Office of Advocacy
January 13, 2002
Mr. Jonathan G. Katz
Dear Secretary Katz:
We are writing to comment on the U.S. Securities and Exchange Commission's ("the Commission") Notice of Proposed Rulemaking, Strengthening the Commission's Requirements Regarding Auditor Independence.(1) The proposed rule implements Sections 201 through 204, and Section 206 of the Sarbanes-Oxley Act of 2002,(2) requiring limitation of services offered by auditors to audit clients, rotation of audit partners, auditor disclosures to audit clients, and other provisions.(3) The Office of Advocacy would like to take this opportunity to comment specifically upon the Commission's request for market information and the Commission's proposal to require audit partner rotation for small audit firms which have historically been exempt from such provisions.
The U.S. Small Business Administration's ("SBA") Office of Advocacy ("Advocacy") was established pursuant to Pub. L. 94-305 to represent the views of small business before Federal agencies and Congress. The Office of Advocacy is an independent entity within the SBA, so the views expressed by the Office of Advocacy do not necessarily reflect the views of the SBA or the Administration. The Regulatory Flexibility Act ("RFA"), as amended by the Small Business Regulatory Enforcement Fairness Act of 1996 ("SBREFA"), gives small entities a voice in the rulemaking process. The RFA requires Federal agencies, such as the Commission, to consider alternatives to avoid overly burdensome regulation of small entities.(4) Advocacy is also required by Section 612 of the RFA to monitor agency compliance with the RFA.(5)
I. Market Information
Once an agency has determined that the rule it intends to promulgate will have a "significant impact upon a substantial number of small entities," the RFA requires the agency to complete an Initial Regulatory Flexibility Analysis ("IRFA").(6) In its IRFA, an agency must include "a description of and, where feasible, an estimate of the number of small entities to which the proposed rule will apply."(7) In addition, an IRFA must contain "a description of the projected reporting, recordkeeping and other compliance requirements of the proposed rule, including an estimate of the classes of small entities which will be subject to the requirement."(8)
The Commission has determined that the proposed auditor independence rule are likely to have a significant impact on a substantial number of small entities, and has therefore included an IRFA with the preamble to its proposed rule published in the Federal Register.(9) The Commission has included a section within this IRFA offering its description and estimate of the number of the entities which will fall within the purview of the proposed auditor independence rule.(10) The Commission noted that it believes there are 2500 small registrants. However, the Commission notes that it possesses "limited data indicating revenues for accounting firms, and [it] cannot estimate the number of firms" which should be included in its IRFA as small entities.(11)
With regard to the number of accounting firms to be affected, Advocacy generally advises agencies to estimate the number of small entities which their regulation will affect. Advocacy believes that the IRFA serves a vital role in analyzing proposed agency action for the benefit of the class of entities to be captured within the regulations. With respect to economic analysis, Advocacy advises agencies that:
Advocacy also encourages agencies to outline what steps they have taken in attempting to estimate the number of small entities that proposed rules would affect. While it is not clear from its IRFA what steps the Commission has taken to collect information on the number of potentially affected accounting companies, the Commission has requested comment on the number of entities to be affected. In response to the Commission's request for market data, Advocacy has collected available government statistical information on the accounting market, as well as contacted industry sources in order to determine the potential impact of the Commission's proposed auditor independence rule.(13) Advocacy offers this information for the Commission's consideration.
The market for both private and public accounting services appears to be highly unconcentrated. The most recent U.S. Census statistics indicate that there were 51,645 audit firms in the United States with a similar number of offices, indicating that the great majority of all accounting firms consist of one office.(14) As discussed below, it appears that the great majority of these firms fall within the SBA definition of "small business" (less than $6 million in revenue).
While the U.S. Census cited above does not classify these firms according to revenue, an average per-firm revenue can be obtained through the use of publicly available IRS tax return information. The IRS indicates that in 1998 there were 46,407 tax returns for accounting firms organized as corporations.(15) Of the firms captured by the IRS data, 99.18% (46,025) would likely qualify under SBA's definition as small businesses, because these firms have less than $3 million in receipts, which is below the $6 million revenue limit in the SBA size standard.(16) A further 318 corporate filers are reported to have an average of $5.7 million in receipts, indicating that the majority of these firms also had less than $6 million in revenues.(17) This leaves 63 firms out of 46,407, or about one-eighth of one percent of the market with more than $6 million in revenues.(18) Although there are a few extremely large accounting corporations within the accounting market taken as a whole, the industry is otherwise highly decentralized and the vast majority of firms appear to fall within the SBA definition of "small business."(19)
The Commission's own analysis of the accounting market from its previous Auditor Independence Requirements of 2001 provides useful background on the market for public accounting. In 2001, the Commission stated that:
The Commission estimated that the top 28 firms audit a large part of the market, leaving around 13% to "smaller" firms, without defining the term. Advocacy's research into IRS accounting corporation statistics show that only 63 firms had enough revenue in 1998 to exceed the SBA definition of small businesses.(21) It would appear then that the vast majority of remaining "smaller accounting firms" are in actuality "small businesses" as defined under the SBA rules.
Further, Advocacy has discussed the proposed rulemaking with small industry representatives, including accountants, American Institute of Certified Public Accountants ("AICPA") staff, and accounting clients. Based upon information received from the AICPA's SEC Practice Section ("SECPS"), the self-regulatory body that administers peer reviews for firms performing audits on public companies, there are approximately 767 audit firms performing SEC engagements. Of these 767 audit firms, 460 firms are currently exempt from the SECPS' own partner rotation rule, meaning that they have less than ten partners and less than five SEC engagements. In fact, SECPS data indicates that 206 audit firms consist of three partners or less, and 263 firms of any size have only one SEC engagement. These 460 exempt firms currently audit approximately 765 small issuers.(22)
II. Audit Partner Rotation Requirements
The RFA requires agencies to evaluate alternatives to proposed regulations "which accomplish the stated objectives of applicable statutes and which minimize any significant economic impact of the proposed rule on small entities."(23) Advocacy recommends that the Commission include a small firm exemption to its audit partner rotation requirements. This exemption would ensure that small issuers which make up a small portion of the market capitalization in this country do not incur marked increases in audit costs in return for a negligible amount of investor protection.(24) Also, such a provision would ensure that small audit firms are not placed at a competitive disadvantage to larger audit firms.(25)
The Commission's proposed rule would label audit firms as not "independent" should the firms use the same lead or review partner to review a firm for more than five consecutive years.(26) The proposed rule would require audit and review partners to cease providing services to clients upon the completion of five consecutive fiscal years, then refrain from working on the engagement for five more years until they would be allowed to work on the engagement again.(27)
The Commission's proposed five-year rotation rule follows closely with the AICPA's own rule, which currently requires all member firms to "assign a new audit partner to be in charge of each SEC engagement that has had another audit partner-in-charge for a period of seven consecutive years, and prohibit such incumbent partner from returning to in-charge status on the engagement for a minimum of two years."(28) However, the current AICPA SECPS requirements contain an exemption for small firms of less than ten partners performing less than five SEC engagements.(29)
As discussed above, Advocacy believes there are approximately 460 small audit firms in this country providing audit services to 765 smaller reporting companies who are currently exempt from the AICPA SECPS prohibition on audit partner rotation. The SECPS exemption from rotation exists because small firms may be unable to rotate partners effectively, given industry specialization and initial knowledge-acquisition costs. Under the Commission's proposal, currently exempt small audit firms would be required to rotate audit partners every five years. Advocacy believes that currently exempt audit firms generally engage in small numbers of SEC engagements (e.g., 3 out of 300 clients), and may rationally decide to cease involvement in SEC engagements.(30)
Advocacy is concerned that small issuers retaining the services of currently exempt small audit firms who decline to offer audit services to them may be forced to engage the services of larger audit firm. Advocacy believes that this could result in significantly increased audit costs to audit consumers in two ways. First, initial costs for new firms would rise, due to the need to familiarize auditors with the client firm's industry and business practices.(31) Second, due to the effective elimination of smaller firms from the competitive market for audit services and the consolidation of the market, larger audit firms may gain some power over price, causing audit prices to rise.(32)
For example, one audit consumer, a local bank filing under Form SB, offered the general observation that it expected its audit costs to rise from 20-25%, should it be forced to retain a new audit firm.(33) This client indicated that the price increase would come from the need for a new auditor to bring itself up to speed with the business of the bank and implement its audit procedures. Since this audit client's fees are already in the range of 5% of net income, the client is considering a going-private transaction given its low level of debt and equity financing.(34)
Advocacy recommends small auditor flexibility to avoid negative impacts on the market for audit services. As previously outlined, currently exempt small auditors provide a significant portion of audit services. SEC engagements typically account for a small percentage of these auditors' practices.(35) Advocacy believes that these small audit providers, who are currently exempt from AICPA SECPS rotation requirements, may decline further SEC engagements due to inability to compete with larger firms that are capable of easily rotating partners among a large pool.
Advocacy recommends that the Commission use its exemptive authority(36) to exempt small audit firms currently exempt from the AICPA SECPS audit partner rotation requirements. While the Commission is charged with determining the ultimate level of flexibility it believes comports with the Commission's charge of investor protection, Advocacy believes that an appropriate standard for an exemption would be the existing small audit firm limit of five SEC engagements and ten partners, as such a level appears to preserve the current level of competition for audit services without threatening the Commission's regulatory goals.
Advocacy appreciates the opportunity to provide its recommendations regarding the Commission's proposed rule on auditor independence. Thank you for your consideration and please do not hesitate to contact me or Michael See of my staff at (202) 205-6533 or Michael.See@sba.gov.
Cc: Robert K. Herdman, Chief Accountant, Office of the Chief Accountant