VIA HAND DELIVERY AND ELECTRONIC SUBMISSION
January 9, 2003
Mr. Jonathan G. Katz, Secretary
File No. S7-49-02
Dear Mr. Katz:
KPMG is pleased to submit its comments on the Commission's proposed revision of auditor independence requirements. We welcome the opportunity to participate in strengthening the disclosure system and increasing investor protection.
We believe that the rules adopted should reflect the specific requirements of the Sarbanes-Oxley Act and the intent of Congress. The overarching criterion, consistent with complying with congressional intent and the public interest, is the effect the proposed rules will have on the quality of the audit.
Our comments reflect our assessment of the rule proposal's potential effect on non-U.S. as well as U.S. accounting firms and issuers. Many of our member firms outside the United States have a direct interest in the new rules because of the number of SEC registrants and affiliates of registrants domiciled outside of the United States which they audit.
Some foreign countries have or are adopting auditor independence standards that are comparable to those in the Commission's proposals. Canada, which has a unique relationship with the Commission under the Multi-jurisdictional Disclosure System (MJDS), is introducing a number of integrated reforms similar to those in the Sarbanes-Oxley Act (including proposed auditor independence standards) that we understand the Commission is evaluating for their comparability with the proposed U.S. reforms. We recommend that the Commission also work closely with the other major foreign regulators (e.g., in the EU and Japan) to ascertain where comparable independence standards exist in those jurisdictions and to explore opportunities for a system of mutual recognition.
The release is quite complex, with well over 100 questions requesting comment. In response, we affirm our agreement with many of the proposals and submit several recommendations for clarification and modification that we believe meet the criterion expressed above. The broadest recommendations are abbreviated in the bullet points below and explained more fully in the remainder of this letter.
The comments following this page address the issues in the sequence they are presented in the release, except tax services which is presented separately before other scope of services issues. Page locations are given in the abbreviated table of contents below.
Conflicts of Interest from Employment Relationships
Scope of Services
Scope of Services - Tax
Scope of Services - Other
Financial Systems Design and Implementation
Appraisals and Valuations
Internal Audit Outsourcing
Broker-Dealer, Investment Adviser, or Investment Banking Services
Audit Committee Pre-Approvals
Compensation for Provision or Sales of Non-Audit Services
Communications with Audit Committees
Disclosure of Professional Fees
Disclosure of Percentages of Fees for Pre-Approved Services
Location of Independence Rules
Appendix A: Summary of KPMG's Views on Partner Rotation
Appendix B: KPMG's Transition Recommendations
Conflicts of Interest from Employment Relationships
We support the Commission's goal, as indicated in the release's cost-benefit section, to assure that relationships created by employment do not negatively affect audit quality, the principle criterion that should be the keystone of the final rules. The proposed one-year "cooling off" period is consistent with the Sarbanes-Oxley Act and is sufficient. However, to operationalize this rule and to ensure its consistent application, several matters need clarification and refinement.
Definition of "Audit Engagement Team." The term "audit engagement team" should explicitly exclude the members of the audit firm's national office. Members of the national office who consult with engagement teams typically do not, by their consultation, develop relationships with client management. In addition, the final rule should include a de minimis exception for all professionals (e.g., the requirement does not apply to audit team personnel with fewer than 40 hours of audit service to the client during the year under audit). Members of the audit engagement team, a very broadly defined term, who devote a minimal number of hours to an audit engagement do not develop relationships with client management during their limited involvement.
Definition of "Cooling Off" Period. The language that would govern the end of the "cooling off" period is too subjective and would be impossible either to apply with consistency or to subject to effective controls and evaluation. As now formulated, the language is "the date that audit procedures commenced," defined as the later of the "date that the accountant commenced the audit for the period covered by the financial statements that included the date of the initial employment of the audit engagement team member" or "the date that the accountant commenced review procedures for the period covered by the financial statements that included the date of the initial employment of the audit engagement team member."
The description of when audit planning begins must accord with the variety of real-world events that constitute audit planning and at the same time be manageable for those who must apply the final rule and those responsible to ensure and evaluate compliance with it. The example given in the descriptive part of the release is simpler than what frequently takes place in the world of practice. Many firms conduct "continuous auditing," where there is no readily identifiable date for the commencement of audit planning. Some explicit criteria are needed to define, for purposes of the final rule, when the "cooling off" period begins and ends.
For these reasons, we recommend that the Commission adopt a specific date for purposes of applying the rule. For example, the "cooling off" period could be defined as the one-year period that begins on the last date the individual performed any audit or review services in connection with the client's financial statements.
"Issuers" Only. The proposal's reach should be limited to employment relationships with "issuers." Relationships with the issuer would replace relationships with "audit clients," a far more embracing term. The Sarbanes-Oxley Act refers only to issuers, and no significant threat to independence would be addressed by extending the applicability of this proposal any more widely. All specified members of the "audit engagement team" who undertake employment with a client in specified positions would still be required by current rules to sever all financial relationships with their former firm.
Transition. The proposed rule will affect corporate hiring practices for accounting-related positions, the personal employment decisions of persons who are or recently have been employed by accounting firms, and the human resource policies, procedures, and communications of accounting firms. Registrants, audit committees, and accounting firms will need time to understand the new requirements and develop needed policies and controls.
With these considerations in mind, we recommend that the rule be effective for employment relationships entered into on or after a date no earlier than 90 days after the publication of the final rule in the Federal Register. All employment relationships entered into before such date that otherwise conform to current SEC independence rules for employment relationships should be grandfathered. The final rule's grandfather provisions should cover situations where former accounting firm personnel already employed with an issuer at the effective date are subsequently promoted into an identified position with the issuer after its effective date, and where former firm personnel assume an identified position with an issuer as a result of a merger.
Scope of Services
The release treats as one of the potential benefits of the proposed rule that it would clarify the "lines of non-audit services that would impair an auditor's independence." We support the effort to clarify these matters and agree with the three broad principles cited in the release (the auditor should not audit his or her own work, perform management functions, or act as an advocate for the client).
The Three Principles. We suggest the three broad principles in the release replace the principles in the preliminary note to the current rules, a change that would eliminate only the principle that prohibits mutual or conflicting interest with the audit client (hereafter, the "mutuality-of-interests" principle). The three principles cover all the ground that is necessary to cover without presenting the ambiguities in the mutuality-of-interests principle. They capture the kinds of mutual and conflicting interests it is necessary to ban or restrict. There is no need for the fourth mutuality-of-interests principle.
Transition. The non-audit-service proposals would affect corporate purchases of services, audit committees' procedures and work, and accounting firms as suppliers of relevant services. The changes would also affect contracts previously entered into in good faith that extend over several years. A contract to provide expert-witness services, for example, can easily span several years. Disrupting many of these contracts would affect the costs to issuers for no gain in audit quality or investor protection.
We believe the new requirements should apply to all contracts to provide newly prohibited services entered into on or after a date no earlier than 90 days after the publication of the final rule in the Federal Register. All existing contracts entered into before that date that are acceptable under current SEC independence rules should be grandfathered to allow for completion of the services in process, so long as the terms of such contract(s) are not materially altered. However, with the exception of contracts to provide "expert services" that fall under the final rule, completion of previously contracted services should be subject to a maximum period of 18 months from the date of publication of the final rule in the Federal Register. "Expert services" that fall under the final rule should be grandfathered until the matter subject to the service is ultimately resolved.
Scope of Services - Tax
The Sarbanes-Oxley Act, the Commission's 2000 rulemaking, and the proposing release confirm that auditors may provide tax services to audit clients. Where they provide such services, auditor independence is not deemed to be impaired. Recognizing "that not all non-audit services pose the same risk to independence," the Commission concluded in its 2000 auditor independence rulemaking that "tax services generally do not create the same independence risks as other non-audit services." That well-reasoned policy judgment was the product of a long, deliberative process, in which "over 100 persons testified, a congressional hearing was held, and over 3,000 comment letters were received." The Commission's judgment was sound in 2000 and continues to be sound today.
The Sarbanes-Oxley Act embodies the Commission's 2000 judgment in the legislation. The Act explicitly permits accountants to provide tax services to audit clients. Section 201 of the Act states that accounting firms "may engage in any non-audit service, including tax services, that is not described" in the list of prohibited non-audit services, and that is pre-approved by the audit committee. Tax services are not among the list of prohibited non-audit services contained in section 201. Indeed, tax services are the only non-audit services specifically described in the legislation as services in which an accounting firm "may engage."
The Act's legislative history confirms that Congress intended that accountants continue to perform tax services for audit clients. As noted above, the SEC's 2000 rule does not restrict the ability of accountants to provide tax services to their audit clients; and a provision in the Sarbanes bill that would have required the Commission to adopt rules more restrictive than its 2000 final scope of services rule was deleted.1 As one member of the Senate Banking Committee observed, that deletion meant "we will live under the current rules," that is, under a regulatory regime in which tax services are permissible.2 Chairman Oxley recently underscored that Congress did not intend for the Act to be interpreted as restricting accounting firms from delivering tax services to audit clients. Chairman Oxley rightly noted that "tax issues are part and parcel of the traditional audit function," and tax services are not prohibited under the Act because "[t]here was no evidence in [Congress's] hearings that indicated that the tax function was untoward or somehow led to fraud."3
The release also endorses the continued provision of tax services by accounting firms. The release cites the Commission's analysis of tax services from 2000, stating that "[a]s discussed in [the Commission's] 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." The release thus emphasizes that "[n]othing 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 by the client's audit committee."
The Release Needlessly Confuses the Status of Tax Services. Despite the Sarbanes-Oxley Act, its legislative history, the 2000 rule, and the above statements from the release, some language in the release is being interpreted by some in the legal profession and others to limit the ability of accountants to provide tax services to their audit clients.4 Two paragraphs of the release may be read to restrict many traditional tax services.
The release suggests that despite the congressional approval uniquely given to tax services, tax services might still be subject to prohibition through application of the "three principles." Congress, in considering the Act, clearly believed that the "three principles" do not apply in a manner that prohibits the provision of traditional tax services.5 Nonetheless, some view the release language applying the "three principles" to tax services to reflect not only a shift in policy by the Commission, but also a position 180 degrees from that of Congress, that would effectively prevent accounting firms from continuing to provide to their audit clients historically permitted tax services.6
The three principles have never been considered to be in conflict with the provision of tax services by accountants to their audit clients. Tax services historically have been considered a special type of non-audit service that were categorically permissible because, as the SEC has acknowledged, tax services are "unique" and "generally do not create the same independence issues as other non-audit services."
The release's confusing language - suggesting that the three principles apply in a manner that would bar some traditional tax services - would dramatically inhibit the performance of permissible tax services by auditors. The language could lead issuers to act under the misperception that they cannot or should not select their audit firm to perform tax services. It will be difficult for an audit committee to conclude with confidence that the provision of a "tax service" by the audit firm would be permissible, and audit committees will be reluctant to pre-approve "tax services" in light of the release's language.
These likely consequences would significantly restrict the ability of issuers to retain their auditors to provide clearly permitted tax services, and could impair audit quality and the quality of the overall services that auditors provide to audit clients.
The Commission should therefore clarify that the application of the "three principles" is not a de facto bar on auditors providing the same tax services to audit clients that they have historically delivered. Given the confusion arising from the release, it is critical that the Commission address this issue at this time and provide clarification in the final release.
Audit Committee Pre-Approval Addresses Independence Concerns Posed by Tax Services. The mechanism chosen by Congress for balancing competing independence considerations is the new statutory requirement of audit committee pre-approval. Pre-approval will mitigate perceived independence concerns with respect to tax services. Audit committees are best situated to determine independence questions precisely because they can balance competing considerations.
Within the pre-approval framework, an audit committee is in the best position to weigh the effect on independence with the benefits of the auditor providing tax services. The challenge for the Commission is to provide audit committees with sufficient guidance to ensure that tax services historically provided to audit clients remain permissible, as Congress intended.
The broader understanding of a company's tax posture that is gained through the provision of tax planning services leads to a better audit, including evaluating the client's tax exposure. Many issuers' income tax expense can amount to 40 percent or more of the issuer's pre-tax earnings. Where an audit firm performs tax planning, its ability to understand a company's tax transactions for purposes of an audit is enhanced.
For these reasons, an audit committee may find that retaining the auditors to provide tax services is highly advantageous.
In sum, the Commission in its final rule should re-emphasize the historic and "unique" status of tax services, and state clearly to issuers, audit committees, and accounting firms that historically permitted tax services remain fully permissible. Clearly this change is needed to comply with the intent of Congress.
Scope of Services - Other
Financial Systems Design and Implementation. The proposed rule to prohibit these services should be governed by the same concept that guides the applicability of the bookkeeping prohibition: The service should not be performed if it is reasonably likely that the results of the services will be subject to audit procedures during the audit of the client's financial statements. This addresses the key issue - whether the auditor is in a position to audit his or her own work. The text of the proposed rule prohibits the design or implementation of systems that aggregate source data or generate information significant to the financial statements or other financial information systems taken as a whole. The "reasonably likely" criterion is needed to explicitly address the condition that makes the service a threat to independence.
Appraisals and Valuations. In many non-U.S. countries the issuance of contribution-in-kind reports and fairness opinions by a company's auditor is recognized by regulatory requirement and in some cases by national law. For example, in Europe there is a long-established practice, and in many cases an actual requirement (such as Italy, Belgium, Austria, and Sweden), for auditors to issue reports in connection with share issuances for non-cash consideration under applicable national law. It is not appropriate for the Commission to override or attempt to override the regulatory or legal decisions of other countries when there is not a real threat to investors' interests. The final rule should contain exemptions for local laws that require these services and for the customary practices of accountants in such countries.
Actuarial Services. The statement in the descriptive part of the release prohibiting the auditor from providing "any advisory service involving the amounts recorded in the financial statements and related accounts for the audit client" is too broad and subject to varying interpretation. The italicized term should be changed to "any actuarially oriented advisory service," which is consistent with the proposed rule and with the intent of Congress as expressed in the Sarbanes-Oxley Act.
Internal Audit Outsourcing. The release asks whether safeguards can be established that allow outsourcing but do not impair independence. We believe the answer to this question is yes. For example, one aspect of internal auditing work may consist of audit work relied on by the external auditor. Performing the work directly by the accounting firm would constitute acceptable external auditing. We do not believe changing the name of the activity to internal auditing negatively affects independence, audit quality, or investors' interests. Current auditor independence requirements are sufficient in such circumstances.
Other internal audit work helps ensure the reliability of information used by third parties. The independent auditor who does such work in the role of internal auditor serves the same objective as is served in the audit of the financial statements. The independence safeguards that protect the financial-statement audit would also protect these other types of audit work.
The final rule should prohibit only true "internal audit outsourcing." The descriptive part of the release says the prohibition does not extend to "discrete items or programs that are not in substance the outsourcing of the internal audit function." This is in keeping with congressional intent to limit the prohibition to matters that, under the theory applied, could put the auditor in a management role. The final rule should be equally precise and equally in keeping with the idea of preventing the auditor from assuming a managerial role.
The Sarbanes-Oxley Act uses the term "internal audit outsourcing." The descriptive section of the release uses the same term. However, the proposed rule uses "internal auditing" after a caption that reads "internal audit outsourcing services." We suggest the term in the final rule match the term in both the caption and the Sarbanes-Oxley Act.
Management Functions. The release asks whether assessing and recommending improvements to internal-accounting and risk-management controls result in the auditor auditing his or her own work. We do not believe these activities result in auditing one's own work. Management is at all times totally responsible for the company's controls, for the cost-benefit decisions necessary to act on any recommendations, and for translating recommendations into practice.
Besides evaluations of internal control over financial reporting in conjunction with audits, auditors will be required in the near term to evaluate and report on issuers' internal control over financial reporting as a result of the Commission's implementation of section 404 of the Sarbanes-Oxley Act. Auditors are highly qualified to do both, and should communicate any observations that would improve controls. Evaluating controls is a traditional task for the external auditor. It would be counterproductive to prohibit recommendations that can help build accountability in the interest of investors and would not impair auditor independence.
The final release should make explicit and unmistakable that the auditor's evaluation of internal control and recommendations for improvement made during an audit or on any permissible other engagement do not impair an auditor's independence.
Human Resources. The text of the proposed rule and the descriptive part of the release are not parallel. The description says that the rule prohibits advising clients about the design of its management or organizational structure. This prohibition is not in the proposed rule under "Human resources" and has no place there. It does not correspond to language in the Sarbanes-Oxley Act. Auditors frequently comment to management and the audit committee about how company functions are organized and make suggestions about possible improvements. There is no threat to independence from these communications, and they often enhance the value of the audit. The prohibition, which we presume was inadvertently included, should be deleted from the descriptive part of the final release.
Broker-Dealer, Investment Adviser, or Investment Banking Services. The proposed rule explicitly applies to both registered and unregistered broker-dealers. We agree that acting as a broker-dealer impairs independence whether the auditor's broker-dealer is registered or unregistered. What should be governing is whether the auditor is engaged in behavior that would otherwise require registration under the securities laws. We have no reason to believe the Commission intends to expand or otherwise change the definition of "broker-dealer" activities that would require registration. However, in the course of explaining the use of the term "unregistered," footnote 48 gives examples that inadvertently create ambiguities. The two sentences beginning, "A person may `effect transactions,' among other ways, by assisting..." should be clarified. It is arguable, for example, that simply helping identify purchasers, with no other activity, does not make one a broker-dealer under current law. The final rule should make clear that no language or provision is intended to redefine what constitutes broker-dealer activity.
Legal Services. The release asks whether any legal services should be exempted from the proposed rule. Some services that can be called legal are assistance in complying with the law, not advocacy - for example, minor, routine and ministerial tasks, such as the completion of filings to dissolve a corporation. Matters that are routine or ministerial or that are immaterial do not pose a threat to auditor independence. We believe that the prohibition should depend on the nature of the service, rather than its designation. This would also facilitate the application of the prohibition to foreign jurisdictions, because there is no globally accepted definition of what constitutes a legal service. The ostensibly hard-and-fast notion of "legal services" is actually subjective because of the varying definitions. It is therefore a potential difficulty for those who would have to apply the idea and a potential source of inconsistent practices.
For these reasons the final release should make clear that services that are routine, ministerial, or involve matters that are immaterial to the financial statements are excluded from the prohibition of legal services.
The release prohibits services that require an individual to be formally credentialed to practice law in the jurisdiction in which the service is provided. This would create a discrepancy between what is permitted in the United States and what is permitted in non-U.S. jurisdictions. Some non-U.S. jurisdictions, such as France, require individuals to be attorneys in order to provide traditional tax services, as the release acknowledges.
The rule should permit any service in a non-U.S. location that is permitted in the United States, even if local law or regulation requires the practitioner to be licensed as an attorney to provide the service.
Expert Services. The proposed rule on expert services appears not to say what was intended. It would prohibit expert opinions in connection with legal, administrative, or regulatory proceedings "or [the accountant acting] as an advocate for an audit client in such proceedings." Because of the word "or," the notion of advocacy is removed from providing the expert opinions, even though that is the supposed basis for their prohibition. The final rule should replace "or" with "when" and make clear that it applies only to services provided in a public forum. In addition, several other matters require clarification.
Providers of expert services are in most situations required to be objective by the institutions and parties they serve. In many jurisdictions (such as the United Kingdom, France, and Germany) expert witnesses are specifically forbidden by the courts from acting as an advocate. The situation is analogous to the permission in the proposed rule to allow accountants to testify in court to facts, not opinions. The final rule should therefore explicitly permit expert-service work when the accounting firm is appointed directly either by a court or by both parties, in which cases there is no threat of advocacy.
There should be no independence impairment for an expert opinion that is used in legal, administrative, or regulatory proceedings, but was formulated without knowledge of its subsequent fate. For example, whether or not findings are subsequently drawn into legal, administrative, or regulatory proceedings should not prevent the following kinds of services performed without knowledge that such proceedings will occur in the future: investigatory work in connection with employee theft or fraud, insider trading, channel stuffing and other channel issues, black-market Peso schemes, royalties, anti-money-laundering investigations, or vendor kick-backs. The final rule should be clear that these services do not result in an independence impairment.
A separate matter is the prohibition of forensic accounting services performed for a client's legal counsel while allowing their provision to the same client's audit committee or its special counsel. The acceptability of the service should not change depending on whether it is provided to the audit committee's special counsel or the client's counsel. Regardless of the party to whom the service is provided, forensic accounting services do not pose a threat to independence and should be permitted.
The proposed rule can be read to prohibit tax opinions and tax services in connection with administrative proceedings before the IRS or other tax authorities. Furthermore, advisory services rendered in conjunction with tax legislation could also be viewed as prohibited. We do not believe these prohibitions were intended. The final rule should clarify that tax services historically provided to audit clients are not prohibited expert services.
Additionally, the descriptive part of the release is significantly broader in scope than the proposed rule because it extends the expert services prohibition to "providing consultation and other services" to an audit client's legal counsel. We believe that the final release language should not broaden the application of the proposed rule.
Clearly, a simple act of conferring with legal counsel with respect to a matter of which the auditor may have knowledge should not impair an auditor's independence. Auditors possess specialized knowledge of a client and are skilled in accounting and financial reporting matters. It would be contrary to the best interests of investors if the auditor were prohibited from sharing that knowledge with a client's legal counsel. Regardless of an attorney's ethical obligations for client advocacy, in consulting with legal counsel regarding a technical accounting, auditing, or tax matter an auditor does not assume the role of an advocate.
Similarly, the extension of the expert services prohibition to "other services" is not appropriate because no specific threat to independence can be discerned from such expansive language. For example, providing supporting services related to the production and cataloguing of documents or materials to an audit client's legal counsel would apparently be barred even though such services do not involve the provision of an expert opinion by the audit firm nor would those services be a form of client advocacy.
The proposed rule would go beyond the Sarbanes-Oxley Act's mandate that the lead engagement partner (lead partner) and concurring review partner be replaced on the engagement every five years. Instead, the proposal would apply the five-year rotation requirement to virtually all partners participating in the audit. It would therefore include partners who participate in the audit in a support capacity. We believe extending the rotation requirement in this way would not add any appreciable protection to the public interest, while nevertheless adding to issuer audit costs and putting audit quality at risk. The rotation requirement should apply to the partner who makes final decisions on the audit and the partner who reviews those decisions.
The lead partner is responsible for all significant decisions related to audit procedures and audit findings. The lead partner is responsible for adherence to generally accepted auditing standards and generally accepted accounting principles, planning the scope of the audit, executing the audit plan, evaluating the findings, and issuing the audit report on the financial statements. Lead partners issue the engagement letter, obtain the client representation letter, and communicate with the audit committee on behalf of the firm. The concurring review partner reviews critical decisions made by the lead partner and the financial statements before the audit report is issued. Every other party on the engagement team is subject to the decision-making authority of the lead partner. Clearly, the proposal should apply to both the lead and the concurring review partners.
The partners other than the lead and concurring review partners (e.g., tax-provision-review, information-risk-management, and actuary partners) are not key decision makers on the audit. They perform a support role. The designation "partner" does not change the role they play. There would be no gain in audit quality or appreciable gain in the independence of the decision making on the audit from extending the rotation requirement to these support partners.
One could make an argument that the partner responsible for the audit of a significant subsidiary is in a position analogous to lead partner, even though subject to the authority of that lead partner. If the Commission believes that it needs to expand the scope of the rotation requirements beyond those partners specified in the Sarbanes-Oxley Act, we believe that the inclusion of lead partners on significant subsidiaries in the scope of partner rotation can be supported considering the overarching objectives of audit quality and investor protection.
Every time a partner is rotated, start-up time is incurred for the incoming partner, and depending on the circumstances, suitable incoming partners may have to relocate their residences and families. The costs of relocation can be high. Assume, for example, that a multinational client's audit engagement team has 25 partners subject to the proposed rotation requirement (on some audit engagements this number will be significantly higher). If five partners each year must rotate off and be relocated at an average cost of $200,000 per rotation, the annual cost to be absorbed by issuers, including the costs of relocating their replacements, would be $2,000,000.
The proposed rule would reduce the maximum rotation period for lead partners from seven to five years, which in and of itself will result in approximately a 30 percent increase in rotations for lead partners. This 30 percent increase in rotational requirements does not consider the effect of the longer period that a lead partner will be required to remain off the audit engagement (from the current two years to five years) or the scope of the requirement now encompassing the concurring review partner. As the number of partners subject to rotation increases, succession planning throughout the profession would become far more costly and difficult (particularly in the case of specialized industry partners and non-U.S. partners with U.S. GAAP/GAAS expertise on audits outside of the United States).
The release recognizes the staffing problems that could arise, but in effect says it would be the profession's responsibility to ensure no diminution in audit quality. We agree that it would indeed be the profession's responsibility, but the costs to shareholders and the risks to audit quality must be justified by a reasonably likely payoff in independence and investor protection. Unfortunately, in this case the costs and risks to audit quality are not so justified.
For the above reasons, we believe the proposed rule should be modified to limit mandated rotation to the lead partner, the concurring review partner, and, if the Commission believes that it needs to expand the scope of the partners subject to rotation beyond that mandated by Congress, lead partners on significant subsidiaries. We believe the rule modified as we suggest would achieve the Commission's objectives.
Investment Companies. Under the proposed rule, a partner performing audit, review, or attest services for any entity in an investment company complex would be required to rotate off the entire complex after five years, not to return for a subsequent five-year period. The partner who audits the investment company registrant would then be precluded from providing audit services to other entities in the investment company complex for five years. Extending the rule so widely would contribute nothing to achieving the Commission's goals for auditor independence.
An investment company complex typically consists of different groups of investment companies and other entities. They can be sponsored by a financial services company but nevertheless have separate and distinct boards and audit committees. The Commission has shown in many ways that it views accountability to an audit committee as part of the desired structure for auditor independence. The Sarbanes-Oxley Act made the audit committee responsible for the appointment, compensation, and oversight of a company's auditors. The requirement for pre-approval of permitted non-audit services is an integral feature of the same set of relationships. The proposed rotation requirements for investment companies are thus in tension with the structure designed to help provide assurance of auditor independence.
We believe a five-year break is unjustifiable for permitting service to a different entity within the investment company complex if the entity has a separate and distinct audit committee responsible for hiring its auditor. Many investment company complexes have two or more accounting firms performing audits throughout the year of various investment companies within the complex and/or performing SAS 70 reviews that evaluate the controls of the accounting systems. This operating environment provides an on-going "fresh look" at the financial reporting systems that is consistent with the Commission's objectives. The Commission may nevertheless believe a period away from any registered entity within the complex as a whole is necessary. If so we recommend it consider reducing from five to two years the hiatus required before performing audit, review, or attest services to a different registered entity within the investment company complex with its own separate audit committee.
Rotation Periods. The Sarbanes-Oxley Act mandates that the lead and concurring review partner cannot serve longer than five consecutive years. However, the Sarbanes-Oxley Act does not specifically mandate a particular break in service for these partners. We support the Commission's proposal for a five-year break in service for the lead partner. We believe, however, that the Commission should adopt a two-year break in service for the concurring review partner, lead partners on significant subsidiaries, and lead partners on investment companies in an investment company complex.
We believe that existing safeguards are sufficient to allow for this two-year break in service. Existing SEC Practice Section requirements for concurring review partners mandate an objective review of the auditing, accounting, and financial reporting matters that are considered significant by the engagement team. Lead partners on significant subsidiaries are subject to the authority of the lead partner (who will be subject to a five-year break in service). Lead partners on investment companies in an investment company complex will be engaged by separate audit committees. We believe the approach we recommend will preserve audit quality by reducing the potential loss of engagement team knowledge and the disruption and costs associated with a greater number of partner rotations, and at the same time accomplish the Commission's objectives.
The Required Break in Service. When a lead partner subject to rotation leaves an engagement after serving in such a role for fewer than five years, the required break in service should be the number of an issuer's fiscal years in which the partner provided service. Each consecutive year of service should call for an equal period off the engagement prior to the right to return to it. The five-year break in service would be reserved for lead partners who have served five consecutive years.
If the Commission adopts our recommendations in the section Rotation Periods the break in service for concurring review partners, lead partners on significant subsidiaries and lead partners on investment companies in an investment company complex would be subject to the two-year maximum period. This rotation regimen would be flexible enough to supply qualified personnel, but rigid enough to satisfy the Commission's objective.
Treatment of Significant Subsidiaries. We recommend that the final rule define a significant subsidiary as one that meets a significance test, based on a measure of total assets and revenues, of 25 percent of the consolidated totals. We believe that the use of total assets and revenues, as opposed to the measures in Regulation S-X, will reduce volatility in the determination of significant subsidiaries and the rotation requirements for audit partners that serve such subsidiaries. If the Commission defines significant subsidiaries in the final rules at a threshold considerably lower from that which we are proposing, the rotation requirement could become unworkable, especially outside of the United States.
The final release should make clear how to treat a subsidiary that is significant one year and not another. We suggest that a subsidiary be defined as significant for purposes of the rule if it is significant in each of the two consecutive years preceding the year in question. A subsidiary would continue to be significant until it failed the test for two consecutive years. In essence, we suggest an approach similar to Regulation S-B in determining when an issuer qualifies for inclusion or exclusion from the small business reporting regime.
The lead partner for a subsidiary that is significant in one year and not the previous year would include, in calculating years of service toward rotation, any years in the same position subject to rotation requirements before the first year the subsidiary qualifies as significant. However, such partners should be allowed to serve an additional year (e.g., the first year deemed significant) regardless of the number of consecutive years of service at the position subject to rotation requirements. The inclusion of significant subsidiaries in the partner rotation requirements mandates that at least one year of transition planning be allowed to ensure audit quality and protection of investors. The subsidiary's failure to meet the significance test would disqualify such partners from rotation even after a fifth year of service on a subsidiary that had previously met the test.
Transition. The proposing release indicates that the Commission is considering whether to delay the application of some proposed rules and specifically considering transition provisions for the proposed rotation requirements. We recommend several transition provisions. Transition provisions are needed in order to prevent unfortunately timed, significant changes in engagement leadership that could put audit quality at risk.
The partner rotation requirements should be effective for fiscal years beginning after December 15, 2003. This would avoid requiring rotations during the current audit or review cycle. Forcing a change in key partners on various audit engagements in the midst of a cycle could cause considerable disruption to the audit process and could threaten audit quality. For example, if the final rule were to be effective upon issuance, the audit firm serving an issuer with a September 30 fiscal year-end would have only 19 days to reassign various partner responsibilities and complete a quarterly review. Audits of off-calendar, fiscal year-end issuers could be complicated by requiring the rotation of partners already involved in planning or interim work.
The final rule should contain provisions facilitating staggered rotations in the implementation period. The two partners whose rotation is mandated by the Sarbanes-Oxley Act are the lead partner and the concurring review partner. The lead partner and concurring review partner, upon reaching five years of service, should be required to rotate off the engagement for the next fiscal year beginning after December 15, 2003 (December 15, 2005 for partners on foreign private issuers), with this proviso: Either the lead partner or concurring review partner, but not both, should be permitted to defer rotation for one year to the next fiscal year beginning after December 15, 2004 (December 15, 2006 for partners on foreign private issuers). In no case, however, would a lead partner on a domestic issuer be permitted to serve in that role for more than seven consecutive years. If both the lead and concurring review partners have exceeded five years of service in the initial year of implementation of the new requirements (fiscal years beginning after December 15, 2003), we believe that accounting firms need the flexibility to stagger the initial rotation of these two partners, subject of course to existing rotation requirements for lead partners. The ability to stagger rotation upon initial implementation will mitigate a significant risk to audit quality. The extended transition period for lead and concurring partners serving foreign private issuers is needed in order to enable reasonable succession planning.
Other partners whose rotation might be required by the Commission's final rule should commence counting their five years of continuous involvement with the next fiscal year beginning after December 15, 2003 (December 15, 2005 for audit partners on significant subsidiaries domiciled outside of the United States). Alternatively, the rotation of these other partners should be phased in over a two-year period to assure an orderly transition.
KPMG's recommendations for partner rotation are summarized in Appendix A.
Audit Committee Pre-Approvals
The Sarbanes-Oxley Act requires audit committee pre-approval of non-audit services to be performed by the registrant's independent auditor. We agree with the Commission's proposed approaches to pre-approval (pre-approval before the accountant is engaged for the service or pre-approval pursuant to detailed policies and procedures put in place by the audit committee).
In the case of an investment company complex, pre-approvals would be required for services to the entities in the complex. Yet entities in an investment company complex can have their own boards and audit committees. It would be inconsistent with the SEC's focus on the role of the audit committee to ignore audit committees within the complex. The passage on pre-approval begins by recognizing "the critical role played by audit committees in the financial reporting process and the unique position of audit committees in assuring auditor independence." It appears to follow from this recognition that the distinct audit committees in an investment company complex should be accorded the same role and position as is accorded the issuer's audit committee. Therefore, the audit committee of an entity within an investment company complex should have exclusive responsibility for pre-approving a service provided to and paid for by that entity.
Since many non-audit services are provided to and paid for by entities providing services to the investment company, typically the investment adviser, we recognize the importance of keeping investment company audit committees informed of these services. Currently, many investment company audit committees require the auditor, investment adviser, custodian and/or other third parties, to inform them of new projects and services that employ the auditor. Many times the audit committees also are part of the preliminary discussion of such services. Therefore, we believe the audit committee of the investment company should be notified on a timely basis, such as quarterly, of those services provided to other entities in the complex, that provide services to the investment company, and that have been pre-approved by other audit committees in the investment company complex.
We recognize that in some cases, the entity engaging and paying for a service that directly relates to the operations and controls of the investment company may not be required to seek pre-approval from that entity's audit committee, or the entity may have no audit committee. This would occur when the entity engaging the auditor for the service is not itself an issuer, or part of an other issuer, or when another firm audits the financial statements of the entity in the investment company complex engaging the auditor. In this situation, we believe the investment company audit committee should pre-approve the service.
Non-U.S. Jurisdictions. Under the Sarbanes-Oxley Act, if a registrant does not have an audit committee, the pre-approval requirements have to be fulfilled by all board members. However, it is not clear how this would work in a dual board system found in some non-U.S. jurisdictions. For example in Germany the audit-committee concept is difficult to relate to local legal requirements, which require a dual board system. In essence the board of directors is organized as a two-tier model: the "management board," which is responsible for the management of the company, and the "supervisory board" which supervises the management and oversees any work done by auditors. Under the law of many such jurisdictions, the supervisory board usually comprises both shareholder and employee representatives. For example, in Germany both groups have the same number of representatives at the supervisory board. The employee representatives are eligible only if they are employees of the group or union members with certain limitations in number and are elected by the employees. These are not independent under the Act's definition.
The final rules should accommodate those foreign private issuers operating under a dual board system.
Transition. Companies and their audit committees will need time to establish the policies and procedures by which they will comply with the proposed rule. The legislative history of the Sarbanes-Oxley Act indicates Congress's intent to allow flexibility with respect to the pre-approval requirement. We therefore recommend that the requirement apply to all new engagements to provide services entered into on or after a date no earlier than 90 days after publication of the final rule in the Federal Register. We also recommend that all engagements in progress as of the effective date should be specifically exempted from all pre-approval requirements.
Compensation for Provision or Sale of Non-Audit Services
We understand the independence concern supporting a ban on directly compensating an audit team's "most senior members" for selling or performing services other than audit, review, or attest services through direct incentive payments. However, we believe the proposal is not clear that only direct incentive compensation is prohibited and does not restrict the prohibition to the engagement team's most senior members.
Direct Compensation. The proposed rule as drafted is not workable given the structure of public accounting firms. As partners in an accounting firm, partners (refer to our comments below under Scope) share in the profits of the firm, which may be increased as a result of the performance of permissible non-audit services. This indirect income or monetary benefit to a partner results from the required partnership structure of the major public accounting firms. For the provision to be workable, the words "direct incentive payments (e.g., commissions, bonuses, special awards, etc...)" need to be included in the final rule. The inclusion of these words in the final rule is both consistent with the Commission's intent, as expressed in the proposing release, and results in a provision that is workable and will permit consistent application.
Scope. The proposed ban should be restricted to the same group of audit partners that are subject to the rotation requirements - the lead partner and the concurring review partner, and, if the Commission deems it necessary to expand the audit partner rotation scope - lead partners on significant subsidiaries of the issuer. To extend the ban further would create no significant improvement in auditor independence, and it would negatively affect audit quality by diminishing the appeal of the profession to quality recruits and employed professionals.
The lead partner is responsible for all significant decisions related to audit procedures and audit findings. The lead partner is responsible for adherence to generally accepted auditing standards and generally accepted accounting principles, planning the scope of the audit, executing the audit plan, evaluating the findings, and issuing the audit report on the financial statements. Lead partners issue the engagement letter, obtain the client representation letter, and communicate with the audit committee on behalf of the firm. The concurring review partner reviews critical decisions made by the lead partner and the financial statements before the audit report is issued. Every other party on the engagement team is subject to the decision-making authority of the lead partner.
The partners other than the lead and concurring review partners, (e.g., tax-provision-review, information-risk-management, and actuary partners) are not key decision makers on the audit. They perform a support role. The designation "partner" does not change the role they play. There would be no appreciable gain in audit quality or the independence of the decision making on the audit from extending the proposed prohibition to these support partners.
The likely effect on recruiting and retaining skilled partners to perform these supporting tasks, and therefore on audit quality, can be inferred from the marketplace. Partners in support roles may choose to practice outside audit firms (in law firms or actuarial organizations, for example), where they would have the same opportunities without the compensation limitations proposed for audit firms.
The effect on tax partners would put audit quality at risk. A separate tax practice would likely be developed to perform tax provision services for audit clients. This would reduce the degree to which the review of the tax accrual benefits from insight into the company's overall tax posture. The narrow role of a tax-accrual-review practitioner would make it difficult to attract top talent to the practice.
The distinction between senior audit team personnel and other members of the audit team is a premise of the proposal in the release. It says, "This proposal recognizes and focuses on the need for independence of the most senior members of the engagement team as well as the accounting firm." In other words, the release already selects a minority of the engagement team for the prohibition based on seniority and authority. Our proposed modification is therefore consistent with the premise underlying the proposal's focus on senior audit-team personnel.
For the reasons above, the focus of the proposed rule should be on the partners who make key decisions on the audit, not on individuals who perform audit-support roles.
We believe that our recommendations are consistent with the Commission's intent, and the final rule needs to consider the other safeguards implemented in the Sarbanes-Oxley Act relative to auditor independence. Specifically, this element of auditor independence must be considered in light of the requirements under the Sarbanes-Oxley Act. Section 301 makes the audit committee directly responsible for the appointment, compensation and oversight of the work of the accounting firm, and section 201 requires audit committee pre-approval of all audit and non-audit services (which the Commission is implementing in this proposed rule). Given the entire package of safeguards, a final rule that prohibits direct compensation to the key decision makers on the audit for the sale or performance of non-audit services to an issuer will achieve our mutual goal of investor protection.
Transition. Many accounting firms base their compensation models and plans on their fiscal year-ends. We therefore believe that, in the event the Commission chooses to include tax partners and other supporting-role partners in the compensation limitations (which we strongly believe it should not), those requirements should apply to the next fiscal year of an accounting firm that commences on or after a date no earlier than 90 days after the publication of the final rule in the Federal Register. However, if the Commission limits the scope of partners affected by those requirements as we have recommended, such requirements should apply on or after a date no earlier than 90 days after the publication of the final rule in the Federal Register.
Communications with Audit Committees
We agree with the Commission that an objective of enhanced communications between audit committees and independent auditors is consistent with the overarching spirit and intent of Congress to improve audit quality. Relevancy and timing are critical criteria to consider when concluding on the relative benefit of any particular communication.
The Auditing Standards Board (ASB) of the AICPA is currently deliberating proposed amendments to several Statements on Auditing Standards to address matters involving communication with audit committees consistent with the proposed rule. We encourage the Commission to monitor the progress of the ASB's activities in this area and allow the deliberative process of the ASB to run its course. This approach will facilitate an open and thoughtful consideration of effective audit committee communications and codify practitioner guidance on this subject matter in one body of literature.
We agree with the Commission that "this Section of the Sarbanes-Oxley Act and these proposed rules largely codify current requirements under Generally Accepted Auditing Standards (GAAS) for auditors of public companies to discuss matters with management and audit committees." However, we believe it is imperative that final guidance on audit committee communication clearly articulate that management is responsible for selection of accounting policies and practices in its preparation of financial information and that management is responsible for determining which accounting policies and practices are deemed "critical."
Critical Accounting Policies and Practices and Alternative Accounting Treatments. AU section 380 of the AICPA Professional Standards currently requires that "The auditor should determine that the audit committee is informed about the initial selection of and changes in significant accounting policies or their application. The auditor should also determine that the audit committee is informed about the methods used to account for significant unusual transactions and the effect of significant accounting policies in controversial or emerging areas for which there is a lack of authoritative guidance or consensus." AU section 380 further states that, "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." With regard to the quality of an issuer's accounting principles as applied in its financial reporting, "the auditor should discuss with the audit committee the auditor's judgments about the quality, not just the acceptability, of the entity's accounting principles as applied in its financial reporting."
We agree that the definition of "Critical Accounting Policies and Practices" should be conceptual in nature. However, communications involving accounting estimates and initial selection of accounting policies should be limited to those that are considered critical, rather than a discussion of "why certain estimates or policies are or are not considered critical and how current and anticipated future events impact those determinations." We see no benefit resulting from a discussion of why certain estimates or policies are not considered critical. In addition, any communication regarding alternative accounting treatments for specific transactions or general accounting policies should be limited to matters material to the issuer's financial statements.
Other Material Written Communications. Existing auditing standards should be amended to "require that the audit committee receive copies of all material written communications between the auditor and management of the issuer. Examples include, but are not limited to, engagement letters, management representation letters, reports issued on significant deficiencies or material weaknesses, and written communications on accounting, auditing, internal control or operational matters."
With regard to audit adjustments, existing auditing standards require that the auditor inform the audit committee about uncorrected misstatements aggregated by the auditor during the current engagement and pertaining to the latest period presented that were determined to be immaterial, individually and in the aggregate. This communication is similar to the summary of uncorrected misstatements included in or attached to the management representation letter. Accordingly, the Commission's reference to "a listing of adjustments and reclassifications not recorded, if any" in the proposed rule is adequately addressed in existing auditing standards.
In addition, AU section 380 indicates that an "auditor should inform the audit committee about adjustments arising from the audit that could, in his judgment, either individually or in the aggregate, have a significant effect on the entity's financial reporting process. For purposes of this section, an audit adjustment, whether or not recorded by the entity, is a proposed correction of the financial statements that, in the auditor's judgment, may not have been detected except through the auditing procedures performed" [emphasis added]. We believe the Commission's reference to a "Schedule of material adjustments and reclassifications proposed" should be made consistent with information currently communicated pursuant to AU section 380. That is, communication of information regarding "material adjustments and reclassifications proposed" should be limited to those proposed corrections to an issuer's financial statements detected during the course of an audit that could have a significant effect on the entity's financial reporting process.
Timing of Communications. We believe that communications pursuant to the proposed rule should take place prior to the auditor's initial issuance of an audit report on an issuer's financial statements. In those situations where auditors' reports are reissued or incorporated by reference pursuant to applicable securities laws or for other purposes, no such communications should be required.
In addition, AU section 722 currently states that, "When conducting a review of interim financial information, the accountant also should determine whether any of the matters described in SAS No. 61, Communication with Audit Committees, as amended, as they relate to the interim financial information have been identified. If such matters have been identified, the accountant should communicate them to the audit committee or be satisfied, through discussion with the audit committee, that such matters have been communicated to the audit committee by management." In these instances, the accountant "should attempt to make such communications with the audit committee, or at least its chair, and a representative of management before the entity files its interim financial information with a regulatory agency." Accordingly, any amendment to AU section 380, as proposed above, would impact communications that might result from the performance of a review of an issuer's interim financial information.
The final rule should alleviate the difficulties with respect to the timing of communications that would be imposed on investment companies. These companies, especially in large fund families, can have numerous fiscal year ends that could require additional meetings of audit committees simply to comply with the letter of the proposed rule's auditor communication requirement. This would needlessly increase the administrative costs to such entities. We therefore suggest that investment companies be permitted additional flexibility in implementing the formal communication requirement, including flexibility with respect to the timing of required meetings.
Transition. In order to allow the ASB time to complete its work on the guidance to be required by the proposal, we suggest this section be effective for fiscal years ending after December 15, 2003.
Disclosure of Professional Fees
Fees for the review of the tax accrual by tax personnel and fees for consultations on accounting and reporting matters should be included in audit fees. They are routine and necessary parts of the audit.
We believe the Commission should require the presentation of a subtotal for audit and audit-related fees because the two are closely related. If the Commission determines that such a requirement is not appropriate, we believe the Commission should permit such a subtotal.
Similar to our comments noted above concerning the requirements for audit committee pre-approvals with respect to investment company complexes, we believe that the fee disclosures for an investment company should be limited to the professional fees that are applicable only to that investment company. There should not be a requirement to include fees for services provided to other entities in the complex. The inclusion of fees for services provided to other entities (such as an investment adviser and other entities providing services) in a mutual fund's disclosures, for example, could be misleading to investors, since the benefits of those services only indirectly impact the investment company. Furthermore, given the differences in size of these entities and the complexity of their operations (i.e., the investment adviser's operations versus the operations of a related investment company) the disclosure of fees billed to all related entities in a complex may confuse a reader about the proportion of fees for audit versus those for non-audit services.
Finally, the proposed amendment to Item 14A (240.14a-101 Item 9(e)(1)), Audit Fees, does not reflect the revised definition of "audit fees" included in the descriptive part of the release. We suggest that this Item reflect the language in the descriptive part of the release (as amended for our comment above to include review of tax accrual and consultations on accounting and reporting matters fees in audit fees). The release states that "...this category also may 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."
Transition. Since current SEC rules require the disclosure of fees billed by principal auditors, we would support the Commission's encouragement for early adoption of the proposed expanded disclosures of professional fees after the final rule is published in the Federal Register. However, since those provisions will expand the requirements for certain issuers (e.g., for entities that are not currently required to file annual proxy statements), we believe that transitional relief is necessary. We recommend that the disclosure requirements be effective for fiscal years ending after June 15, 2003.
Disclosure of Percentages of Fees for Pre-Approved Services
These proposed disclosures are intended to inform shareholders about the performance of their audit committees. They would be in addition to the disclosure of the audit committee's pre-approval policies and procedures. However, as currently proposed, the percentages of fees for pre-approved non-audit services would have to be broken out not only by category of service but also by each of the permitted approaches for approval (pre-approval before the accountant is engaged for the service, pre-approval pursuant to detailed policies and procedures put in place by the audit committee, and fees subject to the de minimis exception).
There is no reason for permitting the two approaches to pre-approval and then acting as if they are not equivalent. If they are equal in the sight of the pre-approval requirements, they should be equal in the sight of the disclosure requirements. Because the audit committee's policies and procedures are required to be disclosed, shareholders would know their audit committee's approach without disclosing the percentages for each type of pre-approval.
Transition. If these disclosures are required at all (and we strongly encourage the Commission to reconsider this matter), the disclosures should be required for the first fiscal year during which the pre-approval requirements are in place for the entire period.
Location of Independence Rules
The descriptive part of the release indicates that the Commission is considering placing the independence rules with other Exchange Act rules, rather than retaining their location in Regulation S-X. Regulation S-X is the traditional location for auditor independence rules as well as other rules on auditor's reports and financial statement requirements. We recommend that the independence rules remain in Regulation S-X. Auditors are accustomed to accessing the rules in Regulation S-X and moving them to another location could easily cause confusion for practitioners.
We would be pleased to clarify any comments you find unclear or answer any questions the comments raise. Please call or write either David Winetroub (212) 909-5552, firstname.lastname@example.org; Sam Ranzilla (212) 909-5837, email@example.com; or Neil Lerner + (44) 207 311 8620, firstname.lastname@example.org.
Very truly yours,
cc: Chairman Harvey L. Pitt
Appendix A: Summary of KPMG's Views on Partner Rotation
Appendix B: KPMG's Transition Recommendations