Grant Thornton LLP
January 13, 2003
VIA ELECTRONIC MAIL
Jonathan G. Katz, Secretary
File no. S7-49-02; SEC Release Nos. 33-8154; 34-46934; 35-27610; IC-25838; and IA-2088
Dear Mr. Katz:
Grant Thornton LLP appreciates the opportunity to comment on the U.S. Securities and Exchange Commission's proposed rule, Strengthening the Commission's Requirements Regarding Auditor Independence as presented in Release Nos. 33-8154, 34-46934, 35-27610, IC-25838, and IA-2088.
Consistent with Grant Thornton's five-point plan to restore public trust announced in February 2002, we believe leaders of accounting firms must set a tone that once again places the firms' professional responsibilities ahead of all other business considerations. Grant Thornton's most valued principle has been, and will continue to be, our uncompromising commitment to professional excellence. We continue to be concerned about the impact of recent events on SEC registrants and the entire accounting profession, and we commend the Commission's progress in its recent rule-making efforts. We understand that Section 208 of the Sarbanes-Oxley Act of 2002 (the "Act") directed the Commission to propose rules to address the independence of accountants that audit and review financial statements and prepare attestation reports filed with the Commission. The releases noted above are in response to that mandate. While Grant Thornton agrees that enhancing auditor independence will provide one step in helping restore public confidence, we believe that the proposed Rules could be significantly improved in several respects.
We have limited our comments to critical issues that we have identified. As discussed more fully in our specific comments, we believe that the proposed Rules could be clarified and revised in a number of respects to be consistent with the intent of Congress in passing the provisions of the Act. We believe our suggestions would allow the Commission to comply fully with the Act, while at the same time protecting the rights of issuers to obtain the services of a competent, experienced independent accountant.
Conflicts of Interest Resulting from Employment Relationships
The one-year cooling-off period is sufficiently long to achieve the desired appearance of independence by the accounting firm. We are opposed to extending the cooling-off period beyond a one-year period, as we do not believe it would enhance the Commission's objective and is not necessary to protect the public interest. In addition, the additional time extension would be even more difficult to monitor in practice. For example, if the cooling-off period was two years or longer, an employee of Grant Thornton could leave the firm through accepting employment at a non-audit client. The former employee could remain at the non-audit client for a short period of time, and then subsequently accept a position with an audit client of the firm. Grant Thornton would not be in a position to have influence over the actions of this former employee and may not have knowledge of this employment arrangement until the firm's independence was in fact, impaired. Issuers would also experience difficulties in monitoring compliance with a longer cooling-off period.
The term "audit engagement team" as used in the proposed Rule 2-01(c)(2)(iii)(B)(1) should be revised to be consistent with how the term is expected to be interpreted under proposed Rule 2-01(c)(6)(i), regarding partner rotation. We note that the proposing release states:
Footnote 14 references Rule 210.2-01(f)(7) of Regulation S-X, which defines audit engagement team members as:
We believe the inclusion of the phrase "all persons who consult with others on the audit engagement team" within the above definition could be interpreted to include, for example, individuals serving in a technical consulting capacity in the national or regional office of an accounting firm. This appears to be inconsistent with the Commission's stated position in Item C. of the proposing Release regarding partner rotation. Item C. states:
The final Rule should utilize a clear and consistent definition of audit engagement team to avoid confusion and misapplication of the Rule. Further, we would like to emphasize that the discussion above with regard to the omission of national office partners from the definition of audit engagement team is included in the proposing Release, not the proposed Rule. Articulation of the Rules' scope should not be left to the language of the Release. We believe that the final Rules, not just the accompanying Release, should reflect as much detail as possible in regards to definitions of terms used, calculation of required rotation and cooling-off periods, and transitional requirements. The final Rule, along with other final Rules adopted, and to be adopted, will be the source for compliance. Grant Thornton would like to make this point in general as to the Commission's many rule-making efforts. All final Rules should fully reflect the compliance expectations of the Commission. Registrants and auditors may look to the proposing Release for background information and the Commission's rationale of the final Rule, but should not be required to look to the proposing Release for definitions or other clarifications needed for compliance. The final Rules should stand on their own and provide the requirements in a clear and concise, yet comprehensive manner.
Consistent with the comments in the above paragraph, we suggest that the phrase "commencement of the audit" be clarified in the final Rule to incorporate more of the interpretation provided in the accompanying Release. Also, it may be beneficial for the final Rules to acknowledge that certain audits involve year-round planning and advance audit procedures that should be taken into consideration in determining the commencement date.
Services Outside the Scope of the Practice of Auditors
Application of General Principles
We have some general concerns as to how the Commission may regard, in its application of its three basic principles, certain services that are routinely provided to issuers by the auditor. For example, in structuring proposed transactions, management frequently consults the auditor with respect to tax, accounting, internal control, and other business consequences. Consulting the auditors regarding the appropriate accounting treatment of a transaction, prior to consummation of the transaction, allows management, the Board of Directors, and the audit committee, to make an informed decision regarding the transaction. These consultations are critical to ensure that registrants achieve the desired results of the transaction, without triggering unintended accounting implications. These consultations also help ensure accurate and timely financial reporting and thus, protect investors. It is unclear from the proposing Release and the proposed Rule whether this type of assistance to management would impair the auditor's independence as the auditor may be deemed to be functioning as part of management, and/or subsequently auditing its own work, or even performing a prohibited expert service. Also, there is the concern that assisting registrants in their response to comment letters received from the staff of the Commission, and participating in follow-up telephone calls with the staff, may be viewed as an impairment to independence. In providing such assistance, the auditor could be viewed as performing a function of management and also acting as an advocate of the audit client, if asked to help provide an explanation on a particular accounting issue to the Commission staff. We suggest that the final Rule (and not only the Release) address these concerns, in addition to others that will surely arise, by including a discussion of the routine types of services that auditors currently provide and how those services would be viewed under the final Rule. A practical discussion of this nature is critical for compliance with the Rules, especially for the smaller, less sophisticated issuers. These smaller issuers do not employ numerous accounting and tax specialists, and must rely upon these consultations with their auditors, to ensure accurate and timely financial reporting.
The definition of "bookkeeping or other services" should be clarified to provide further guidance regarding the treatment of audit adjustments proposed by the auditor. During the normal course of an audit, the auditor routinely discovers audit differences that are proposed to management for posting to the general ledger. Of course, the registrant must fully understand and agree with these adjusting entries. However, proposing such adjustments could be interpreted as preparing or originating source data underlying the audit client's financial statements. There is also the risk that the auditor could have the appearance of auditing his/her own work in this circumstance.
We are also concerned about the definition of "preparing financial statements". It is unclear as to the level of assistance the auditor can provide to management in the preparation of the financial statements and related notes. Auditors have routinely advised management in complex accounting areas, such as tax accruals, accounting for compensation arrangements, and derivative transactions. Auditors also have routinely aided management by reviewing and commenting on draft footnotes to the financial statements. Often the comments and recommended changes can be extensive. Because management reviews the financial statements and disclosures and clearly accepts their responsibility for the fair presentation of the financial statements, we believe appropriate safeguards are in place to conclude that the auditor is not auditing his/her own work. To avoid confusion, however, we believe the definition must be clarified, especially for the benefit of small issuers.
We do not believe that prohibiting the auditor from providing these services would further the purposes of the Act. We also believe that a prohibition on these services would pose significant hardship on smaller issuers that depend on the audit firm to provide these services. We suggest that the final Rule address the above concerns, by including a discussion of the routine types of services that auditors currently provide and explicitly indicate that these services are permissible under the Rule.
Internal Audit Outsourcing
The final Rule should be revised to clarify the types of services that would be considered "any internal audit services related to the internal accounting controls, financial systems, or financial statements, for an audit client". We believe that the auditor should be able to provide additional services, at management's request, within a particular department or operating cycle. For example, the auditor should be able to expand, at the request of management, the scope of confirmation testing or inventory observation procedures. These individual projects, or engagements, should not be viewed as providing internal audit outsourcing services to the client, and thereby impairing the auditor's independence.
We believe that auditors should be allowed to perform operational audits unrelated to the internal accounting controls, financial systems, or financial statements. An operational audit should not cover items that would be significant or material to the subject matter of the audit. For example, the auditor could perform a technology effectiveness assessment or efficiency analysis without impairing independence.
We do not believe that making recommendations for improvements on the design of internal accounting controls and risk management controls would result in the auditor auditing his or her own work. If the auditor makes recommendations on the design of the internal accounting controls, management must fully understand the proposed control system, accept the design, and perform the steps necessary to ensure full implementation and operating effectiveness of the controls. In short, management must take full responsibility for the appropriateness and effectiveness of the design. Management must also take responsibility for monitoring the effectiveness of the system on an ongoing basis. We agree that the auditor should not perform implementation services for an audit client, as the auditor would be functioning as a part of management.
In summary, recommending improvements to the internal accounting controls should not impair the auditors' independence when the auditors are required to issue an attestation report on the effectiveness of the internal control system. As noted in the proposing Release, these services can be extremely valuable to companies, and they may also facilitate the enhancement of a registrant's accounting system and the performance of a high quality audit.
Grant Thornton believes that the only time an accounting firm can perform or assume management functions or responsibilities for an audit client without impairing independence is in the rare case of an extreme emergency (e.g., destruction of client records due to unusual disaster, such as the events on September 11, 2001) and only when the registrant has no other viable alternative. In addition, in these emergency situations, the auditor would be permitted to perform these services only with the express approval of the Commission staff.
As previously mentioned, consultations with the auditor regarding the appropriate accounting and tax treatment of a proposed transaction, prior to consummation, allows the Board of Directors and the audit committee to make an informed decision, thus avoiding unintended accounting and tax implications. The accounting for compensation arrangements is extremely complex, and it is prudent, and in the best interests of the shareholders, for the auditor to be consulted on these arrangements. Again, these consultations assure accurate and timely financial reporting. Additionally, much of the focus on executive compensation arrangements is in regards to the tax implications, both for the registrant and for the individual. We believe consultation in regards to tax issues is an allowed non-audit service under the proposed Rules.
It is not clear from the proposed Rule and accompanying Release, whether the auditor would be prohibited from assisting a registrant in responding to any regulatory proceeding (e.g., responding to SEC comment letters as mentioned previously, or responding to accounting and auditing questions from federal and state banking regulators). The meaning of the term "administrative proceeding" should be clarified in the final Rule. For instance, is an investigation (informal or formal) by the Commission's Division of Enforcement of the SEC considered an administrative proceeding? And if so, would the auditor be considered to be acting as an advocate for their client if the auditor attends meetings with the Commission staff or otherwise assists the registrant in responding to the questions of the enforcement staff? Would attending a meeting with a client with the Internal Revenue Service be considered to be acting as an advocate for the registrant? While we believe investigations are not "administrative proceedings", the Commission should eliminate possible misunderstandings. Providing information and assistance in these settings does not require the auditor to act as an "advocate" for the client, but to provide the auditor's knowledge and professional conclusions. We do not believe that assisting an audit client in responding to the above situations would impair the auditor's independence. Therefore, it would be beneficial to provide a more robust definition and discussion of the term "advocate" in the final Rule.
We believe that an auditor should be permitted to serve as a non-testifying expert for an audit client in connection with a proceeding. Auditors should be allowed to provide consultation and other services to an audit client's legal counsel in connection with litigation, administrative, or regulatory proceedings. The proposing Release indicates that the audit committee could engage the auditor to provide advice or forensic services, in fulfilling its responsibility to conduct its own investigation of a potential accounting impropriety, provided that the auditor does not take on the role of an advocate in such an investigation. The Release also indicates that the audit committee may also engage legal counsel and the auditor's work product could be shared with counsel without impairing the auditor's independence. Therefore, the auditor could, in practicality, be used to assist the audit committee and counsel in investigating an impropriety, but then later would be prohibited from providing assistance to counsel if the impropriety resulted in a legal proceeding. This prohibition could result in audit committees hesitating to engage the auditor, which has the best understanding of the registrant's business, internal accounting controls, and accounting practices, to perform initial investigations or forensic services. We do not believe that this outcome would be in the best interests of the audit committee or the registrant's shareholders.
The definition of "expert services unrelated to the audit" is not clear and should be revised. The proposed Rule defines the term as providing "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." The accompanying Release has broadened this definition to also cover:
The wording included in the accompanying Release suggests that providing advice through consultation with counsel (without rendering a formal opinion) would be prohibited. This interpretation seems to be broadening the scope of the wording in the proposed Rule. In summary, where the accounting firm is providing technical research, analysis, and information to either the audit committee or client's counsel, such activities should not be viewed as the kind of advocacy that would impair independence.
At Grant Thornton, we specialize in providing services to middle-market companies. While we believe that our comments on the Proposed Rules have general applicability, we have also addressed some of the unique issues facing middle-market companies in complying with the Proposed Rules.
We believe that: (1) Congress intended to exempt tax services from the list of prohibited services; (2) the Commission should not prohibit a specific category of tax services; and (3) the final Rule should clarify, consistent with the Act itself, that tax services are permissible, subject to audit committee pre-approval.
Intentions of Congress
We believe that Congress intended to exempt tax services from the list of prohibited services. Section 201 of the Act states that, "A registered public accounting firm may engage in any non-audit service, including tax services, that is not described in any paragraphs (1) through (9) of subsection (g) for an audit client, only if the activity is approved in advance by the audit committee of the issuer..."
The Commission's proposed Rule is consistent with the above paragraph, as the Rule's text list of prohibited services does not include "tax services" within the list. The proposing Release also indicates "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 audit committee." The proposing Release also adds that "as discussed in our previously proposed rules on independence, 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."
While the above statements are consistent with the Act, the proposing Release also contains conflicting and confusing language, which could have the practical effect of limiting the provision of tax services by the auditor to an issuer. The confusion relates particularly to one paragraph of the proposing Release. The wording is as follows:
The above wording has already created much controversy and confusion for issuers, their legal advisors, and auditors, particularly the sentence including the wording "formulation of tax strategies (e.g., tax shelters) designed to minimize a company's tax obligations." We understand that the legal counsel for some issuers have told them not to engage their auditors to perform any type of tax service that involves "strategies" to "minimize a company's tax obligation" which is the basic purpose of most tax planning and tax advisory services.
Most tax planning and advisory services regarding the potential tax treatment of transactions could be characterized as services "designed to minimize a company's tax obligations." The suggestion that all such services could be prohibited is inconsistent with the legislative intent and other statements in the proposing Release and would result in inconsistent interpretation and application in practice.
The above quoted paragraph has also created uncertainty as it indicates that "the accounting firm and the audit committee should be mindful of the three basic principles" when determining whether a tax service is permissible. This wording may cause confusion as it could be interpreted to prohibit a broad range of tax service because they may fall into the definition of "legal" or "expert" services.
We are also uncertain as to why the three basic principles would be applicable to typical tax services provided to audit clients. We believe that providing those typical tax services to audit clients, such as reviewing the tax accrual and assisting management in responding to an Internal Revenue audit, would not violate any of the three principles. It is unclear as to why assisting the company in responding to an IRS inquiry may place the auditor in an "advocacy role" and thus in violation of the basic principles. Auditors are providing their tax expertise on the tax issues, while management must take responsibility for the process and any negotiations or decisions made during the regulatory proceeding.
We note that the three basic principles discussed above cannot be found in the Act itself. However, the Senate Banking Committee report that accompanied the Sarbanes-Oxley Act of 2002, discussed the three principles in regards to the prohibition of non-audit services such as bookkeeping services, financial information systems design, appraisal or valuation services, actuarial services, and internal outsourcing services to an audit client. The discussion surrounding the three principles and prohibited services did not include the mention of "tax services". In the report, the Senate Committee does not suggest that the principles should be applied to services not included on the list, and does not suggest that the principles should be applied to a service that was expressly permitted by the statute, namely "tax services".
We also note the that the House Financial Services Committee stated the following with respect to the Act:
In addition to improving the quality of the audit, the quality and efficiency of the tax services are improved by allowing the accounting firm to provide a broad range of tax services. The accounting firm understands the business and history of its client and understands the tax issues and the related exposures. This long-term relationship is especially important for middle-market companies that do not have the in-house tax expertise to respond quickly to tax issues and do not have the internal resources to supervise an array of outside advisers who would not have a deep understanding of the company's particular facts. Given that a factual understanding is paramount in rendering advice on a complex tax issue, we believe that in these circumstances, an investor who may have initial independence concerns would actually prefer that the accounting firm continue to provide these tax services. A prohibition of these services may actually cause more significant investor concerns.
In summary, we believe in considering the various non-audit services that are prohibited under the Act, Congress understood the need for balancing the auditor independence concerns with the need to maximize the quality of the audit and the tax services provided. We believe that both branches of Congress had no intention of prohibiting certain categories of tax services by requiring consideration of the three principles to tax services. Instead, Congress chose to address the independence concerns related to tax services by requiring pre-approval of tax services by the audit committee. We urge the Commission to respect this decision.
No Prohibition on Specific Categories of Tax Services
As expressed in the above paragraphs, we do not believe it was the intention of Congress to restrict the types of tax services an auditor could provide to a client. The Commission has likewise not previously used the three principles in regards to tax services. In the Commission's Proposed Rule, Revision of the Auditor Independence Requirements, issued in June 2000, the Commission requested comments on issues related to tax services. The Final Rule Revision of the Commission's Auditor Independence Requirements, issued in November 2000, did not restrict tax services. We believe the Commission, after holding hearings on the subject, exercised careful judgment in formulating the final Rules. There has been nothing to suggest that the Commission's final Rules were inadequate because they failed to prohibit tax services.
We believe that Congress did intend to provide certainty and clarity as to what is prohibited and what is not, to both auditors and audit committee members alike. The above quoted paragraph included in the proposing Release has not provided a clear distinction on prohibited services. Referring to the term "tax strategies" and the application of the principles to tax services does not provide a clear line between prohibited and permitted services.
The above quoted paragraph also refers to the term "tax shelter". We understand why the Commission has not defined the term. For many years, tax experts at the Department of Treasury and the Internal Revenue Service, attorneys, the AICPA, and many other groups, including Congress, have tried to define the term and distinguish illegal transactions from legitimate tax planning. If the Commission is attempting to prohibit illegal transactions, we endorse those efforts. Regardless of the independence rules, advisors should not be promoting illegal transactions. We understand that the Commission is working with other governmental agencies and practitioners to address this issue in new laws and regulations, therefore we suggest that this not be included as an issue of independence and defined in the Commission's proposed Rules.
We would like to reiterate that allowing audit firms to continue to provide tax services to its SEC registrants not only does not raise independence concerns, but will also enhance the quality of the audit. We note that there are at least one SEC Commissioner and one employee, the Chief Accountant, who agree with our position. SEC Commissioner Paul Atkins recently stated:
We encourage the Commission to provide clarity to audit committees in the proposing Release by indicating that the three principles are not meant to restrict the provision of tax services. As such, the final Rule should be clear in that (1) tax services are permissible under the independence rules; (2) tax services that audit firms provide to their clients do not violate the three basic principles; and (3) tax services must be pre-approved by the audit committee.
Grant Thornton does not believe that requiring issuers to engage forensic auditors would provide any meaningful benefit to the audit process. The engagement of a second group of auditors would in fact, undermine the "peer review" and quality control standards process, which is now in the hands of the Public Company Accounting Oversight Board (PCAOB). Congress has given the PCAOB the oversight and disciplinary authority to regulate auditors and that process should be allowed to develop. For the Commission to currently adopt rules requiring issuers to engage a second set of auditors would place an additional burden upon the Commission and the PCAOB, as the forensic auditors would also need to be subject to regulation and inspection. We suggest that the Commission concentrate on the directives issued by Congress, and assist the PCAOB in establishing its system of oversight of the profession. The PCAOB should be allowed to function as intended by Congress, and after a period of time, the results of its activities may be analyzed. Until the results of the efforts of the PCAOB are available, the Commission should refrain from adopting rules regarding forensic auditors. Further, while adopting forensic auditor rules may assist smaller accounting firms in gaining additional work in this area, the audit costs would be increased for all issuers. Smaller issuers located in certain demographic areas, including foreign filers, would be disproportionately disadvantaged, since they would now have to engage two accounting firms outside of their local area. In summary, until the benefits of requiring forensic auditors are readily apparent, the Commission should not consider adopting such rules.
Individuals Subject to Rotation Requirements
We would like to address the Commission's many requests for comments in regards to partner rotation. With regard to the proposed rotation time period, we do not object to the shortened rotational period of five years from the current seven years rotational requirements. However, we do believe that extending the rotation requirements to partners, principals and shareholders beyond the two individuals identified in the Act, is inappropriate and unnecessary. Section 204 of the Act mandates that the lead (or coordinating) partner, and the partner responsible for reviewing the audit, (known in practice as the "concurring partner"), be subject to mandatory rotation after five years. We believe that this directive issued by Congress, requiring rotation of these two specific individuals, is sufficient to achieve the desired results of rotation. After reviewing the testimony and considering all of the independence issues, Congress specifically limited the rotation requirement to these two professionals.
We agree with the Commission's comments in the proposing Release that the lead partner as well as the concurring review partner performs critical functions that impact the conduct and effectiveness of the engagement. These two individuals must have a thorough understanding of the client's business, internal accounting controls, accounting practices, the audit process, and the results of that process. The lead partner and the concurring reviewer have historically been held responsible for the quality of an audit, internally by their accounting firms and in recent cases, externally by the Commission, the AICPA, and other regulatory bodies and legal jurisdictions. To extend the requirement for rotation to all partners that perform audit services to the issuer (e.g., the tax services partner and partners assigned to the audit of subsidiaries in multiple locations of a large conglomerate) would have the unintended impact of weakening the audit quality. We believe that the longer an individual serves a client, more knowledge of the client is obtained, and consequently, more effective audit procedures are routinely and consistently developed. To require rotation of partners that are not directly responsible for the critical decisions and judgments that are made on the overall audit, would have the impact of decreasing the experience and audit knowledge in the field, which we strongly believe was not the intent of Congress.
Further, we are unclear as to why the rotation requirement would extend to "tax partners who perform significant services related to the audit engagement" and perhaps other specialists that may serve the client in some function. With regard to tax services, there is no professional requirement to assign tax partners to the audit engagement. Accounting firms use the tax partners and other tax personnel to review the tax accrual as part of the audit process. However, in some small engagements, the lead audit partner may take on that responsibility. Small accounting firms may not even employ a separate tax partner. It appears that this requirement may have unintended consequences to those smaller accounting firms or smaller offices of international firms. Certain industries are subject to specific tax rules that apply to no other industry (e.g., insurance companies, securities dealers, real estate investment trusts and mutual funds, banks, and savings and loan institutions). If a small firm or small office of a larger firm has such a publicly held company as a client, it may well have only one partner with the requisite technical experience in the industry-specific tax rules. The same holds true for other industry specialists that may serve the client in some capacity. Requiring mandatory rotation of these individuals may force some accounting firms and certain offices of accounting firms, to consider whether they can continue to serve these clients. It would most certainly cause significant increases in the audit costs to registrants.
We again emphasize that expanding the individuals subject to rotation beyond what is in the Act, will have the impact of forcing small accounting firms out of the practice of auditing public companies. These smaller firms will have difficulty with personnel resources and succession planning if the rotation requirements extend beyond the lead and concurring partner. Additionally, an issuer will be concerned as to how the smaller accounting firm will be able to meet the rotation requirements and may be concerned that the issuer would have to change accounting firms after five years. This concern could cause many issuers to shy away from engaging smaller accounting firms, and yet the larger accounting firms may not be willing to accept a small engagement. Although the potential impact on smaller accounting firms and smaller issuers will be quite significant, there will also be an impact on those smaller offices of the international accounting firms. Smaller offices serving public clients will need to use personnel from other geographical locations to meet the rotation requirements. Utilizing audit partners and tax partners from outside the local office to serve a local client is not considered the best approach to serving a client and managing the risks associated with the client. Further, the increased costs of travel and other inefficiencies due to such an arrangement will be passed on to the issuer. The unintended consequences may be that the largest accounting firm in a particular geographical area may end up engaged to audit all of the public companies in the local area, as that firm will have the most local resources available to ensure adequate service and the best pricing for those services.
Five-Year " Time Out" Period
In regards to the five-year "time out" period, we believe that this required length of time is excessive. We see no reason to extend the current AICPA SEC Practice Section (SECPS) requirement for a two-year time-out period. As noted in the proposing Release, the purpose of the SECPS rotation rules is to periodically bring a fresh perspective to the engagement. The intention is that the new lead and concurring partners will lend a fresh set of eyes to the engagement and perhaps a different perspective as to the registrants' accounting and auditing issues. We believe that a two-year time-out period, enhanced by rules clearly defining what the rotated partners can and cannot do during this "time out" period, will address the concerns of the Commission noted in the proposing Release and meet the objectives of Congress.
We also suggest that the final Rule clarify how the rotation period and "time out" period should be calculated if a client dismisses the audit firm, but re-engages the audit firm after a one or two-year period.
We strongly believe that if the Commission insists on a five-year time-out period, many of the same anticompetitive issues noted in the above paragraphs, in regards to the number of partners subject to rotation, are equally valid. Grant Thornton strongly believes that extending the rotation requirements to all partners who perform audit services for the issuer, coupled with a required five-year time-out period will in effect, eliminate all the smaller accounting firms in each local market from auditing public companies. This will result in limiting the choices available and increasing the audit costs for small issuers and will lead to accounting firm monopolies over audits of issuers in some geographical areas.
Rotation Requirements for Small Firms
Given that international accounting firms will be addressing the same rotation issues in some locations as smaller accounting firms, we do not believe that requiring different rotation requirements for small firms is appropriate. We suggest that the Commission reconsider the objectives of the rotation requirements and review the proposed Rule requirements in light of those objectives. A change of the proposed Rule requirements, as discussed above, will result in more equitable and fair treatment for all accounting firms in all geographical locations.
Given the significant impact that the rotation requirements will have on all firms, we suggest that the Commission adopt a two-year transition period. The two-year time frame is the same as the period that is allowed for companies initially going public by the SECPS membership rules. Under the SECPS rules, partners that have already served the client for seven years are allowed to continue to serve on the engagement for two consecutive annual periods after the company completes its initial public offering or otherwise becomes subject to the Commission's reporting requirements. We believe this period of time will be necessary for all firms to adequate plan for the massive rotation that will be required under the proposed Rules. Given the number of individuals covered by the proposed Rule and the shortened five-year time period, there could be engagements where all partners associated with the audit must rotate. It would be in the best interests of issuers and their shareholders to allow for an orderly, planned transition of the partners. Two years would allow the new partners to obtain knowledge of the client, and enable them to obtain as much information as possible from the current, experienced, lead and concurring partners. We believe that this transition will help ensure the performance of a quality audit going forward. Further, some accounting firms may need time to relocate their partners to serve existing clients. We believe two years is a reasonable transition period and will be necessary to comply with the significant rule requirements.
Audit Committee Administration of the Engagement
We believe that the audit committee should be required to pre-approve all audit, review, or attest engagements and all permissible non-audit services performed by the auditor. The audit committee should be permitted to establish detailed policies and procedures for the administration of this approval process. For example, the audit committee could choose, in accordance with its written policies, to pre-approve certain categories of services, up to a certain dollar amount, to be performed by a specific time period (e.g., six months or one year). We do not believe that allowing an audit committee to operate in this manner lessens or alters the responsibility of the audit committee to appoint, compensate, and manage the relationship with the auditor. The critical point is that the audit committee takes responsibility for the auditor relationship and does not delegate the responsibility to management.
For example, the audit committee could pre-approve on January 1, tax consulting services, up to a maximum of $50,000, to be performed by the end of the twelve- month period ending December 31. This approach to the pre-approval process would be especially beneficial in the area of tax consulting services. The need for tax planning and consulting services frequently arises spontaneously. Tax services must often be provided on short notice due to the business exigencies. For example, the tax implications of entering into a specific contract may require immediate analysis. Many of these tax engagements are small and may only require a $5,000 to $10,000 fee to research an issue and/or write a memorandum of recommendations for the registrant's management. Requiring specific approval by the audit committee of these types of consultations would be cumbersome to the issuer's business and would prevent the expeditious exchange of information between the company's tax department and their audit firms. A delay in obtaining the necessary information from the audit firm would not be in anyone's best interest. For these reasons, we urge the Commission to permit the audit committee to establish detailed policies and procedures under which the pre-approval process can be administered. The Commission will be able to monitor the actions of the audit committee through the disclosures required by Item 9(5) of the proposed Rules in regards to proxy statement disclosures.
Proposed Rule 1-02(c)(b) of Regulation S-X provides:
We suggest that the above paragraph be edited to insert "direct" just prior to the word "compensation". We assume that the Commission was concerned about an engagement team partner receiving direct compensation (e.g., bonus or other compensation) related to procuring a non-audit service or product from the audit client. As currently worded, the paragraph could be interpreted more broadly, in that an engagement partner could not participate in the portion of firm-wide partnership earnings that includes profit related to non-audit services realized from the partner's audit client. Since partner income is usually calculated on firm-wide earnings, carving out partners and the non-audit profit realized on their engagements, from firm-wide earnings, would present a logistical nightmare. It would also result in unfair compensation treatment for certain partners that are assigned to engagements that acquire non-audit services. We do not believe this was the intent of the proposed Rule. We suggest that the Commission also provide examples of what is meant by "direct compensation" in the final Rule.
Assuming that the final Rule will be revised to clarify that direct compensation is prohibited, this may not have a great impact on partnership compensation for many firms. Grant Thornton, for example, already plans to issue shortly an internal policy prohibiting the payment of any type of commission or bonus based on non-audit services sold to a public company.
Communications with Audit Committees
Alternative Accounting Treatments
We do not believe that the auditor should be required to discuss alternative accounting treatments with management. We believe that these decisions are the responsibility of management. Specifically, we want to strongly emphasize that the registrant's management has an obligation to communicate, to the auditors and the audit committee, the alternative accounting treatments that management considered and the possible impact those alternatives could have on the issuer's financial statements. In regards to communications with the audit committee, the final Rule should clarify if the auditor is expected to communicate all alternative accounting treatments for all transactions, or only those alternatives for transactions considered to be material to the financial statements. The Rule should also clarify how often this discussion is expected to occur.
Timing and Form of Communications
It would be preferable if the timing of the communications by the auditor, with the audit committee, occurred prior to the release of earnings by the issuer; however, if not possible, they should occur prior to the filing of reports or registration statements with the Commission. We do not believe that it is necessary for the communications regarding critical accounting policies and alternative accounting treatments to be in writing. We believe conducting timely, oral discussions with the audit committee will meet the objectives of the proposed Rule, though at times providing written guidance ensures a thorough understanding of the issue. However, this need not be a matter of federal regulation. Further, requiring these communications to be made in written form may have the unintended effect of slowing down the communication process.
The list of recommended other communications should be clarified to indicate whether draft communications are expected to be communicated to the audit committee. For example, it is not clear whether a letter that has been issued in draft form, but has not been finalized at the time of the release of earnings and is pending a response from management, is required to be communicated. Documents are often issued in draft form to management to make sure that the auditor has accurately portrayed the audit finding or situation. We believe that only final documents should be required to be communicated to the audit committee.
Grant Thornton commends the Commission for expanding the proxy disclosures of professional fees to four categories. We suggested this type of expanded disclosure in our previously mentioned five-point plan, as we believe that the current requirements allowing the grouping of services can result in misleading and confusing disclosures. We have no objection to expanding the disclosures to require two years of information.
Audit Committee Actions
We suggest that information regarding how many times the audit committee meets per year and details on the timing of those meetings (e.g., before the release of earnings) would be of interest to shareholders.
We thank you for the opportunity to comment and would be pleased to discuss any of our comments with the Commission or its staff. Please direct your questions to Karin French, Partner in Charge of SEC Regulations, at (703) 847-7533.