impairment of auditor independence and the appearance of impairment.2 We were the first major accounting firm to sell its consulting practice (in May 2000),3 and in 2000 worked closely with the Commission and Staff to develop an independence rule that, although it ultimately did not go as far as we had urged in prohibiting accounting firms from selling consulting services, made a number of important improvements in the then-existing independence restrictions.4
Congress struck the right balance in the Act, by providing a role for both government and marketplace regulation. To reach the appropriate balance, Congress elevated the oversight role and responsibility of audit committees of corporate boards of directors. True to both the spirit and the letter of the Act, there is significant public policy benefit from audit committees being a decisive force in the service relationship with the audit firm.
The audit committee, as a body that is independent of management, now has the power to obtain outside expertise as needed, exercise authority over the audit firm, and pre-approve all audit firm services. In carrying out its responsibilities, it is essential that, among other things, audit committees understand the scope of permissible and prohibited non-audit services. We note in our comments areas where we believe the proposed rule could confuse audit committees and, in doing so, jeopardize audit quality.
Summary of Comments:
Our comments focus on three areas: proposals that would undermine rather than improve audit quality; proposals that are outside of or contrary to the Act's intent; and proposals that present practical implementation problems for auditors and audit committees that could frustrate the intent of the Act. Several issues are particularly significant: (1) statements in the proposing release regarding possible restrictions on the provision of tax services (which would be contrary to the Act); (2) the proposed partner rotation requirements (which would reach much further than the Act and would undermine audit quality); and (3) the proposed limit on partner compensation from non-audit services (which is not addressed in the Act and would, as drafted, be unworkable).
Tax Services - Congress did not prohibit accounting firms from performing tax services - a bedrock accounting firm activity that long pre-dates the federal securities laws - for audit clients. In fact, it did just the opposite. In Section § 10A(h) of the Securities Exchange Act (added by Section 201 of the Act), Congress singled out tax services as the only non-audit services that are expressly permitted, subject to audit committee pre-approval.
The proposing release is generally consistent with the legislative intent. For example, the proposing release specifically states that tax services are unique and do not raise independence concerns, in part because they involve detailed tax laws that must be applied consistently and are subject to review in an audit by the Internal Revenue Service. 67 Fed. Reg. at 76790, 76798. But conflicting and confusing statements, largely contained in one paragraph of the proposing release, create much uncertainty. Indeed, in the few weeks since the proposing release was published, many companies have responded to the conflicting signals in the Commission's release by putting tax work on hold pending the issuance of a final rule.
The controversial paragraph in the proposing release raises three separate issues. First, it suggests that audit committees, in deciding whether to pre-approve tax services, assess those services with respect to three "basic principles": that the auditor cannot audit its own work, serve as management, or act as an advocate for the audit client. 67 Fed. Reg. at 76790. But Congress cited these principles as the basis for the list of prohibited services in Section 10A(g), not as the basis for analyzing permitted services under Section 10A(h). This also is how the Commission has used these principles in the past - namely, as guidelines for the Commission (not audit committees and accounting firms) in determining what non-audit services should be prohibited. Requiring that audit committees apply these abstract principles to tax and other permitted non-audit services - with the risk of violating the Exchange Act or needing a financial statement re-audit by another accounting firm if they guess wrong - would undermine basic objectives of the Act: that there be a "clear line around a limited list" of prohibited services (S. Rep. No. 107-205, at 18 (2002)), and, importantly, that audit committees have certainty about what is and is not allowed.5
Second, the same paragraph contains broad language raising concerns about "tax strategies . . . designed to minimize a Company's tax obligations." 67 Fed. Reg. at 76790. Some commentators have read that sentence as suggesting that all tax planning might be a prohibited service. But denying investors the efficiency and audit-quality benefits resulting from the interrelated nature of audit and tax services would be contrary to the intent of the law. Audit quality has benefited from increased knowledge developed on a comprehensive basis through the inclusion of tax professionals focused on a contemporaneous understanding of client business operations, transactions, and reporting obligations.
Third, it appears from the one paragraph in the release that the Commission might want to prohibit certain types of tax services relating to "tax strategies" or "tax shelters." Even if the Act contemplated the adoption of a Commission rule in this area, tax experts at the Department of the Treasury, the Internal Revenue Service, and elsewhere have made attempts to define tax shelters and to distinguish improper strategies from wholly legitimate tax-minimization planning for many years with minimal success. It does not seem feasible for the Commission to draft an appropriate tax shelter rules within the time-compressed framework of this rulemaking.
In addition to affecting audit quality, limitations on an auditor's ability to provide tax services to its audit clients actually would have a perverse effect: it would result in less independent review of tax strategies and less transparency for investors. The Act's requirements for audit committee oversight, and the new proxy statement disclosure requirements for non-audit services, only apply in situations where the company's auditor provides the tax advice. This added layer of public policy protection relative to tax activity is not required where other accounting or law firms serve as the tax advisor.
Accordingly, as Congress intended, the Commission should let audit committees decide whether tax services are appropriate. The Commission should affirmatively state in the text of the rule (as Congress did in the text of the Act) that tax services are permitted subject to audit committee pre-approval.
Partner Rotation - The Act requires that the lead audit partner and the reviewing partner rotate off the audit engagement after five years of service. We support the "fresh look" that the auditor rotation rules are intended to achieve, but the expanded reach of the rule proposal, which goes well beyond the Act's requirements, would affect audit quality negatively.
The rule proposal dramatically expands that requirement by requiring rotation of all partners who provide audit, review, or attest services for the issuer, or for any significant subsidiary or on a material account balance, and by requiring a five-year "cooling-off" period for these partners. For major clients, it would require that scores of audit, tax, and other partners rotate off of the engagement every five years. In our view, this requirement would not enhance investor protection and would increase audit risk.
We recommend a more balanced approach, although one that still would go further than the Act requires. It would require:
(1) Rotation for certain key partners but not all partners who participate in the audit,
(2) Five-year term limits for certain partners and seven- to ten-year limits for certain other partners, and
(3) A five-year cooling-off period for certain partners and a two-year period for certain others.
In addition, we recommend transition provisions that would promote audit quality through a staggered rotation of those key audit partners subject to the revised final rules.
Partner Compensation - The proposed partner compensation rule would prohibit "any partner" on the engagement team from receiving any share of the profits from the sale of non-audit services. Read literally, the proposal would bar accounting firm partners from sharing in the overall profits of the partnership, which is not a reasonable or practical proposal.
Ernst & Young supports a rule that prohibits direct compensation - bonuses, commissions, or similar special payments - to audit partners for selling non-audit services. Such a prohibition would enhance investor confidence in the independence of auditors. Accordingly, we propose modifications to the rule text that would achieve that result and make the rule more workable.
Other Issues - Other aspects of the proposal discussed in more detail below include the following:
- The proposing release extends the prohibition against "expert services" well beyond what Congress seems to have intended and beyond the text of the proposed rule itself. The underlying purpose of this particular restriction was to prohibit accountants from serving as "advocates" for their clients in public adversarial proceedings. We recommend some clarifications to align the proposal with this intent.
- The proposed restriction on legal services has no impact on accounting firms in the United States because state laws and regulations prohibit accounting firms from engaging in the practice of law and because the Commission long has prohibited such practice. The rule proposal would, however, affect the practice of foreign law by non-U.S. lawyers who are associated with accounting firms. It would change the focus of the Commission's existing rule on legal services by extending a blanket prohibition to non-U.S. legal services even though such services have been provided to a limited extent for many years without any adverse impact on the markets or investor confidence and in accordance with Commission guidelines. The proposal tracks almost word-for-word the Commission's July 2000 proposed independence rule, which the Commission modified substantially address significant concerns about the effect of the proposed rule on foreign lawyers, who are governed by laws and regulations that are generally quite different from those in the United States. The proposing release gives no explanation of why the Commission might replace the existing restriction with language that it so recently rejected. We urge retention of the existing prohibition.
- The proposal would amend the current proxy disclosure fee categories or "buckets" to make them more accurate and meaningful, particularly by creating a new "audit-related" fee disclosure requirement. We support this proposal, although we suggest some fairly modest changes. The proposal also would require a new type of fee disclosure relating to the process by which non-audit services are pre-approved by the audit committee. This new layer of fee disclosure is both unnecessary and inappropriate because it would be confusing to investors, could mislead investors as to the nature of the pre-approval process, would be difficult for audit committees to implement, and could discourage audit committees from establishing policies and procedures pursuant to the Act's pre-approval requirements. For these reasons, it should be dropped.
- The Act and proposed rule include a "revolving-door" proposal that would impose a one-year "time-out" before accountants can be employed by an audit client. While this provision does restrict employment opportunities for audit professionals, we are not opposed to this restriction, but we do have comments relating principally to the scope of the persons covered by the restriction and the method for measuring the one-year period.
- We believe the proposals regarding communications with audit committees could be quite beneficial in enhancing the committee's oversight role. Under the proposal, as written, however, communications with audit committees would be required of all critical accounting policies and practices and estimates and for all alternative accounting treatments, regardless of materiality. We believe that a materiality requirement should be added to avoid obscuring matters of significance from the desired attention of the audit committee.
- A number of concerns cut across many or most of the proposals: the impact on investment companies, the impact on non-U.S. accounting firms, and the need for transition and grandfathering rules for many of the new requirements. We offer suggestions on all of these matters.
Table of Contents
- Tax Services
- Analysis of Proposal
- Partner Rotation Requirements
- Analysis of Proposal
- Overall Recommendation
- Specific Recommendations Concerning Partners in Various Roles
- Lead Audit Partner
- Reviewing Partner
- Other Partners on the Audit Engagement Team
- Special Considerations for Investment Companies
- Transition Period
- Compensation to Partners
- Analysis of Proposal
- Effective Date
- Non-Audit Services Other Than Tax
- Expert Services
- Legal Services
- Analysis of Proposal
- Other Non-audit Services
- Bookkeeping and Related Services
- Financial Information Systems Design and Implementation
- Appraisal or Valuation Services, Fairness Opinions, or Contribution-in-Kind Reports
- Actuarial Services
- Internal Audit
- Management Functions
- Human Resources
- Broker-Dealer, Investment Advisor or Investment Banking Services
- Effective Date
- Pre-Approval of Services
- Pre-Approval Processes Generally
- Pre-Approval Policies and Procedures
- Delegation of the Pre-Approval Authority
- Timing of Pre-Approval
- Need for Finding
- Investment Companies
- Pre-Approval Fee Disclosures
- Effective Date
- Proxy Disclosure
- Audit Fees
- Audit-Related Fees
- Periodic Reports
- Investment Companies
- Effective Date
- Employment with Clients
- Scope of the Proposal
- Commencement of the One-Year Period
- Effective Date
- Communications with Audit Committees
- Auditor and Management Responsibilities
- Application to "Issuers"
- Critical Accounting Policies
- Alternative Accounting Treatments
- Investment Companies
- Effective Date
A. Tax Services
1. Analysis of Proposal - Section 201 of the Act adds a new Section 10A(g) to the Exchange Act to prohibit accounting firms from providing nine specific services to their audit clients. Tax services are not included in that list. On the contrary, Section 10A(h) states: "A registered public accounting firm may engage in any non-audit service, including tax services, that is not described in any of paragraphs (1) through (9) of subsection (g) for an audit client" if that service is pre-approved by the audit committee (emphasis added). Thus, Congress singled out tax services, alone among non-audit services, and placed it expressly within the permitted service category of Section 10A(h) rather than in the prohibited service category of Section 10A(g).
The Commission's rule and proposing release largely reflect this statutory language. The rule text lists the prohibited services and does not include "tax services" within that list. The proposing release states that "tax services traditionally have been viewed as closely related to audit services and as not being in conflict with an auditor's independence." 67 Fed. Reg. at 76798. Likewise, the proposing release states: "Nothing 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." 67 Fed. Reg. at 76790. And, the proposing release adds that "[a]s discussed in our previously proposed rules on independence [that is, the rules proposed in June 2000], tax services are unique, not only because there are detailed tax laws that must be consistently applied, but also because the Internal Revenue Service has discretion to audit any tax return." Id.6
But the proposing release contains conflicting and confusing statements as well, which have had the practical effect of significantly stifling the provision of tax services by an accounting firm to an SEC registrant that it audits. The confusion arises particularly from the discussion in one paragraph of the proposing release (footnotes omitted). It states as follows:
Classifying a service as a "tax service" however, does not mean that the service may not be within one of the categories of prohibited services or may not result in an impairment of independence under Rule 2-01(b). The accounting firm and the registrant's audit committee should consider, for example, whether the proposed non-audit service is an allowable tax service or constitutes a prohibited legal service or expert service. As part of this process, the accounting firm and the audit committee should be mindful of the three basic principles that cause an auditor to lack independence with respect to an audit client: (1) The auditor cannot audit his or her own work, (2) The auditor cannot function as a part of management, and (3) the auditor cannot serve in an advocacy role for the client. For example, where an accountant provides representation before a tax court the accountant serves as an advocate for his or her client and the accountant's independence would be impaired. Another example would be the formulation of tax strategies (e.g., tax shelters) designed to minimize a company's tax obligations. The provision of these types of services may require the accountant to audit his or her own work, to become an advocate for the client's position on novel tax issues, or to assume a management function.
Id. This statement already has created enormous uncertainty for SEC registrants, their legal advisors, and accountants. Particularly because of one sentence in the paragraph - stating a possible prohibition on "the formulation of tax strategies (e.g., tax shelters) designed to minimize a company's tax obligations" - a number of our clients have told us that their outside counsel have advised them not to retain their audit firm to perform any tax services that involve "strategies" to "minimize a company's tax obligations," which is, of course, a basic purpose of most tax planning and tax advisory services.7
All tax planning and advice regarding the potential tax treatment of transactions could be characterized as services "designed to minimize a company's tax obligations." The suggestion that such services may be prohibited creates significant uncertainty, is inconsistent with the legislative intent and the other statements in the release, and would result in inconsistent interpretation and application of the law by audit committees, their counsel, and accounting firms.
The paragraph quoted above also creates uncertainty because of the statement that, in determining whether a tax service is permissible, auditors and their clients "should be mindful of the three basic principles." This results in such a vague and unworkable standard that the desired "clear line" around prohibited services is anything but clear. We do not believe the principles were intended to be applied by auditors or their clients to tax services, nor do we believe that such application could be accomplished in a practical way. The principles also cause confusion because they provide the basis for certain persons to contend that a broad range of tax services must now be prohibited by the Act because they might be shoehorned into a definition of "legal" or "expert" services.8
The three principles are not found in the Act itself, but they do appear in the Senate Banking Committee report. S. Rep. No. 107-205, at 18. The context in which those principles appear in the report is important. The report states that Congress heard testimony from some persons who supported a "complete prohibition on non-audit services by accounting firms for their audit clients," but that the Committee rejected that approach. Id. at 16. Instead, the Committee listed nine specific prohibited services. The Committee explained: "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." Id. at 18.
The report then goes on to explain that these specifically-listed services were prohibited because their provision could violate the three principles. Id. First, bookkeeping, financial information systems design, appraisal or valuation, actuarial and internal audit outsourcing are appropriately prohibited because they can result in the auditor "audit[ing] its own work." Id. Second, human resources services such as recruiting and hiring officers and directors can result in the auditor "function[ing] as part of management or as an employee of the audit client" and therefore should be prohibited. Third, legal and expert services and broker-dealer work are prohibited because such activities could result in the accounting firm "act[ing] as an advocate of the audit client." Id.
Thus, Congress cited the three principles as the basis for including certain activities within the list of specific, prohibited non-audit services, leaving other services to the discretion of audit committees. It did not suggest that those principles must or even should be applied to services not included on that list, and it certainly did not suggest that those principles should be applied to a service that was expressly permitted by the statute itself, namely "tax services." The Committee report contains a fairly detailed discussion of the audit committee pre-approval process established by Section 10A(h) (the section that permits "tax services"), but nowhere in that discussion is there any mention of the "basic principles" referenced in the Commission's proposing release. See S. Rep. No. 107-205, at 19-20.9
The Commission has likewise not previously used the principles in this manner. The Commission has stated that the principles are useful to regulators in determining which services should be added to the prohibited services list, but they are not intended to be used by audit committees to determine if particular tax services are permissible. As the Commission stated in its adopting release to the 2000 independence rules, Rule 2-01(c) lists prohibited services (much the same as the Act's list), but there might be other services that would be added to the list at a later time. Thus, the Commission stated: "For other services, and in particular future services, the Preliminary Note makes clear that in applying the general standard in Rule 2-01(b) [that is, the `reasonable investor' test for assessing auditor independence], we will look in the first instance to the four factors. The four factors provide guiding principles for the Commission, similar to what a `conceptual approach' would provide." 65 Fed. Reg. at 76029. Importantly, the Commission stated that "we" and "the Commission" will look to these principles, not (as in the paragraph from the proposing release quoted above states) that "the accounting firm and the audit committee" must look to them every time a particular non-audit service requires pre-approval.
There are many traditional tax services - services that have been provided to audit clients for almost a century - that some commentators have argued could potentially result in the auditor's "auditing its own work." They have contended that even the most basic, non-controversial advice in connection with corporate tax return preparation arguably can affect the related tax accrual calculations for financial statement purposes.10 Likewise, there are many tax services - again, services that the accounting profession has provided for many decades without causing concern about an impact on auditor independence - that certain commentators have viewed as potentially constituting "advocacy" for the audit client, including tax compliance, tax planning, appearances before the IRS and other tax authorities, and so on.
Accordingly, although the proposing release states that "nothing in the proposed rules is intended to prohibit an accounting firm from providing tax services to its audit clients when those services have been pre-approved," the practical effect of the language in the paragraph quoted above is to do just that. It seems highly unlikely that the Commission actually intended that these three principles would essentially swallow the entirety of the statutory approval of tax services and thereby prohibit a substantial component of the traditional scope of tax services auditors provide their audit clients. Indeed, application of these principles to tax not only would be at odds with what Congress intended, but also would be contrary to the Commission's prior application of these principles. In 2000, the Commission adopted these same principles (with one additional one) as part of a Preliminary Note to its new independence rules, but they were not deemed to affect the provision of tax services. At the same time that the Commission adopted these principles in the Preliminary Note, the Commission rejected suggestions that it limit tax services, stating that "tax services generally do not create the same independence risks as other non-audit services." Final Rule: Revision of the Auditor Independence Requirements, 65 Fed. Reg. 76008, 76052 (Dec. 5, 2000).
The end result is substantial confusion in the public and among audit committees, companies, and their advisors.11 As noted, there is nothing in the statute or the Committee report supporting a restriction on tax services, nor is there any suggestion whatsoever that the SEC's existing auditor independence rules, adopted in 2000, were inadequate because they failed to ban tax services. What Congress did intend was that auditors and audit committee members have some certainty and clarity as to what is prohibited and what is not - hence the goal of a "clear line" between these two categories of services. S. Rep. No. 107-205, at 17. See also H.R. Rep No. 107-414, at 2 (2002) ("[I]t is appropriate to continue dealing with non-audit services by having the Commission proscribe specific services rather than casting doubt on a broad range of non-audit services."). The language in the paragraph quoted above, referring to impermissible "tax strategies," and the application of the principles to tax services, obscures that line.
Importantly, allowing audit firms to continue to provide tax services to its SEC registrants not only does not raise independence issues, but will also enhance audit committee oversight, transparency, and audit quality. The Act's requirement for audit committee pre-approval of non-audit services only applies where the company's auditor is involved in the provision of tax advice. Moreover, fees for tax services are only disclosed in the proxy statement when paid to the company's accountant. Accordingly, tax services provided by a company's accountant not only will have the added review by the independent audit committee, but the fees and services will be disclosed publicly. Regarding quality, audits have benefited in many circumstances from increased knowledge developed through the inclusion of tax professionals focused on the contemporaneous understanding of client business operations, structure, transactions, and reporting obligations. As the Commission has noted in its proposing release, tax services are unique among non-audit services in that they are integrally related to the audit. See 67 Fed. Reg. at 76798, stating that "tax services traditionally have been viewed as closely related to audit services and as not being in conflict with an auditor's independence."
The controversial paragraph quoted above also includes a passing reference in a parenthetical to the term "tax shelter." Understandably, the Commission does not define the term. Tax experts at the Department of the Treasury and the IRS, members of Congress, tax practitioners in the American Bar Association and the AICPA, and academics alike, for many years, have made numerous attempts to define the term and distinguish illegal transactions from legitimate tax planning.12 If the Commission is expressing its desire to prohibit illegal transactions, we would wholeheartedly endorse the concept. Such illegal transactions, however, should not be promoted by an advisor or practitioner, regardless of independence rules. Congress, Treasury, and the IRS are working with practitioners to address the issue in new laws and regulations. We respectfully submit that this is not an issue of independence to be defined in an SEC rule.
2. Recommendations - We urge the Commission to provide certainty to audit committees in its adopting release by stating that the three principles are not meant to restrict the provision of tax services. We also ask that the final rule, consistent with the Act itself, include an explicit recognition that tax services are permissible, subject to audit committee pre-approval.
We should note that we are not recommending that the Commission include in the rule text a non-exclusive list or definition of permitted tax services. We think it is unrealistic to ask that the Commission immerse itself in the particulars and nuances of various tax services in such a short timeframe, as would be necessary to adopt a complete list. Most significantly, developing a list of permissible - and, by implication, impermissible - tax services appears inconsistent with the basic approach taken by the Act: allow tax services, but require that they be subject to audit committee pre-approval.13
More specifically, we recommend that the Commission clarify the statements in the proposing release as follows:
a. First, the Commission should clarify that the "basic principles" are meant to be used by regulators in determining what non-audit services should be prohibited, but need not be applied by audit committees every time a non-audit service is being considered for pre-approval.
b. Second, the paragraph in the proposing release quoted above expressed a concern that auditors might provide a prohibited service, label it a "tax service," and argue that it is therefore permissible. In particular, the Commission Staff has stated previously the view that representation of an audit client before the tax court is a prohibited activity. The Staff's view was based on the appearance of public advocacy and the impression that such services were akin to legal services. Accordingly, the release stated that this service was prohibited.14 67 Fed. Reg. at 76790. We can think of other possible examples of similarly improper circumventions of the prohibited services list. For example, an auditor might seek to provide a broker-dealer service and argue that because there are tax implications of certain brokerage activities the service is permissible. That clearly would be improper. But, at the same time, we do not believe that the Commission meant to suggest that a wide range of other tax services might be swept into question by virtue of a broad reading of the terms "legal services," "expert services," or "advocacy" as they are used in the proposing release.15 The adopting release should make this clear. And any additional prohibited services should be clearly defined by the Commission through a rulemaking process.
c. Finally, by citing the three principles, the Commission apparently sought to give audit committees some guidance on how they should carry out their pre-approval responsibilities with respect to tax services. We believe that the Commission might give audit committees some alternative guidance on things to consider when establishing their pre-approval policies and procedures with respect to tax services.
For example, in determining what policies and procedures they will follow in pre-approving tax services, an audit committee might consider whether the auditor is making tax decisions for the company rather than merely advising the company. The tax returns and financial statements are the company's, not the accounting firm's. The accounting firm should never be in a situation where it is assuming a decision-making role for management on tax issues.16 This is particularly the case for large and complex tax transactions, which could give rise to concerns about a potential impairment of the auditor's objectivity. In such a situation, client personnel should evaluate independently whether a particular tax strategy is appropriate. If management personnel do not have the necessary skills, management or the audit committee might appropriately seek outside help - in the form of a second opinion from a law firm, another accounting firm, or other expert - to determine whether the tax strategy is appropriate. Indeed, the Act establishes a procedure for this to happen: in Section 301, audit committees are given "the authority to engage independent counsel and other advisors, as it determines necessary to carry out its duties."
In addition, the Commission might suggest that an audit committee, in establishing its pre-approval policies, inquire whether the accountant is involved in strategies identified by the Internal Revenue Service as a "listed" transaction. Such transactions have been specifically identified by the IRS as warranting extra scrutiny.17 Finally, the Commission could note other factors that audit committees should take into consideration, such as the existence of detailed tax rules that thereby help ensure the accuracy of the financial statements; the IRS discretion to audit any tax return; the ability to secure third-party tax opinions; and the quality controls of the accounting firm.
These types of considerations could be taken into account by an audit committee in establishing the audit committee's pre-approval policies and procedures pursuant to Section 202 of the Act. Audit committees might ask these types of questions in order to assist them in fulfilling their statutory and fiduciary obligations. Moreover, in contrast to developing definitions or lists of either prohibited or permitted services, this type of guidance to audit committees would be consistent both with the Act and the Commission's prior efforts to give audit committees guidance in carrying out their duties. Such guidance would appropriately be coupled with two points - that tax services are permissible under the independence rules, and that audit committees and their auditors are not required to assess tax services through application of the three principles. This approach would provide audit committees the assurance that tax services may be provided as long as appropriate pre-approval policies are followed and would significantly diminish the uncertainty prompted by the proposing release.
B. Partner Rotation Requirements
1. Analysis of Proposal - The proposed rule would implement the audit partner rotation requirements in Section 203 of the Act by limiting the lead audit partner and the reviewing partner to a maximum of five consecutive years in such roles. In addition, the proposal goes much further than the Act by imposing a maximum of five consecutive years of service for all partners on the "audit engagement team" and requiring a five-year cooling-off period for all such partners.
We support mandatory partner rotation. The profession for several years has required rotation of the lead audit partner on audits of public companies after seven years of service in such a role through an AICPA SEC Practice Section requirement. And, although that requirement mandates only a two-year cooling-off period before the lead audit partner could again be involved in the audit, our firm generally has approached rotation of the lead audit partner as entailing a seven-year cooling-off period (i.e., a full term for the successor lead audit partner) unless unforeseen circumstances arise. However, we strongly believe that an expansion of mandated partner rotation that is too broad carries a high risk of unintended consequences that puts audit quality at risk and runs contrary to the best interests of investors. Doing what is best for investors requires a careful balancing of the "fresh look" that partner rotation provides with the heightened risk to audit quality arising from a loss of continuity on the audit team.
There are several possible adverse effects to consider in finding the right balance. These include the effects on audit quality where there are geographic shortages of qualified personnel (such as persons with industry or functional expertise), out-of-pocket costs that will need to be borne by issuers, and the effects of more frequent relocation and increased travel on attracting and retaining qualified people in the accounting profession.
In addition, there are very significant transition issues to consider. Whatever the new requirements may be, transitioning to them will require an extended time period to make sure that there are not even more unintended consequences from too abrupt a rotation of partners.
2. Overall Recommendation - We believe that the proposed rule does not produce the right balance between the objectives of the fresh look and the benefits of continuity. Instead, the proposal leans too far in one direction and thereby produces a disruptive situation - too many partners would be required to rotate too frequently, creating too much loss of continuity and increased audit risk. In fact, one of the shortcomings in the proposed rule is its simplicity - all partners on the audit team around the world (except for those working on clearly insignificant subsidiaries) are viewed equally. We believe that a more appropriate solution would recognize the distinct differences in the roles among partners on an audit engagement, especially with respect to their involvement in significant auditing, accounting, and reporting matters and their relationships with the issuer's management and the audit committee. Such a solution would (1) mandate rotation for certain key partners, but not for tax partners, other specialists, or other partners with limited roles, (2) have five-year term limits for some partners and seven to ten years for others, and (3) require a five-year cooling-off period for some partners but only a two-year period for others. In addition, we believe that transition provisions are necessary to promote audit quality through a staggered rotation of those key partners subject to the revised final rules.
3. Specific Recommendations Concerning Partners in Various Roles - Set forth below is a discussion of the various roles that partners play in the audit process, together with our specific recommendations for rotation requirements for partners in each of those roles.
a. Lead Audit Partner - The lead audit partner role is much more important than any other role on the audit. In essence, this partner "signs" the firm's report on the issuer's financial statements. This partner is involved in some capacity in all significant auditing, accounting, and reporting decisions. As noted above, the SEC Practice Section already requires the lead audit partner to rotate off an audit engagement for at least two years after seven years in the lead role.
We certainly believe that rotation of the lead audit partner is important in protecting the public interest, and we support a maximum of five consecutive years in such role (required by the Act) followed by a mandatory five-year cooling-off period (added by the Commission). However, we believe that the Commission's proposal as it relates to the lead audit partner suffers from the absence of a "training" period prior to taking on the lead audit partner role. To function well in the lead role, the auditor needs sufficient knowledge of the client's industry, business, business and financial risks, internal controls, and people. As proposed, the rule would count years in a secondary role (gaining much of the requisite experience) against the permitted years of service in the lead role. For example, two years as a partner working on parts of the audit and getting prepared for the lead audit partner role - perhaps in an overseas location for a multinational client - would result in a maximum three-year stint as the lead audit partner. As a result, particularly on the largest, most complex audits, the lead audit partner would be rotating much too often.
We urge the SEC to permit the lead audit partner to serve five years in the role, consistent with the intent of the Act, notwithstanding having served as a partner on the audit engagement team in other capacities prior to assuming the lead audit partner role.18 This would be not only a very appropriate transition provision - otherwise, a partner who has worked as a partner on parts of the audit for five years preparing for the lead role, and who has just become the lead audit partner, would instead be required to immediately rotate off - but also a sound ongoing provision. The need for additional flexibility is particularly acute for audits of foreign private issuers because, as is discussed further below, there is a scarcity of partners with sufficient expertise in U.S. GAAP and GAAS in many foreign locations. Should the SEC determine that some limitation on a lead audit partner's overall service on an audit engagement is needed post-transition, at least a two-year period of prior service should be permitted (i.e., seven years of consecutive service consisting of five years in the lead role preceded by two years in a different partner role).
b. Reviewing Partner - The reviewing partner has a very important but unique role in that he or she is not really a member of the audit engagement team.19 The SEC Practice Section has required a "concurring partner" review on audits of public companies for several years. The role as envisioned by the SEC Practice Section is to provide an objective review of the accounting, auditing, and financial reporting matters that were considered significant by the engagement team.
Because the role is so important, we support the mandatory rotation of the reviewing partner after a maximum of five consecutive years in such role (required by the Act) and the Commission's proposal to require a mandatory five-year cooling-off period before a lead audit partner could become the reviewing partner. We do not necessarily believe that a partner should be precluded from assuming the reviewing partner role because he or she already has served for five consecutive years in other partner roles on the engagement, or that a reviewing partner needs a five-year cooling-off period before assuming another partner role on the engagement. Should the Commission conclude that such prohibitions are necessary, we would strongly urge that such provisions be in place only after a transition period. For transition purposes, the Commission should (1) permit the reviewing partner to serve five years in the role, consistent with the intent of the Act (see note 18, supra), notwithstanding having served as a partner on the audit engagement team (but not as the lead audit partner) prior to assuming the role, and (2) not count previous years in the reviewing partner role against the rotation requirements for other partner roles.
c. Other Partners on the Audit Engagement Team - The rule proposal extends the five-year rotation requirement to other partners who provide audit services to the issuer or any of its significant subsidiaries (as defined in Regulation S-X). Depending on the size and complexity of the audit, this proposed requirement - which is not a requirement of the Act - could affect a great number of partners on a single engagement.
The SEC's stated objective in extending the rotation requirement is to ensure that professionals do not "grow-up" or spend their entire careers on one engagement. However, the proposed rule would apply to many partners who certainly do not spend their entire careers on audit services provided to the client and might not even spend much time at all on the audit in any particular year.
For partners who spend a smaller percentage of their time working on the audit, work on smaller divisions or subsidiaries, or work in only one or a few areas of the audit, there is much less need to rotate. The threat of too much "coziness" is much less because such partners spend a smaller percentage of time on the engagement and the effects on the consolidated financial statements of any significant auditing, accounting, and reporting issues associated with their areas of the audit are considered and evaluated by the lead audit partner and reviewing partner. Moreover, rotating such partners as frequently as the partners in more critical roles likely would increase audit risk and hurt audit quality disproportionately. With respect to subsidiaries in smaller markets and especially foreign locations, it is not uncommon for there to be a scarcity of well-qualified partners who could handle the assignment. In many locations, large firms are in a similar position with respect to other partners as the smaller accounting firms are with lead audit and review partners - and the SEC has specifically expressed interest in the possible hardships on smaller firms from the proposed rules.
Quite often, the staffing of foreign location work is particularly difficult. In addition to knowledge of U.S. GAAP and GAAS, producing high-quality work often requires special language skills, the ability to understand cultural differences, and other unique skills. In many foreign locations there are only one or two partners capable of handling U.S. assignments well, and mobility often is not well accepted or required as a condition of employment. At the same time, such partners handling the foreign location work would not make the most critical decisions with respect to the consolidated financial statements of an issuer, nor would they have regular contact with members of the issuer's top management and audit committee. Thus, there is considerable risk that the proposed rules will harm rather than help audit quality in foreign locations.
The proposed rules also would mandate rotation of partners who participate in audit engagements as specialists in various subject matters. Examples include tax partners who participate in auditing tax provisions and related balance sheet accounts, information systems and controls specialists who participate in control risk assessments and testing, derivatives valuation specialists who participate in auditing the client's valuations, and actuaries who participate in auditing loss reserves of insurance companies.
Mandatory rotation of these specialists suffers from many of the same drawbacks as rotation of partners in foreign locations. There are far fewer of these specialists than auditors in each firm, and their knowledge of not just the subject matter but also the business and industry of the client is essential to performing effective audit procedures. And although their involvement is very important to auditing various complex areas, their work is overseen by others (such as the lead audit partner) who consider the significant auditing, accounting, and reporting matters in making final decisions before signing off on the audit report.
One could easily conclude that the rotation of the lead audit partner and the reviewing partner would provide a sufficient number of fresh eyes, and that the rotation of other partners would fail a cost/benefit test and in many situations could harm rather than help audit quality. Our firm supports extending mandatory rotation requirements to some other partners who participate in the audit, but we strongly believe that such requirements should apply to fewer partners and should mandate less frequent rotation than would be required for the lead and reviewing partners.
In our view, only those partners at the corporate level who have substantial and continuing contact with the issuer's top management and audit committee and have influence over significant auditing, accounting, and reporting matters, as well as those handling the audit work at the larger subsidiaries, should be subject to mandatory rotation requirements.20 For these partners, we suggest that a longer period of service should be permitted - perhaps a seven to ten-year period in one or more roles other than lead audit partner or reviewing partner - and that the required cooling-off period be two years. Partners who participate less extensively in the audit, such as audit partners handling audit work at smaller subsidiaries and specialist partners (including tax partners) involved with audit work focused on a narrow area of the financial statements, should not be subject to rotation.
d. Special Considerations for Investment Companies - Under the proposed rules, the rotation requirements extend to any entity within the investment company complex. The proposed rules thus would prohibit a partner from rotating between two separate investment company issuers within an investment company complex, as well as to or from an advisor or other entity under common control with the advisor. The proposed rules go beyond the requirements of the Act, which only established rotation requirements for an issuer (i.e., an individual mutual fund registrant or a public company advisor).
We do not believe there is a need to restrict rotation within an investment company complex. However, if the Commission believes such restrictions are necessary, we recommend that only the lead audit partner responsible for overall quality, internal control, and conduct of registered investment company audits within the investment company complex, as well as the overall independent review partner, should be restricted from rotating to other entities within the investment company complex, and not the other partners assigned to individual investment companies and other entity audits within the investment company complex. Other partners would be permitted to rotate between individual investment companies and other entities within the investment company complex.
4. Transition Period - We suggest that the new rules for rotation of the lead audit partner and the reviewing partner should become effective for audits of financial statements of issuers other than foreign private issuers for fiscal years beginning after December 15, 2003. For calendar year issuers, the new rules would become effective for the timely review of the financial information for the quarter ended March 31, 2004, and the audit of the financial statements for the year ended December 31, 2004. Such a transition period not only would provide the firms an opportunity to make partner reassignments in an orderly manner, but also would provide the Public Company Accounting Oversight Board an opportunity to address the several interpretive issues involved in how years of service are counted in various situations (e.g., initial public offering, re-audits, carve-outs, spin-offs, mergers, etc.).
Consistent with the Commission's view that firms should stagger partner rotations to avoid key turnover at the same time, we suggest that the reviewing partner be permitted an extra year so that both the lead audit partner and the reviewing partner would not be forced to rotate in the same year. We also suggest that any other key audit partners subject to rotation should start with a fresh clock (any years of service prior to the effective date should not count against the newly imposed limits), or alternatively, rotation of such partners should be phased in over at least a three-year period in an orderly manner.
A higher percentage of lead audit partners on foreign private issuers than on domestic issuers would require rotation upon the effective date because auditors of foreign private issuers have not been subject to the SEC Practice Section rotation requirements in the past. To avoid adverse effects on audit quality from too much rotation at the same time, and in light of the scarcity of partners with sufficient expertise in U.S. GAAP and GAAS in many foreign locations, the SEC should provide an additional two years for transition, i.e., the requirements should become effective for fiscal years beginning after December 15, 2005.
C. Compensation to Partners
1. Analysis of Proposal - The Act does not require that the Commission adopt restrictions on how accounting firms may compensate their partners. Nonetheless, the Commission has proposed to prohibit "any partner, principal or shareholder who is a member of the audit engagement team" from being compensated "based on the performance of, or procuring of, engagements with that audit client to provide any services other than audit, review, or attest services." 67 Fed. Reg. at 76794.
We agree that audit partners should not be directly compensated for selling non-audit services. Thus, we would support a rule that prohibits firms from making special payments to their audit partners, such as bonuses, commissions, special awards, or similar incentives directly tied to the sale of non-audit services. This appears to have been the intention of the rule drafters, because the proposing release does use the word "direct" in describing the prohibited compensation arrangements (67 Fed. Reg. at 76794), although it is inconsistent in doing so. Likewise, the proposing release describes the rule as being designed to prohibit "cash bonuses and other financial incentives to sell products or services, other than audit, review or attest services to audit clients." Id.
We note in this regard that Ernst & Young does not have any such direct compensation programs, and we believe that such programs could raise an appearance of an independence impairment. Likewise, an audit partner's compensation is not directly tied to the fees generated from any particular client. There are a wide number of factors that we take into account in determining a partner's compensation, with a heavy emphasis on the quality of the partner's audit performance.
But we are concerned that the text of the rule as proposed would disallow even our system of distributing partnership profits. The proposed rule does not include the word "direct," and it makes no reference to bonuses or similar financial incentives. As drafted, it would bring into question the basic structure of a partnership, that is, that partners share in the overall profits of the partnership. The proposed rule would apparently prevent partners from sharing in the overall success of the firm through typical profit-sharing arrangements. This is both unnecessary and impractical.
2. Recommendation - We believe that the final rule should include in the rule text the word "direct" as an adjective for "compensation." In addition, the rule text should refer specifically to the types of compensation arrangements that cannot be paid to audit partners for the sale of non-audit services. These would include cash bonuses, cash awards, commissions, or other special payments. We are concerned that, absent such a specific description of what is meant by "direct" compensation, the typical "dividing of the pie" that occurs at any partnership, including ours, might be second-guessed - and an SEC registrant might need a financial statement re-audit because the auditors are deemed to have lacked independence - because an audit partner's compensation was based in part on revenues or profits (both audit and non-audit) generated from clients that he or she serves.
If the Commission rejects this approach, or leaves some ambiguity in the reach of the rule, then we would urge three amendments that would at least mitigate our concerns. First, the rule should not cover "any" partner on the audit engagement team, because this would include persons who spend only a small portion of time on the audit (such as tax or specialty partners). Second, with respect to audit partners, we recommend that the compensation restriction should apply only to services whose fees are disclosed as "Tax Fees" or "All Other Fees" in the proxy statement. "Audit-Related Fees" are so closely related to audit work that they should be treated like an audit fee for this purpose. Third, we recommend that the final rule refer to "issuers" rather than to "audit clients." Audit clients as defined in the SEC rules can include remote affiliates that are not audited by the accounting firm, and the audit partners' involvement in the sale of non-audit services to such entities would have little or no effect on independence with respect to the audit of the registrant.
3. Effective Date - We recommend that the final rules on audit partner compensation be made effective as of the start of the accounting firm's next fiscal year beginning 90 days after publication of the final rules in the Federal Register.
D. Non-Audit Services Other Than Tax
1. Expert Services
The proposed rule prohibits expert services unrelated to the audit, which are defined as "provid[ing] expert opinions for an audit client in connection with legal, administrative, or regulatory proceedings or acting as an advocate for an audit client in such proceedings." 67 Fed. Reg. at 76789. The rule therefore links either "expert opinions" or "advocacy" to a "legal, administrative, or regulatory proceeding." The release further explains that the Commission's concern involves situations where the accountant's "experience and expertise" is used "to support the contentions of the audit client in various adversarial proceedings." Id. This is consistent with the legislative history of the Act. In this regard, the release quotes a statement of Senator Sarbanes: "A public company auditor, to be independent, should not act as advocate of its audit client (as it would if it provided legal and expert services to an audit client in judicial or regulatory proceedings)." Id. at 76783.
But notwithstanding the emphasis in the rule and proposing release on "adversarial proceedings" where "advocacy" is involved, the discussion in the release sweeps in activities where neither adversity, a pending proceeding, nor real "advocacy" is involved. The result is considerable confusion. We do not urge any change in the rule text, but we suggest that the Commission's adopting release clarify certain issues addressed in the proposing release.
As a preliminary matter, it is by no means necessarily the case that an expert is an "advocate" for the client even when he or she testifies for the client in court. The federal courts' rules of evidence, as well as those in the majority of states that pattern their rules after the federal rules, indicate that factual analysis and conclusions, not one-sided advocacy, are the subjects on which a qualified expert may testify.21 Indeed, the AICPA Code of Professional Conduct prohibits subordinating the CPA's judgment to another,22 and an ethics ruling specifically addresses expert witness services, stating, "A member serving as an expert witness does not serve as an advocate but as someone with specialized knowledge, training, and experience in a particular area who should arrive at and present positions objectively."23 But we do acknowledge that there may be an appearance of an impairment of independence when the accounting firm testifies on behalf of the client in a public proceeding. The rule, however, should be limited to that situation - namely, providing testimony or expert opinions for an audit client as a "hired gun" expert witness in a public adversarial proceeding. Indeed, this would appear to be the type of activity that Congress sought to prohibit when it included the "expert service" prohibition in the Act. It also would appear to be the intent of the proposed rule text.
The proposing release, however, states that the rule would prohibit the auditor from being "engaged by the audit client's legal counsel to provide . . . accounting advice, opinions, or forensic accounting services, in connection with the client's participation in a legal, administrative, or regulatory proceeding." 67 Fed. Reg. at 76789. This broad statement raises many questions and much uncertainty.
In particular, companies frequently retain their accounting firms when there is no pending proceeding. For instance, the accounting firm might be asked to investigate a possible financial impropriety, or to provide the client with assistance in compiling the facts for a business interruption insurance claim. Later, the accountant may be required to testify as to what he or she did or what he or she found. That testimony is factual in nature, but a court might nonetheless qualify the witness as an expert in order for him or her to testify with regard to certain conclusions. This type of engagement should be permitted.
The mere possibility that the investigation needed by the client could result in a dispute is not enough to justify prohibiting the accountant's investigative role, whether the investigation is conducted directly for management or the audit committee, or is conducted for them by retention through inside or outside counsel. Denying the company the ability to use its accounting firm that is familiar with its systems operations and business to respond quickly to a perceived risk requiring investigation may prevent the company from being able to protect its interests adequately and, accordingly, the interests of its shareholders.
There are many benefits to investors in allowing the accounting firm to perform this work. The accounting firm already is familiar with the issuer and its business, so less time is required to "get up to speed." Frequently, matters requiring the assistance of experts arise during the course of the audit, so the accounting firm can respond without needing significant amounts of time to become familiar with the issue. The firm also will coordinate its efforts in providing such services with the audit already underway to make sure that filing deadlines with the SEC are met. Performing this work may provide the auditor with valuable, in-depth knowledge that may improve the quality of audits. Channels of communication and points of contact within the issuer already will be known, enabling a more rapid response. The issuer also knows the level of service and quality that the accounting firm can provide. We see no benefit, and the release offers none, in prohibiting expert services even when they do not constitute "advocacy" under any common definition of that word; when they can benefit shareholders through decreased costs and timely response; and when they do not present a question of independence in fact or appearance.24
For many of the same reasons, private consultation with the company's counsel (functioning as a "consulting expert" as distinguished from a "testifying expert") should be allowed. The consulting expert's role is an extension of fact-finding to assist counsel in its analysis and differs markedly from the role of a testifying expert. Indeed, the Federal Rules of Civil Procedure recognize the distinction between those roles.25 The SEC's concerns about zealous advocacy are, as described above, particularly unfounded with respect to the consulting expert because the consultations between the expert and counsel are private, and counsel may elect not to adopt any or all parts of the consulting expert's analysis.26
We also recommend the Commission to make clear that the rule does not prohibit accounting firms from assisting their clients in handling tasks that support resolution of various disputes (including legal, regulatory, or administrative proceedings), such as document management, electronic evidence discovery, and discovery management. By their very nature, accounting firms have experience managing large projects in multiple locations and encompassing large volumes of information - experience that clients frequently do not possess. Although provision of these support services may be "in connection with legal, administrative, or regulatory proceedings," they are tangential to the process, are not a form of advocacy, and are conducted largely in private. We do not believe this type of activity was intended to be prohibited by the proposed rule because it does not include provision of an "expert opinion" and does not constitute "advocacy," but we urge the Commission to make this clear.
Another situation for which we ask clarification is where the accounting firm is retained to provide expert services to a group of companies, such as co-defendants in a lawsuit. If only a minority of those companies are audit clients (for instance, fewer than 20% by number or percentage of anticipated fees), then it would seem appropriate to allow the accounting firm to accept the engagement. Expert testimony for a group of companies, most of which are not audit clients, clearly does not raise the same concerns about "advocacy" as does testimony for a specific audit client.
Finally, there is a different type of arguably "expert" service as to which we request clarification from the Commission. Our firm and other accounting firms sometimes are retained by audit clients to assist them on legislative matters. Most of the legislative services that we perform for SEC audit clients relate to tax matters, and they frequently involve work with coalitions of companies. The proposed rule links expert services to "legal, administrative, or regulatory proceedings" (in particular, proceedings that are "adversarial" in nature). Legislative services do not involve such proceedings, and, accordingly, the services almost certainly are permitted under the proposal. However, because of the proposing release's emphasis on "advocacy" as a prohibited activity, there already is some uncertainty among audit clients. With the goal of "clear lines" between permitted and prohibited services, we ask that the Commission make clear that because legislative assistance and advice does not (by its very nature) involve any type of "legal, administrative, or regulatory proceeding," much less a proceeding that might be "adversarial," it is not restricted by the "expert service" prohibition.
2. Legal Services
a. Analysis of Proposal - In the United States, state laws and regulations prohibit accounting firms from engaging in the practice of law. Accordingly, our comments concerning the proposed rule on legal services are limited to the effect of the proposed rule on the provision of foreign legal services - those involving non-U.S. law - by law practices associated with Ernst & Young.
By way of background, there are some 2,700 lawyers, in more than sixty countries in law practices that are affiliated or allied with Ernst & Young in some manner. The majority of these practices are independent law firms that are not part of, not controlled by, and share no revenues with, the Ernst & Young organization. Notably, the Act itself does not extend to such loosely aligned entities. Nonetheless, some of these independent law practices could be considered "associated entities" of Ernst & Young under the Commission's rules, which employ a much broader and more nebulous concept of "association" than Congress employed in the Act. Accordingly, the proposed rule on legal services potentially could affect thousands of professionals who are neither part of nor controlled by an accounting firm.
Currently, the Commission's independence rule bars accounting firms and associated law practices from providing U.S. legal services to registrant audit clients of the accounting firm. However, such law practices are allowed to offer limited foreign legal services to such clients pursuant to guidelines provided by the Commission. These guidelines, originally articulated by the Office of Chief Accountant in informal discussions with the major accounting firms, later were embodied in the adopting release for the December 2000 independence rules. In essence, they permit the provision of non-U.S. legal services to audit clients so long as the services are routine and ministerial, or involve matters not material to the consolidated financial statements of the registrant audit client. Typically, such services do not involve "advocacy" for a client as that term is generally understood.
The approach to legal services in the proposed rule is fundamentally different than the current approach. Instead of focusing primarily on U.S. legal services, the proposed rule would prohibit "any service to the audit client that, under circumstances in which the service is provided, could be provided only by someone licensed, admitted or otherwise qualified to practice law in the jurisdiction in which the service is provided." 67 Fed. Reg. at 76788. The proposal is based on language that the Commission proposed in its July 2000 rule proposal, but ultimately decided not to adopt.27
We have significant concerns about the proposed rule. We are unaware of any reason to change the current approach, under which accounting firms and associated law practices have been operating without any problem for years. We know of no suggestion that the limited foreign legal services currently allowed have either contributed to or led to an audit failure, undermined investor confidence, or threatened auditor independence in any way. Nor are we aware of anything in the Act or its legislative history to suggest that Congress was dissatisfied with the current approach. To the contrary, the proposal runs afoul of the apparent legislative intent not to codify the rules that were proposed, but not adopted, in July 2000 (see supra note 8). It therefore appears to us that curtailing the limited foreign legal services currently permitted would deprive registrants of their choice of counsel in many cases - and disrupt and cause economic harm to independent law firms that have chosen to associate with accounting firms - without countervailing benefit.
We also are concerned that the proposed approach would be unworkable in light of the fact that the nature of legal practice, and who may engage in it, differs extensively from one country to another. In France, for example, in the overwhelming majority of circumstances, only lawyers may provide tax advice. In other countries, by contrast, certain work that may be done only by lawyers in the United States is not so restricted. As a result, the proposed rule, which focuses on the rules of the jurisdiction in which a service is provided, would create a "patchwork quilt" of permitted and prohibited services around the world. The decision as to whether a particular service impairs independence would, in effect, not be made by the Commission based on a careful assessment of the interplay between the service and the audit, but rather by local bar regulators or governments who are unlikely to have audit independence in mind when deciding whether a particular service should be restricted to lawyers. We do not see how such a result would benefit either registrants or investors.28
In light of these concerns, we disagree with the approach to legal services in the proposed rule. We suggest that the Commission instead adhere to its existing approach to legal services.
Should the Commission wish to revisit the definition of legal services, we believe that a more logical approach would be to treat legal services and expert services in the same manner. The Act refers to both types of services jointly in a single subparagraph (unlike other restricted non-audit services, which are listed separately). A final rule could track the Act's structure and include a provision covering both types of services, such as the following:
(ix) Legal services and expert services unrelated to the audit. Providing legal representation or expert opinions for an audit client in connection with legal, administrative, or regulatory proceedings, or acting as an advocate for an audit client in such proceedings.
Under this approach, the restriction on legal services, like that on expert services, would be focused on those areas where true "advocacy" is involved. Although a lawyer must always approach his or her duties with zeal, there is much that a lawyer does that cannot reasonably be considered "advocacy" in any meaningful sense of the term. In such matters, which include activities such as advising a client on legal obligations, conducting corporate investigations or due diligence, and drafting documents, the client is looking to the lawyer for objective, accurate professional advice, not "advocacy" as that term is commonly understood.
b. Recommendation - For the reasons stated above, we suggest that the Commission withdraw the proposed rule and instead retain the current restriction on legal services, which we believe has worked well for many years.
3. Other Non-audit Services
a. Bookkeeping and Related Services - The proposal would prohibit bookkeeping where it is "reasonably likely" that the results of the bookkeeping services will be subject to audit procedures during an audit of the audit client's financial statements. This is an appropriate formulation of the standard and is consistent with the Commission's long-standing position that the auditor should not audit the bookkeeping work performed by his or her accounting firm. The proposal reflects the fact that there is no self-review threat where such services are performed for an affiliate of the audit client (parent, investor, or entity in an investment company complex) that is audited by a different accounting firm, provided, of course, that the accountant does not perform management functions as prohibited by Proposed Rule 210-2-01(c)(4)(vi). The "reasonably likely to be subject to audit procedures" standard also is consistent with the statement in the Senate Banking Committee report that "an accounting firm, in order to be independent of its audit client, should not audit its own work, which would be involved in providing bookkeeping services, financial information systems design, appraisal or valuation services, actuarial services, and internal audit outsourcing services to an audit client." S. Rep. No. 107-205, at 18.
b. Financial Information Systems Design and Implementation - We agree with the proposed rule. The Commission in 2000 proposed a similar prohibition but instead adopted a disclosure requirement rather than an absolute prohibition. This service, which is what the major accounting firms traditionally called their "consulting" practice, is clearly an activity that Congress sought to prohibit.
Only two matters should be noted. First, unlike the bookkeeping proposal, this proposed rule does not include the "reasonably likely to be audited" standard, even though the "should not audit its own work" principle was the reason for this prohibition given in the Senate Banking Committee report (quoted above). The same standard should be applicable here. Second, we believe that advisory and compliance tax services that involve some aspects of systems design, implementation, and data-gathering should not be prohibited. This is "tax-only" work that is appropriately viewed as a tax service.
c. Appraisal or Valuation Services, Fairness Opinions, or Contribution-in-Kind Reports - We generally agree with the proposals, including the statement in the proposing release about the permissibility of such services for non-financial reporting purposes, and the examples given of transfer pricing and cost segregation studies. In order to avoid uncertainty, we suggest that, similar to the examples given, valuations solely for tax purposes, such as those performed for tax planning and documentation purposes,29 also would be considered valuations for non-financial reporting purposes.
Regarding contribution-in-kind reports required in various foreign countries, we agree with the statement in the proposing release that the Commission Staff should accommodate, on an expedited basis, statutory requirements in those jurisdictions. Further, it should be made clear in the adopting release that there is no independence concern where a contribution-in-kind report is issued as a result of an internal reorganization (typically as a result of a tax reorganization) involving transfers solely among wholly-owned subsidiaries (i.e., there is no effect on outside minority interests).
d. Actuarial Services - Consistent with the proposed rules and the proposing release, we agree that in providing actuarial services to audit clients, independent accountants should not perform management functions or audit their own work. The key question is whether the actuary makes computations or decisions that determine amounts that will be recorded in the client's financial statements. Actuaries associated with accounting firms provide other advisory services that do not involve the determination of the amounts in the financial statements and related accounts. Examples include advising an insurance client on the actuarial implications of converting financial reporting processes to comply with regulatory requirements, such as converting from GAAP to International Accounting Standards or from Statutory Insurance Accounting to GAAP; assisting the client by providing various data and statistical analysis; and advising on processes and framework. In this connection, consistent with the proposed rule on Appraisal or Valuation Services, and in order to provide certainty and clarity to audit committees, the adopting release should state expressly that actuarial services for non-financial reporting purposes, such as those that do not involve the determination of amounts in the financial statements, as well as actuarial work solely for tax purposes, are not prohibited by the rule.
e. Internal Audit - We agree that internal audit outsourcing services should be prohibited for SEC audit clients where it is reasonably likely that the results of these services will be subject to audit procedures during an audit of the client's financial statements. The proposal, however, does not include the "reasonably likely" standard. It should be added to the rule to be consistent with the Senate Banking Committee report (quoted supra page 37). We also suggest that the rule refer to "any internal audit outsourcing services," instead of "any internal audit services," because accounting firms offer other services related to the internal audit process, such as training and process improvement, which are not and should not be prohibited.
f. Management Functions - We agree with the proposed rule. The proposing release states that the auditor must not design and implement internal accounting and risk management controls. We agree that assuming responsibility for the design and implementation of such controls would be a management function. However, the Commission should make clear that if the client or a third party hired by the client designs and implements a system, the accountant may provide advice and assistance to the client in the design and implementation of controls. The key consideration in this situation is that the accountant is merely providing risk and control advisory services, and the accountant is not exercising any decision-making with respect to the system selection, design, and implementation.
It is important that the accountant be allowed to assist in advising the client as controls are being designed and implemented. Otherwise, the auditor may, during the audit, find deficiencies in the controls that could have been avoided if advice had been provided earlier. Making clear that the auditor can provide these type of risk advisory services is consistent with the investor protection goals of the Commission and the encouragement to registrants (often expressed by the Commission Staff) to "get it right the first time."
g. Human Resources - We agree with the proposed rule. However, the proposing release has a statement that is inconsistent with the rule. The proposing release states: "Under the proposed rule [which deals with Executive Recruiting], an auditor's independence also is impaired when the auditor advises an audit client about the design of its management or organizational structure . . . ." 67 Fed. Reg. at 76787. We do not believe that this activity impairs auditor independence because the accountant is merely advising, and we suggest the statement in quotes above be deleted from the proposing release.
h. Broker-Dealer, Investment Advisor or Investment Banking Services - We agree with the proposal and have no comments.
i. Effective Date - New Section 10A(g) prohibits the provision of non-audit services by "registered public accounting firms." Accordingly, these restrictions should not apply until firms register with the Public Company Accounting Oversight Board. Alternatively, because firms might register at different times and a uniform effective date would be desirable, the rule could provide an effective date of 30 days after commencement of the operation of the Board whether or not firms are registered (which could be no later than May 26, 2003). Thus, to the extent the new rules exceed current requirements, there would be time for firms and registrants to adjust to the new requirements. If the Commission chooses not to key the effective date to registration with the Board, it should not make the rules effective earlier than 90 days after publication in the Federal Register to allow time for an orderly transition. In all cases, existing contracts in process at the date the rules are published in the Federal Register should be grandfathered provided they are not materially modified. Such grandfathering should not exceed a period of eighteen months to ensure there is no long-term continuation of services that are prohibited under the new rules. In addition, because the proposed restriction on foreign legal services would require significant adjustments to be made by foreign legal practices (even practices only loosely affiliated with accounting firms) and would require their clients to retain new legal counsel, we urge that the Commission provide substantial additional transition time if our proposal to retain the current approach to legal services is not adopted.
E. Pre-Approval of Services
The rule proposal would require the audit committee of the issuer30 to pre-approve all services to be provided by the independent accountant. We generally agree with the proposals and endorse the Commission's decision not to prescribe specific approaches that must be followed by each audit committee, but rather to provide audit committees with flexibility to adopt pre-approval policies and procedures that can achieve maximum effectiveness given their own particular issues and circumstances. We have the following specific comments on the proposal:
1. Pre-Approval Processes Generally - Proposed Rule 210.2-01(c)(7)(i) and (ii) distinguishes between the pre-approval requirements applicable to "audit,31 review and attest reports required under the securities laws," and requirements for non-audit services. As to non-audit services generally, the audit committee has the flexibility to pre-approve them on an engagement-by-engagement basis or to pre-approve them pursuant to "policies and procedures established by the audit committee." As to audit/review/attest services, however, the proposed rule states that the audit committee must pre-approve "all such engagements." This engagement-by-engagement approval requirement for audit and other attest services is inconsistent with the description in the proposing release, which states that "the proposals do anticipate that the audit committee may approve broadly the provision of audit, review and attest services by the auditor to the issuer and the subsidiaries." 67 Fed. Reg. at 76793. We do not see any reason for a distinction in the pre-approval requirements applicable to audit/review/attest services and to non-audit services. We urge that the rule be clarified accordingly.
2. Pre-Approval Policies and Procedures - The proposing release describes the "policies and procedures" approach to pre-approval as requiring that these be "detailed as to the particular service." Id. We believe that this is inconsistent with the Senate Banking Committee report, which does not require such specificity. See S. Rep. No. 107-205, at 20. The report does state that the procedures and policies may not "permit any service that management determines appropriate" or allow the auditor to perform "all non-audit services permissible under law." Id. We agree that such a broad approach would be improper, but we believe that audit committees may pre-approve specific categories of services as opposed to individual engagements.
3. Delegation of the Pre-Approval Authority - We note that the proposing release indicates that the Act allows for one committee member to be delegated the authority to pre-approve services, but it does not state the requirement in the Act that the decisions of such member be presented to the full audit committee at its next regularly scheduled meeting. We suggest that this be added either to the rule or the release.
4. Timing of Pre-Approval - As the Committee report notes, the audit committee may pre-approve at any time in advance of the activity, but the Commission may want to specify a maximum period of time in advance. It does not seem appropriate that services be pre-approved more than a year in advance of the commencement of the services. This would be consistent with the suggestion in the Committee report. S. Rep. No. 107-205, at 20.
5. Need for Finding - The Committee report states that there is no requirement for the audit committee to make a particular finding in order to pre-approve an activity (indeed, Congress rejected proposals that a specific finding be made in order for the service to be approved, see id. at 19). Audit committee members are required to vote consistent with the standards they determine to be appropriate in light of their fiduciary responsibility and such other considerations as they deem appropriate. The Commission should consider incorporating this guidance into its final release to be helpful to audit committees.
6. Investment Companies - We have concerns about Proposed Rule 210.2-01(c)(7)(iii), which would require a registered investment company's audit committee to pre-approve other than "audit, review and attest" services (as defined) (hereinafter referred to as "non-audit services") provided not only to the fund, but also to the advisor and any entity controlling, controlled by, or under common control with the advisor that provides services to the fund.
The Investment Company Act of 1940 requires that the investment company's board of trustees approve, at the beginning of the fiscal year, retention of the independent accountants. In connection with such approval, the trustees consider the scope of services, both audit and non-audit, performed during the prior year. Based on an internal Ernst & Young analysis, approximately 60% of the 100 largest investment company complexes use the same auditing firm for the audits of the investment company and for the investment advisor. Accordingly, in situations where the advisor is a public company, two separate audit committees may be required to approve non-audit services provided to the investment advisor. If the public company advisor is the subsidiary of another public company, it is possible that three audit committees would be required to approve the same service. The nature of many non-audit services, such as due diligence, may require timely action that would render this process unworkable.
Additionally, some investment advisors, such as insurance companies, are the ultimate parent company in an investment company complex. Thus, all services provided to any entity within the entire organization must be approved by the investment company's audit committee. In some situations, this may require investment advisors to convey information that otherwise is material non-public information to investment company trustees (such as a pending acquisition of a public company advisor). Such a requirement would restrict the ability of independent corporate directors to make business decisions without prior approval from trustees of advised funds, which may not meet more frequently than quarterly.
Investment company audit fees tend to be quite small. Ernst & Young charges some investment companies audit fees as little as $15,000. Large financial institutions may use their auditing firm to provide many audit-related and other services. As a result, the audit committee of a single fund may hold "veto" approval over important and large-fee services to large brokerage, insurance, and banking organizations. We have been told by several large financial institutions that they will proscribe the auditors of the investment company from performing non-audit services for the advisor and other entities within the investment company complex. If this happens, some accounting firms simply may elect not to perform audit services for these investment companies because of the availability of much more substantial non-audit work. We do not believe that the investing public would benefit from such a result.
For these reasons, we recommend that an investment company audit committee should be required to approve in advance audit and non-audit services provided only to the investment company and paid for by the investment company.
7. Pre-Approval Fee Disclosures - We urge the Commission to make changes in the proposed proxy disclosure requirements relating to the pre-approval process. Item 9(e)(5)(ii) would require disclosure of the percentage of the fees disclosed as Audit-Related, Tax, and All Other Fees that were: (1) expressly pre-approved on an engagement-by-engagement basis, (2) provided pursuant to pre-approval policies and procedures previously established by the audit committee, and (3) approved pursuant to the de minimis exception. The proposing release indicates that "investors would benefit from knowing what percentage of the fees reported in each of the . . . categories were pre-approved by the audit committee pursuant to the policies and procedures instituted by the audit committee," and "that disclosure would provide insight into the extent to which the audit committee takes an active, direct role in considering each category of non-audit fee engagements." 67 Fed. Reg. at 76799.
Although we support other changes in the rules applicable to proxy fee disclosures (discussed below), we do not understand the rationale for the proposed disclosure of the percentage breakdown. We believe this requirement could create a misleading impression by suggesting to investors that unless the audit committee pre-approves each specific engagement, it is not fulfilling its responsibilities under the Act. To the contrary, we believe that establishing appropriate pre-approval policies and procedures, and adhering to them, will be at least as effective and efficient, if not more so, in ensuring audit independence than for the audit committee to pre-approve each separate tax compliance, audit-related, or other engagement, regardless of whether they are of a recurring nature and regardless of size, on an ad hoc basis.
Further, categories (1) and (2) will not in many cases fit into precise disclosure buckets. For example, a company might have pre-approval policies and procedures that require specific pre-approval of particular engagements (such as particular types of non-audit services, or services that exceed a specific dollar amount). It is not clear into which bucket such practices would fall.
If any disclosure in this area is required, we recommend that it only extend to disclosure of the percentage of fees disclosed that were approved pursuant to the de minimis exception. This, coupled with disclosure of the committee's pre-approval policies and procedures, would provide ample transparency while avoiding potential confusion or information overload.
8. Effective Date - Section 202 of the Act contains the pre-approval requirements for audit and non-audit services. Both audit and non-audit services are defined in Section 201 of the Act as those provided by registered public accounting firms. Thus, to ensure that issuers have sufficient time to develop appropriate pre-approval policies, procedures, and protocols, our comments regarding effective date and transition are the same as those under non-audit services above. Specifically, the pre-approval requirement should apply only to new engagements entered into on or after the effective date; preexisting engagements should not be subject to approval even if they are in process at the effective date of the pre-approval requirement.
F. Proxy Disclosure
The proxy fee disclosure proposals would expand the types of services that are included in the Audit Fee category, and also would separate from the current All Other Fees category two new categories - Audit-Related Fees and Tax Fees. We believe this proposal will provide more useful information to investors by depicting the audit relationship more accurately and by making clear that most of the services provided by auditors are audit, audit-related, or tax services traditionally provided by accountants, as opposed to "consulting" services. Accordingly, except for the proposed pre-approval disclosure buckets discussed above, we support the proposal. We have the following specific comments:
1. Audit Fees - The proposing release indicates that the proposed rule would "expand the types of fees that should be included" in the audit fee category to include "services that generally only the independent accountant can reasonably provide, such as comfort letters, statutory audits, attest services, consents and assistance with and review of documents filed with the Commission." 67 Fed. Reg. at 76798. However, the text of the proposed rule does not include these additional types of fees. We suggest that Item 9(e)(1) be revised by adding "and other attest services, in addition to services that generally only the independent accountant can reasonably provide."
2. Audit-Related Fees - As proposed, Item 9(e)(2) would cover "assurance and related services . . . that are reasonably related to the performance of the audit or review of the registrants' financial statements." Based on the discussion in the proposing release (i.e., that such fees are assurance and related services that are traditionally performed by independent accountants), and the purpose of the category, we suggest that the description be changed to "assurance and related services, including those reasonably related to the performance of the audit or review of the registrant's financial statements." For example, for banks and other regulated entities, there are various attest reports that are required to be filed with the regulator that clearly are the types of services traditionally performed by the independent accountant, but do not necessarily relate to the performance of the audit or review of the financial statements.
The proposing release indicates that consultation concerning financial accounting and reporting standards would be included in Audit-Related Fees. We believe that consultations necessary for signoff on the consolidated financial statements would be included more appropriately within the Audit Fees category rather than Audit-Related Fees. We suggest the following distinctions:
- Consultations on accounting matters that arise during or in connection with quarterly review work or the annual audit should be reported as Audit Fees.
- Assistance provided to a company in assessing and implementing a new accounting or financial reporting standard would be included in Audit Fees.
- Accounting assistance such as a special review of a proposed merger transaction, impairment or restructuring charge would be reported as Audit Fees if relied upon in connection with the GAAS opinion (i.e., the effect of the proposed transaction is included in the registrant's consolidated financial statements), or as Audit-Related Fees if not relied upon in the GAAS opinion (i.e., the proposed transaction is not consummated or otherwise not included in the registrant's consolidated financial statements).
3. Tax - The proposing release indicates that "[t]he `Tax Fees' category would capture all services performed by professional staff in the independent accountant's tax division." 67 Fed. Reg. at 76799. However, work done by tax professionals in connection with the audit or quarterly reviews, such as review of the tax provision and accruals, should be reported as Audit Fees. Accordingly, the final release should expressly exclude such work from the Tax Fees category.
4. Periodic Reports - We agree with the proposal for annual disclosure of pre-approval information, but we see no need to extend the disclosures to semi-annual reports.
5. Investment Companies - The Commission solicited comment on how fee disclosure rules should apply to investment companies and related entities. Consistent with our recommendation above that investment company audit committees be required to pre-approve services for the registrant only, we suggest that the disclosure of fees mirror the pre-approval requirement - that is, the various categories of fees should be for the registrant investment company only. As noted previously, investment company audit fees may be as little as $15,000. Disclosure of other fees for the registrant, its investment advisor, and certain other parties could mislead a reader into believing that independence is impaired given the magnitude of the numbers.
If the Commission elects to require disclosure of fees paid to the advisor and other parties, then it should require separate disclosure of each category of fees paid to (i) the investment company registrant and (ii) other entities excluding the registrant.
6. Effective Date - Although we believe that the proposed changes to the fee disclosure categories will improve disclosure, it may be difficult for many calendar year-end companies to comply with the new requirements with respect to their annual proxies for 2002, which will be due only a few weeks after a final rule is likely to be published. Accordingly, we suggest that the Commission encourage the new format for all filings made after the availability of the new rules, but require it only for registrants whose fiscal years end on or after June 30, 2003.
As noted above, we do not support the requirement for any percentage breakdown of the method by which services are pre-approved, except perhaps for services approved pursuant to the de minimis exception. If the Commission retains any such requirement, it should not be effective until at least one full year of activity is covered by the new rules.
G. Employment with Clients
1. Scope of the Proposal - Section 206 of the Act states that it is unlawful for a registered firm to perform audits for an issuer if a Chief Executive Officer, Controller, Chief Financial Officer, Chief Accounting Officer, or equivalent was employed by the firm, and participated in any capacity in the audit of that issuer during the one-year period preceding the date of the initiation of the audit. Proposed Rule 210.2-01(c)(2)(iii)(B) exceeds the Act's requirements in two major respects.32
First, instead of the bright lines provided by the Act, the proposal would expand the scope to a greater, and more subjective, number of positions by including all persons in a "financial reporting oversight role."
Second, instead of applying only to employment with the "issuer," the proposal applies to employment with "audit clients," a defined term that includes affiliates of the audit client, which can include remote affiliates audited by other auditors.
We believe that going beyond the Act's requirements in these two areas is both inappropriate and unnecessary for the protection of investors. Existing rules already require anyone who leaves an accounting firm to join an audit client of that firm in a financial reporting role to sever financial ties with the accounting firm and to have no continuing influence over the firm. The creation of additional uncertainty as to who is covered by the one-year restriction and where they may work seems contrary to the intent of Congress.
2. Commencement of the One-Year Period - As proposed, the one-year cooling-off period would be calculated by counting backwards from the date "when the accountant began the current fiscal year's audit or when the accountant began review procedures necessary to conduct a timely review of the registrant's quarterly financial information associated with the current fiscal year." 67 Fed. Reg. at 76782. We believe the proposed rule would be difficult to apply in practice because of the difficulty in determining, especially for multi-location engagements, when the audit or review procedures actually "began." Accordingly, we propose that an objective, bright-line test be established by assuming that work on the current year's audit/review begins on the day after the registrant files its Form 10-K for the previous fiscal year.
This bright-line approach would make it easy to ascertain the applicable one-year period for any given employee. For instance, if a registrant filed its Form 10-K for 2001 on April 1, 2002, audit procedures for the 2002 audit would be deemed to have commenced on April 2, 2002. The one-year period would mean that a restricted employee who joined the registrant on or after that date could not have been a member of the engagement team on or after April 1, 2001.
We further propose that the determination of whether independence is impaired be made at the date of employment and not be affected by events subsequent to that date, such as an acquisition of a company. For example, assume that an employee of an accounting firm leaves the firm to become controller of Company X, a non-client that is later acquired by Company Y, an audit client of the accounting firm. As a result of the acquisition, the former employee becomes the controller of the combined X/Y. Excluding this situation from the scope of the rule would be consistent with the Senate Banking Committee report, which indicates that the intent of Congress was to restrict "an employee of the accounting firm who worked on the issuer's audit and subsequently seeks to be employed by that issuer in a senior management capacity." S. Rep. No. 107-205, at 22. Another example would be a merit promotion caused by the unexpected departure or death of an individual holding one of the restricted positions.
We also propose that the final rule include a de minimis test - for example, less than ten hours - so that individuals who spend only a few hours on the audit in a fiscal period would not be considered a member of the audit engagement team for purposes of the rule. Such an exception would be consistent with the rule for the exclusion from "covered persons" for individuals who spend less than ten hours on non-audit services. Although such persons would still be considered covered persons, they should not be subject to the more onerous provisions of the rule.
3. Effective Date - The rule should not be made effective earlier than ninety days after publication in the Federal Register, to give time to disseminate the information. This window of time is particularly important to ensure that registrants are aware of the ramifications as presumably the rule would apply to former accounting firm personnel who already have left the firm as of the effective date, but who may seek employment with an issuer audit client of the firm during the one-year period. Importantly, the final rule should clearly indicate that former firm personnel who have become associated with issuers in compliance with the Commission's rules prior to the effective date are grandfathered.
H. Communications with Audit Committees
1. Auditor and Management Responsibilities - We believe it is essential for an audit committee to be informed about important matters pertaining to the issuer's financial statements before they are filed with the Commission. It should not be important whether management or the auditor first makes the communications. What is important is that the audit committee be informed about the matters and the views of management and the auditor. As the proposing release points out in discussing critical accounting policies, "[p]roactive discussions between the audit committee and the company's senior management and auditor . . . are appropriate." 67 Fed. Reg. at 76796.
It also is important to keep in mind that management is responsible for the issuer's financial statements. In that context, it is appropriate for certain communications to be made by management - for example, those related to critical accounting policies and practices, which are required to be discussed further in management's discussion and analysis, and the selection of new or changes to accounting policies.
Accordingly, we believe the proposed rule should be revised to require the auditor to assure that the communications are made and, where communications are made by management, to state to the audit committee the auditor's views regarding management's communications. In addition, we suggest that the adopting release recommend that each audit committee establish the protocol it wishes management and the auditor to follow in their communications with the committee.
2. Application to "Issuers" - The proposed rule would apply to "issuers" rather than to "audit clients." This is an appropriate result. Application of the requirement to "audit clients" would mean that the audit committee could be burdened with unimportant information.
3. Critical Accounting Policies - The proposed rule for critical accounting policies and estimates and the proposing release, considered together, could be interpreted to mean that all accounting policies and estimates need to be discussed with the audit committee - regardless of materiality. The proposing release states as follows:
We do not propose to require that those discussions follow a specific form or manner, but we expect, 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.
67 Fed. Reg. at 76796 (emphasis added).
We believe that the communication requirement pertaining to critical accounting policies should relate only to those that are material to the issuer's financial statements. (With respect to estimates, please see section 5 below.)
4. Alternative Accounting Treatments
a. We believe that the communication requirement should relate only to matters that would have had a material effect on the issuer's financial statements. This would avoid burdening the audit committee with communications about matters of little or no importance.
b. With respect to the Act's requirement that the auditor state the "treatment preferred by the registered public accounting firm," we believe it would be useful for the adopting release to provide context by reference to current audit literature. In ASR 177, the Commission stated, in the context of preferability letters, that "professional accounting judgment can be applied to determine whether an alternative accounting principle is preferable in a particular set of circumstances." Current audit literature addresses directly the nature and extent of communication of an auditor's judgments about the quality of accounting principles. AU Section 380.11 states in part as follows:
Objective criteria have not been developed to aid in the consistent evaluation of the quality of an entity's accounting principles as applied in its financial statements. The discussion should be tailored to the entity's specific circumstances, including accounting applications and practices not explicitly addressed in the accounting literature. . . .
We recommend that the adopting release take note of the subjectivity inherent in determining whether a particular accounting treatment is preferable by endorsing the context described in the above literature.
5. Estimates - We note that neither Section 204 of the Act nor the proposed rules refer to accounting estimates. Yet several sections of the proposing release (i.e., the last paragraphs under "Critical Accounting Policies and Practices" and "Alternative Accounting Treatments") suggest that a discussion of critical accounting estimates is required. The adopting release should make reference to and embrace the current audit literature regarding the nature and extent of communication of accounting estimates. AU Section 380, "Communication With Audit Committees," states as follows regarding management judgments and accounting estimates (paragraph .08) (emphasis added):
Accounting estimates are an integral part of the financial statements prepared by management and are based upon management's current judgments. Those judgments are normally based on knowledge and experience about past and current events and assumptions about future events. Certain accounting estimates are particularly sensitive because of their significance to the financial statements and because of the possibility that future events affecting them may differ markedly from management's current judgments. The auditor should determine that the audit committee is informed about the process used by management in formulating particularly sensitive accounting estimates and about the basis for the auditor's conclusions regarding the reasonableness of those estimates.
6. Investment Companies - The proposed rule specifies that the communications between the auditor and the audit committee must occur prior to the filing of the audit report with the Commission. Investment companies may have multiple year-ends. The proposal could require boards of trustees to meet every month of the year to comply with the requirement for formal communication with the audit committee prior to filing the financial statements. Additional board meetings would compound shareholder costs.
In lieu of this proposed rule, we recommend that the audit committee and the auditor establish tailored communication protocols to enable each audit committee to determine how to execute their responsibility consistent with their charter and the Act, which only requires "timely" reporting to the audit committee.
7. Effective Date - The effective date should provide sufficient time for audit committees to establish the protocols they wish management and auditors to follow in their communications. We suggest that communications be required for audits of financial statements of issuers for fiscal years ending after December 15, 2003, with earlier implementation encouraged.
We have a concern about one proposed change in the current definition of "Accounting Role/Financial Reporting Oversight Role" in Proposed Rule 210.2-01(f)(3). In order to make clear that the "cooling-off" requirements discussed above only apply to persons with financial oversight responsibilities, the proposal would split up the existing definition of Accounting Role and Financial Reporting Oversight Role into two components - persons with an accounting oversight role (now described in (f)(3)(i)), and persons with a financial statement oversight role (now described in (f)(3)(ii)).
As indicated above, we do not believe this change is necessary because the cooling-off period should not apply to any position other than the four specified by the Act. However, if the Commission does not change the proposal, we are concerned that the proposing release, in discussing "accounting role," indicates that it includes certain individuals in clerical positions in the accounting department. This suggests that an accounting clerk (as opposed to an accounting manager or supervisor) would be included in the definition. The result would be significantly different than our understanding of the type of position intended to be covered by the existing definition,33 particularly since the Codification of Financial Reporting Policies indicates that the Commission "has chosen not to reach as many persons in the audit client's accounting department as are covered by the audit sensitive category in the AICPA's employment rules."34 Thus, if the Commission moves forward with this definitional change, we recommend removal of the reference to clerical positions, and staying with the existing language in the Codification (Section 602.01.D.2.b).
* * *
We appreciate the Commission's consideration of our comments on this issue. If the Commission or the Staff have questions about the comments in this letter, please contact us.
Ernst & Young LLP
cc: Chairman Harvey L. Pitt
Commissioner Paul S. Atkins
Commissioner Roel C. Campos
Commissioner Cynthia A. Glassman
Commissioner Harvey J. Goldschmid
Giovanni P. Prezioso, General Counsel
Jackson M. Day, Acting Chief Accountant
|1|| Proposed Rule: Strengthening the Commission's Requirements Regarding Auditor Independence, 67 Fed. Reg. 76780 (proposed Dec. 2, 2002).
|2|| See Letter of Ernst & Young LLP, Comments on Proposed Rule: Revision of the Commission's Auditor Independence Requirements (September 25, 2000), available at http://www.sec.gov/rules/proposed/s71300/ernsty2.htm.
|3|| See Ernst & Young LLP, SEC No-Action Letter, 2000 SEC No-Act. LEXIS 664 (May 25, 2000).
|4|| See Letter of Ernst & Young, supra note 2.
|5|| See also 67 Fed. Reg. at 76783 (quoting Senator Sarbanes as describing "one of the fundamental objectives of the conference report: to draw a bright line around a limited list of non-audit services that accounting firms may not provide.").
|6|| The release also states: "While we do not define `tax services,' we understand that tax services can include a range of activities including the preparation of tax returns, tax compliance, tax planning, tax recovery, and other tax-related services." 67 Fed. Reg. at 76790. And, as discussed infra, the release contains a lengthy description of the tax services that would be included in the "Tax Services" proxy statement fee disclosure. 67 Fed. Reg. at 76782-76783.
|7|| A widely-circulated article in the Wall Street Journal published just after the SEC issued its proposal reported that "[l]awyers seeking more of the [tax advisory] business" had concluded that the rule proposal would bar accounting firms from performing a wide range of services. The article cited a tax lawyer at a major law firm, who also served as chair of the American Bar Association's Section on Taxation, for this analysis. The article stated:
[T]he potential impact could go far beyond tax shelters, some legal experts say. A lot of tax-planning advice relates to business arrangements designed to minimize taxes, said [the lawyer]. Audit firms also advise on balance-sheet reserves for unpaid taxes in the event tax authorities challenge a particular transaction, advice that could be deemed auditing their own work, [the lawyer] said.
Cassell Bryan-Low, Audit Firms May Face Tax-Service Sales Ban, Wall St. J., Dec. 4, 2002, at A2. See also SEC Proposals for Auditor Independence Could Bar Selling of Tax Strategies to Clients, 234 DTR G-12 (BNA) (Dec. 5, 2002).
|8|| The words "legal" and "expert" services were included in a list of prohibited services contained in the Commission's independence rule proposal of June 2000. The text of the Act originally would have had the Commission adopt definitions of those prohibited services that were "substantially similar" to those in its proposed 2000 auditor independence rule, which was more restrictive than the final rule that the SEC adopted after the notice-and-comment period. That "substantially similar" 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." 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). The Committee preferred this outcome because the final rule reflected the careful judgment of the Commission, which "worked very hard and held many hearings on this subject." Id. During the floor debate, Senator Dorgan attempted to re-insert the "substantially similar" provision through a floor amendment, but the Senate never adopted it. See Sen. Amend. No. 4216. Thus, it would be starkly inconsistent with the legislative history if the SEC were to define the terms "legal" or "expert" services in a manner not merely more restrictive than its final independence rules but also even more restrictive than the SEC's July 2000 rule proposal, which did not propose to prohibit tax services. See Proposed Rule: Revision of the Auditor Independence Requirements, 65 Fed. Reg. 43148, 43172 (proposed June 30, 2000) ("The proposed rule would not affect tax-related services provided by auditors to their audit clients. Tax services are unique, not only because there are detailed tax laws that must be consistently applied, but also because the Internal Revenue Service has discretion to audit any tax return.").
|9|| The only reference to the Act's treatment of tax services is contained in the section-by-section analysis of Section 201, where it is stated: "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 [Act]." S. Rep. No. 107-205, at 51. Further indication of Congressional intent was provided in the recent statement by Rep. Oxley, who "noted that in creating the legislation, lawmakers considered and debated the role of auditors in delivering tax advice to clients and determined that this service was `part and parcel' of the traditional audit function and part of the way auditors have historically worked with their clients . . . ." PR Newswire, Dec. 10, 2002, Financial News.
|10|| It also is difficult to distinguish tax advisory work and accounting advisory work (which, of course, auditors routinely provide to their audit clients). Both activities arguably could result in the auditor "auditing his own work," yet it would hardly be reasonable or consistent with audit quality to bar the latter.
|11|| See Wall Street Journal article, supra note 7, for evidence of public discord.
|12|| See generally Deborah H. Schenk, Symposium on Corporate Tax Shelters, Part I: Foreword, 55 Tax L. Rev. 125 (Winter 2002). Currently, different sections of the Internal Revenue Code contain different definitions for the term "tax shelter."
|13|| If the Commission were to decide that such a definition is necessary, the starting point could be the description in the proposing release of the services that would be included in the "Tax Services" proxy statement fee disclosure. It states:
The "Tax Fees" category would capture all services performed by professional staff in the independent accountant's tax division. Typically, it would include fees for tax compliance, consultation and planning . . . . Tax consultation and tax planning encompass a diverse range of services, including assistance and representation in connection with tax audits and appeals, tax advice related to mergers and acquisitions, employee benefit plans and requests for rulings or technical advice from taxing authorities.
67 Fed. Reg. at 76799. In addition, we would urge that the following services be included in that description: tax opinions; practice before federal, state, local, and non-U.S. taxing authorities and planning and compliance services with respect to the taxes and similar items such as customs and duties administered by these authorities; practice before state, local, and similar foreign administrative review boards; preparation of original and amended tax returns, claims for refund and tax payment; tax credits, tax abatements, and other tax matters relating to economic development incentives; legislative and regulatory advice and assistance; cost segregation, transfer pricing, and valuation reports prepared for tax purposes; pension-related services closely related to tax issues; tax services that involve some aspects of design, implementation, and data gathering for tax planning; and compensation advisory services.
|14|| We do not, however, believe that a prohibition on "tax court" appearances should extend to foreign lawyers who are associated with an accounting firm and who appear before foreign tribunals on tax matters. As was discussed at the Commission Roundtable on December 18, 2002, some countries do not have the equivalent of an IRS appeals process, and tax disputes may proceed directly to a court. In addition, foreign lawyers in some countries, such as Germany, are not serving as "advocates" for their clients - they are statutorily required to be impartial and not identify with the interests of their clients. It clearly would be too difficult for the Commission to try to distinguish between legal practices in foreign countries in the context of this rulemaking, so we ask the Commission to limit its prohibition to appearances in U.S. tax court. (Similar concerns about the proposal's impact on foreign legal practices are discussed below in relation to the prohibition on legal services.)
|15|| Indeed, the proposing release states: "A broad interpretation of this prohibition could lead one to conclude that almost all services provided by a certified public accountant (CPA) could be considered to be `expert' services. For example, 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 all expert services because the Act specifically provided for an auditor to be able to perform certain services, including tax services, if the audit committee approves them in advance." 67 Fed. Reg. at 76784.
|16|| See AICPA Code of Professional Conduct, ET § 101.05 Interpretation 101-3 - Performance of other services.
|17|| A "listed transaction" is a transaction that is the same as or substantially similar to one of the types of transactions that the Internal Revenue Service has determined to be a tax avoidance transaction and identified by notice, regulation, or other form of published guidance as a listed transaction for purposes of 26 U.S.C. § 6011 (which establishes the authority for the IRS to require disclosures and statements on tax returns). Note that these transactions are not per se illegal; rather, they are transactions the IRS has designated as ones it will challenge.
|18|| As the Senate Banking Committee report makes clear, the intended focus of the Act is on the tenure of the lead audit partner and review partner in those respective roles. S. Rep. No. 107-205, at 21 (explaining that "the bill requires [a firm] to rotate its lead partner and its review partner . . . so that neither role is performed by the same accountant for the same issuer for more than five consecutive years") (emphasis added). The Commission recognized as much in the proposing release. 67 Fed. Reg. at 76791 (noting that the Act "clearly specifies that the lead audit partner and reviewing partner should serve on the engagement in that capacity for no more than five consecutive years") (emphasis added).
|19|| To the extent the proposed rule may suggest otherwise, we suggest that it be rephrased.
|20|| We recommend that the threshold for a rotation requirement be higher than the significant subsidiary definition in Regulation S-X (10% of various consolidated measures) and should be decoupled from the significant subsidiary definition to avoid unnecessary volatility in subsidiaries moving over and under the threshold from year to year. Instead, we suggest that the threshold simply be 20% of either assets or revenues.
|21|| See, e.g., Selvidge v. U.S., 160 F.R.D. 153, 155-156 (D. Kan. 1995); Fed. R. Evid. 702; Wis. Stat. 907.02.
|22|| "In the performance of any professional service, a member shall maintain objectivity and integrity, shall be free of conflicts of interest, and shall not knowingly misrepresent facts or subordinate his or her judgment to others." ET § 102.01. Rule 102 - Integrity and Objectivity.
|23|| ET § 191.101, Interpretation 191-202-203 - Client Advocacy and Expert Witness Services.
|24|| The proposing release does state that the audit committee (rather than a law firm hired by the committee) could retain the accounting firm to investigate a potential financial impropriety (see 67 Fed. Reg. at 76789), but this is not how such investigations typically are handled. Generally, in order to be able to assert relevant privileges, an outside law firm, not the audit committee, retains the accounting firm.
|25|| See Fed. R. Civ. P. 26(b)(4)(B).
|26|| Unlike a testifying expert witness, the work of a consulting expert is generally discoverable only upon a showing of "exceptional circumstances." Id. See also Fed. R. Civ. P. 26(a)(2).
|27|| The 2000 rule proposal was as follows: "Providing any service to an audit client or an affiliate of an audit client that, in the jurisdiction in which the service is provided, could be provided only by someone licensed to practice law." 65 Fed. Reg. at 43192.
|28|| If the Commission should choose to adopt an approach that depends on the jurisdiction in question, we suggest that the focus should be on the home jurisdiction of the lawyer (or the jurisdiction whose law is being advised on, which is likely to be the same thing), rather than the jurisdiction where the service is provided. If, for instance, a Spanish lawyer sitting in Madrid would be permitted to provide certain advice on Spanish law to an audit client, the same lawyer should be permitted to offer the same service while in Paris or New York on business.
|29|| An example of a tax-only valuation is an international tax restructuring strategy that requires valuations of various businesses or assets. This includes a valuation of tangible property to facilitate the use of foreign tax credits and the allocation of interest. In these cases, fair market valuations are performed for assets that have been acquired previously and will continue to be recorded at historical costs for financial statement purposes. Another example would be appraisals of the value of tangible property solely to assist clients in their efforts to properly minimize their state and local property taxes.
|30|| We agree that the proposal should apply to issuers, consistent with the Act. The Commission asked whether it should apply to a broader population such as "audit clients" as defined in Regulation S-X, which would include affiliates, many of which would be non-audit clients. We do not believe it is necessary or appropriate to go beyond the Act.
|31|| The proposing release indicates that the proposed rules recognize audit services to be broader than those required to be performed pursuant to GAAS, e.g., comfort letters, statutory audits required for issuance companies, and various statutory audits required internationally. We agree with this approach, which is consistent with the proxy disclosure of Audit Fees.
|32|| The proposal refers to a member of the audit engagement team. The final rule should clarify that this does not include the concurring or independent review partner (who performs review procedures required by the SEC Practice Section) or National Office personnel who consult on technical issues because they are not members of the audit engagement team. If the Commission believes the review partner should be covered by the rule, it should specifically so state.
|33|| This would have implications in the application of the SEC rules on family relationships.
|34|| It should be noted that the AICPA definition of "audit-sensitive" once included accounting clerks, but the AICPA subsequently conformed its rules. ET § 92.16 - Key Position.