13 January 2003
Jonathan G Katz
Dear Mr Katz
Strengthening Auditor Independence
I am writing in connection with the Commission's proposed rule changes with respect to Auditor Independence pursuant to the Sarbanes Oxley Act.
By way of introduction, The Hundred Group of Finance Directors comprises the finance directors of the100 largest companies listed on the London Stock Exchange. We meet periodically to discuss issues affecting major corporates, and selectively respond to governmental and other consultation exercises where we believe that our role in companies and collective experience give us a particular insight into often complex matters.
Auditor independence is essential to the proper functioning of capital markets, and we welcome the Commission's efforts to strengthen that independence and help restore investor confidence.
There are two specific matters in the proposals published on December 2nd 2002 on which we particularly wish to comment. These relate to a potentially severe restriction of the tax services that firms can supply to audit clients, and the proposed extension of the five year partner rotation rule from the engagement and concurring partners to all partners involved in the audit.
We believe that the proposed rules in both these areas have the capacity to undermine audit quality and increase cost. Additionally, the proposed rules would appear to go beyond the intentions of the Sarbanes Oxley Act.
The Commission's December 2nd document articulates well three basic principles that affect an auditor's independence with respect to an audit client. The document however goes on to describe "the formulation of tax strategies (e.g. tax shelters) designed to minimise a company's tax obligations" as an example of where an accountant's independence would be impaired.
Tax services are not amongst the list of prohibited non-audit services contained in the Sarbanes Oxley Act. Indeed, tax services are the only non-audit services specifically described in the legislation as services in which an accounting firm "may engage".
The use of the example referred to will, quite probably, result in confusion over what is permitted under the proposed rules. The principles themselves are clear and can be applied by audit committees to each individual circumstance.
Audit firms are uniquely positioned to gain full insight into the affairs of a company, and it is to the detriment of the company (and its shareholders) if it is to be denied receiving the benefit of advice prompted by such insight.
A significant restriction in the scope of tax services provided by firms to audit clients could also have the long term damaging effect of weakening the tax practices of the audit firms. It is important that the firms are able to recruit and retain high quality tax professionals who are motivated to apply themselves to the audit of financial statements.
One other matter in relation to tax services is the proposed prohibition on the provision of legal services by audit firms to their audit clients. A number of tax services involve quasi "legal" services of a routine nature, and in some jurisdictions tax advisors are required by local law to be registered as lawyers. Such "legal" services are very different from the "advocacy" that the proposed rules seek to stop. The rules should not be phrased in a way that prevents the efficient provision of otherwise permitted tax services.
The proposals significantly extend the partner rotation rules set out in the Sarbanes Oxley Act. In addition to the lead partner and the concurring partner, the proposed rules would require five year rotation of all partners, including partners on subsidiaries and in specialist functions.
Whilst the rotation of lead and concurring partners responsible for the audit of an issuer's consolidated financial statements is well understood, the rotation of every partner with any involvement in a group's audit would cause significant disruption and additional cost, as well as, perhaps more worryingly, a reduction in audit quality as audit knowledge and experience is lost. In many territories or specialist functions, there is just not the depth of high quality personnel available to manage such a widescale rotation policy without this risk to audit quality.
The potential for loss of audit independence has very different significance when considering the work of the lead and concurring partners on a central engagement team versus the work on subsidiaries. The work of a subsidiary auditor is subject to oversight and quality control by the lead engagement partner who takes overall responsibility for the financial statements to which he or she attaches the firm's opinion. There is no similar oversight or check on the lead and concurring partners, which is why rotation is so much more important in relation to them.
Another matter that may require further clarification in final rules relates to the ban on compensating partners for the sale or provision of non-audit services (NAS). It is to be expected that, in any partnership, partners will usually benefit from all revenues of the partnership however derived. Any final rule on compensation should make it clear that it is the direct link of incentive awards to NAS that are targeted.
In some jurisdictions, appraisals and valuations (such as contribution-in-kind reports and fairness opinions), unrelated to the financial statements per se, are required from the auditors by local law. The final rules should avoid putting issuers in jeopardy of being in breach of local regulatory requirements.
Auditors are expected to comment on the quality and efficiency of the accounting and internal controls that they review as part of their audit work. The final rules should make it clear that an auditor's review of accounting and controls and the making of recommendations for improvement should not be prohibited.
In closing, we would make one last comment. In addition to auditor independence, it is of paramount importance that there is a strong and vibrant audit profession that can attract and retain high calibre individuals. In formulating its final rules, the Commission should have due regard to the impact of any rule, or rules taken together, on the long-term development of the profession.