Institut der Wirtschaftsprüfer
Jonathan G. Katz
Düsseldorf, December 27, 2002
Dear Mr. Katz,
Subject : File No. S7-49-02
We thank you for the opportunity to comment on the above-mentioned proposed rule.
The German Institut der Wirtschaftsprüfer (IDW), a private organization, and the Wirtschaftsprüferkammer, a professional self-regulatory body under public law, represent the German audit profession.
The provisions of the Sarbanes-Oxley Act are not limited to US accounting firms. Foreign public accounting firms that provide services to SEC registrants or foreign affiliates of US registered public accounting firms may also become subject to the Sarbanes-Oxley Act. Consequently, the Sarbanes Oxley Act of 2002 affects German auditors in important ways.
We support the objective of the Act to restore investor confidence in capital markets. However, the Act is designed for the US legal environment and addresses primarily problems of auditor independence in a US context. In Europe, and in particular in Germany, we have our own requirements for auditor independence that are tailored to the legal environment in our country.
The SEC states that the scope of prohibited services should be judged against three basic principles:
Violating these principles is considered to impair an auditor's independence.
In Europe - and in particular - in Germany, the first and second principles have long been part of our requirements for auditor independence and therefore auditors in Germany comply fully with these two principles. However, given the differences between the German and American legal environment, we do not agree that a German auditor acting in an advocacy role for audit clients - whether as a lawyer or in a similar capacity - necessarily impairs auditor independence.
Compared to the American legal system, the role of lawyers as client advocates within the German legal system is based on a fundamentally different conception of client advocacy. Client advocacy by lawyers in an American legal system emphasizes that a lawyer's core professional obligation is to advance client interests within applicable regulatory and ethical requirements. In other words, an American lawyer is generally obligated to undertake whatever lawful and ethical means necessary to assist in the furtherance of a client's cause or endeavor and may not act against the interests of the client once an engagement has been accepted. Consequently, in the U.S., the economic interests of a lawyer may be more closely aligned with that of the client than in the German legal system. Contingent fees - which are not permitted in Germany - represent a prime example of such an alignment of economic interests between a lawyer and his or her client.
In our view, this clearly demonstrates that, depending on circumstances in an individual jurisdiction, there is no single correct approach to ensure adequate auditor independence. Therefore, our primary concern is that the SEC acknowledge that, due to legal requirements that are different from those in the U.S., different approaches to safeguard auditor independence that are, nonetheless, just as effective as the approach pursued by the Sarbanes-Oxley- Act and the proposed SEC rules, may be necessary.
As far as Europe is concerned, we believe that this holds true for the EU Recommendation on Auditor Independence. In May 2002, the European Commission issued a recommendation on the fundamental principles for statutory auditor independence in the EU that addresses the same goals as the proposed SEC rules. The recommendation supplements other EU directives regarding EU statutory auditors by setting forth principles for maintaining objectivity and the appearance of objectivity in conducting audits. Rather than totally banning an extensive list of non-audit services by auditors, the recommendation identifies factors that should be assessed in evaluating whether the objectivity of an auditor is at risk. Because it is principle-based and not based on detailed rules, the EU Recommendation would have covered many of those situations that have been criticized in the US. In Germany laws are in the process of being passed by the government to comply with the requirements of the EU Recommendation.
Given this background, we hold the view that it makes little sense to subject German or European auditors to two different sets of rules for auditor independence. If two different - but similarly effective - systems exist, requiring foreign auditors to comply with the provisions of the Sarbanes-Oxley-Act and the proposed SEC rules in addition to their domestic independence rules entails a significant financial and administrative burden for these auditors without enhancing their independence. Furthermore, in this situation conflicts with their domestic laws and regulations may occur.
Since the EU Recommendation on independence was drafted for the European legal environment, it is more effective in safeguarding the independence of European auditors than the requirements of the Sarbanes-Oxley Act and its concomitant SEC interpretations, which were designed for an American legal environment rather than for a European one. Therefore, we believe that the SEC should recognize the European requirements as equivalent to the U.S. approach and as fulfilling the purpose of the Sarbanes-Oxley-Act.
In light of this general view and to supplement the comments made by our representative, Dr. Knorr, in the hearing on December 17, 2002, the focus of our subsequent responses is on matters particularly relevant from a European and, more specifically, a German perspective.
1. Services Prohibited to Assure Auditor Independence
In principle, the EU Recommendation does not ban any specific non-audit services. However, it does recommend various safeguards in specific instances, such as when an auditor provides internal audit services. One such safeguard is to ensure the active participation of the audit client's management or governing body in making decisions the overall system of internal controls and the consideration of information provided by the auditor.
1.1. Financial Information Systems Design and Implementation
We agree with the SEC that design or implementation of an audit client´s financial information technology systems used to generate information forming part of that audit client´s financial statements threatens the independence of the auditor when the auditor is placed in a management role or is auditing his or her own work. However, audit work includes testing those hardware and software systems that are used by the audit client to generate the financial information disclosed in its financial statements. Consequently, auditor independence is not impaired when the auditor assists in the selection or tests computer software and hardware systems that generate financial data used in or underlying the financial statements. In our view, the engagement of the auditor by the audit client to review alternative systems does not place the auditor in a management role. Based on this review the client decides which system to install. The provision of such a service would generally not compromise the auditor's independence, provided that cost and benefits of the systems reviewed are properly documented and discussed with the audit client. However, an auditor's independence would be compromised if the auditor has a significant financial interest or a significant business relationship with any of the potential systems suppliers.
An auditor should accompany the implementation of a financial information system to help ensure it meets audit purposes and ordinarily tests the effectiveness of a such a system once installed as part of the financial statement audit. Furthermore, the independence of an auditor is not threatened when an auditor recommends that weaknesses identified in the financial information system during the audit or review of the financial statements. Hence, criteria need to be developed that define the dividing line between recommendations to improve systems before or after systems implementation that do not threaten an auditor's independence from consulting engagements with respect to information systems that do threaten that independence.
1.2. Appraisal or Valuation Services, Fairness Opinions, or Contribution-in-Kind Reports
Under the SEC´s current independence rules, an accountant is deemed to lack independence when providing appraisal or valuations services, fairness opinions, or contribution-in-kind reports for audit clients. However, the current rules contain certain exemptions that are eliminated in the new proposal. Pursuant to the proposal, because the auditor would be placed in a position where he or she is auditing his or her own work, an auditor would not be independent when he or she provides appraisal or valuation services or contribution-in-kind reports where there is a reasonable likelihood that the results of the service will be subject to audit procedures by that auditor. The proposal also takes the view that providing a fairness opinion would also impair the independence of the auditor because doing so places the auditor in a management role or may require the auditor to audit the results of his or her own work.
Our independence requirements comply fully with the principles that an auditor cannot function as a part of management and cannot audit his or her own work. However, we believe, auditor independence cannot be impaired providing valuation services when either
Engagements to review or to issue an opinion on valuation work performed by others, or to collect and verify data to be used in a valuation performed by others (e.g., typical ,,due diligence" work in connection with the sale or purchase of a business), cannot be regarded as valuation services in the above-mentioned sense. Therefore one should distinguish between valuation services that actually represent an assurance engagement and those valuation services provided as non-audit services. Providing valuation service as an assurance engagement (e.g., the so called ,,Gründungsprüfung" according to Art. 33 of German Stock Corporation Law) cannot impair the independence of the financial statement auditor because management is responsible for the both the subject matter subject to the assurance engagement and subject to audit.
If, with regard to certain routine valuations, the underlying assumptions are determined by law (e.g., tax rates, depreciation rates for tax purposes), other regulations (e.g., a requirement to apply certain interest rates), or are widely accepted within the audit client's business sector, and when the techniques and methodologies used are based on general accepted standards, or even prescribed by laws and regulations the degree of subjectivity inherent in the item concerned may be insignificant. In such circumstances, the result of a valuation performed by an informed third party, even if not identical, is unlikely to be materially different. The provision of such valuation services might therefore not compromise an auditor's independence, even if the value itself could be regarded as material to the financial statements, provided that the management of the audit client has at least approved all significant matters involving judgement. However, if the resulting valuation is material in relation to the financial statements, the auditor should consider whether a self-review threat remains that should be mitigated by additional safeguards. It may be appropriate to address such a threat by setting up a valuation service team separate from the engagement team and that each team report to managers or partners heading different departments.
1.3. Legal Services
Under existing rules with respect to providing legal services, an auditor is deemed to lack independence when he or she provides legal services to an audit client where the person providing the service must be admitted to practice before the courts of a U.S. jurisdiction. The proposed rule provides that an accountant is not independent of an audit client if the accountant provides any service to the audit client and that service may only be provided by someone licensed, admitted or otherwise qualified to practice law in the jurisdiction in which the service is provided. Thus, the proposed rule would apply to foreign and U.S. accounting firms and legal practices equally, and thereby minimize, and possibly eliminate, the instances where legal services can be provided by the auditor to the audit client.
In other democratically legitimatized legal environments, such as in many continental European legal systems based on civil rather than common law, the role of a legal adviser may differ significantly from that in the U.S. For example, in Germany a lawyer is considered to be an independent organ within the legal system, in which a lawyer is required to advise his client objectively without identifying himself or herself with the economic or other interests of the client. Consequently, contingent fee arrangements are expressly forbidden in Germany. In fact, the basis for the remuneration of lawyers in Germany is a fee scale regulated by statute. By not aligning the interests of a client's legal advisor with that of the client through the prohibition of contingent fee arrangements, in Germany a lawyer is considered by the public not to be just a representative of a particular client, but is viewed as an objective advisor.
The questions raised by the SEC demonstrate that the SEC appears to have noted that, for historical and cultural reasons, other countries have an understanding of the role of legal advice which differs from that in the U.S. Hence, the question as to whether the provision of legal services to or acting in an advocacy role for an audit client impairs an auditor's independence can only be assessed by examining the legal framework within which that auditor operates or legal advice is provided. From a European point of view, the provision of legal advice does not a priori impair the independence of the statutory auditor to the extent that the auditor does not audit his or her own work nor assumes management functions. In Germany, the independence of an auditor is considered to be impaired only if the results of his or her legal advice have a direct impact upon the contents or presentation of the financial statements.
1.4. Expert Services
The proposed SEC rule states that an accountant´s independence is impaired in relation to an audit client if the accountant provides expert opinions for that audit client in connection with legal, administrative, or regulatory proceedings or acts as an advocate for an audit client in such proceedings. Since the activities described as expert services would, for the most part, be considered legal services under German law, it should be stressed again that from a German perspective, those providing such services may not identify themselves with the interests of their clients: a German lawyer or Wirtschaftsprüfer (German public auditor) must act as an independent advisor of the client. Pursuant to § 43 WPO (Article 43 or the Law Regulating the Wirtschaftsprüfer Profession in Germany) a Wirtschaftsprüfer acting as an advisor or consultant is legally required to provide advice in an impartial manner. Consequently, the American understanding of expert services appears to differ fundamentally from the European - and in particular - from the German understanding of such services.
1.5. Tax Services
Pursuant to Section 201 of the Sarbanes-Oxley Act, accounting firms are not prohibited from providing tax services to their audit clients. The audit committee of the client must pre-approve the provision of tax services by the auditor. It therefore appears that American law does not intend to prohibit tax services in general. The SEC grants a special status to tax services not only because of detailed nature of tax law, which must be consistently applied, but also because the Internal Revenue Service is entitled to audit any tax return.
In view of the German legal environment, we believe that tax services in Germany are even more deserving such special status that considers them compatible with audits of financial statements. Unlike in the U.S., in Germany tax consultancy may only be provided by professions specifically licensed to provide such services, such as Wirtschaftsprüfer (German public auditors), Steuerberater (licensed tax advisors) and lawyers. In the provision of these types of tax consulting services, Wirtschaftsprüfer (German public auditors) have the same rights as Steuerberater (licensed tax advisors). The members of each of these two professions must pass national government examinations in tax law and are required to maintain their independence of their clients. In particular, members of neither profession are permitted to engage in any commercial business activities. The provision of tax advice is explicitly regulated by statute.
Furthermore, in Germany there is a substantial connection between the commercial financial statements that are required under the German commercial code and the financial statements that are required to be prepared for tax purposes. The intensity of this connection exceeds the link between US GAAP financial statements and tax information prepared under the Internal Revenue Code in the U.S. Because of this intensive link in Germany, under the so-called "Maßgeblichkeitsprinzip" (governing principle) the commercial financial statements are the legal basis for the preparation of the financial statements for tax purposes. Furthermore, under the "umgekehrte Maßgeblichkeit" (converse governing principle) the tax treatment of specific financial statement items may govern their treatment for accounting purposes. The intensity of this link is also demonstrated by the fact that both the short auditor's report and the long-form audit report issued by Wirtschaftsprüfer on a client's financial statements must both be submitted to the tax authorities. If misstatements in the financial statement lead to an unfounded determination of the tax base, the Wirtschaftsprüfer may become liable to the tax authorities for such misstatements .
Unlike in the U.S., in which the tax system is based upon self-assessment, enterprises in Germany are subject to tax audits continually, since tax authorities are required to determine the tax bases. Tax advisors, whether as Wirtschaftsprüfer or Steuerberater, are bound by much more extensive legislation than in the USA, so that the provision of tax advisory services by an auditor, which pursuant to German law are viewed as legal services, do not impair the independence of the auditor to the extent that the auditor does not review his or her own work nor performs management functions.
2. Partner Rotation
We support the overall objective of the proposed SEC rule with regard to internal partner rotation to increase investor confidence in the independence of auditors when they perform audits of financial statements. A mandatory internal rotation within accounting firms of auditors that sign the auditor´s report for publicly listed audit clients was introduced into law in Germany in 1998.
With respect to determining which partners, principals and shareholders of accounting firms should be covered by such rotation, the proposed SEC rule goes beyond the minimum specified by the Sarbanes-Oxley Act (Sec. 301). The Act requires that only the lead or co-ordinating audit partner and the audit partner responsible for reviewing the audit rotate every five years. The proposed SEC rules would require rotation not just of the lead and reviewing partner, but of all partners who perform audit services for the issuer. This rotation requirement would include the lead partner, the concurring review partner, the client service partner, and other "line" partners directly involved in the performance of the audit (including tax partners who perform significant tax services related to the audit engagement).
We do not think that the extension of the scope of mandatory audit partner rotation to all partners who perform audit services for the issuer is necessary to achieve the overall objective of the rule mentioned above:
An internal rotation of only partners that sign the auditor´s report rather than of other audit partners and staff members involved on an audit is based on the view that knowledge of a business is gained over time and that the rotation of an entire audit team would lead to the loss of the accumulated knowledge and experience. On the other hand, rotation of partners ultimately responsible for the audit would contribute the most to the minimization of independence risks associated with over-familiarity with an audit client´s management, yet allow the retention of institutional memory and experience by other members of the audit team.
Instead of introducing a mandatory obligation to rotate all partners involved in an financial statement audit, the audit firm should be obliged to apply safeguards within its quality control system to minimize independence risks arising from the involvement of other audit team members. Pursuant to the EU Commission Recommendation - Statutory Auditors' Independence in the EU - the Statutory Auditor should also consider independence risk arising from the prolonged involvement of other members of the engagement team, including the senior staff engaged on audits of entities which are consolidated into an audit client's consolidated financial statements, and from the composition of the team itself. The auditor should apply safeguards, such as rotation and measures under the audit firm's quality assurance system, to seek to ensure that the engagement will continue to be performed effectively without compromising independence.
Furthermore, in line with the EU Commission Recommendation, we believe that a two year ,,time out" period is sufficient to safeguard an individual from related independence threats related to familiarity or trust.
Under Section E Compensation the SEC addresses situations where partners, principals, or shareholders of the firm who work on the audit of an enterprise are compensated for selling non-audit services to the same audit client. The SEC provides that an accountant is not independent if, at any point during the audit and professional engagement period, any partner, principal or shareholder of the accounting firm who is a member of the audit engagement team earns or receives compensation based on the performance of, or procuring of, engagements with the audit client, to provide any services, other than audit, review, or attest services.
We would like to stress that an audit, and to a certain extent, reviews, provide an insight into the systems and procedures of client operations and provide the auditor the opportunity to propose improvements to the client. In our view, the potential "added value" benefits of an audit should not be wasted. Improvements to client procedures may enhance the quality of financial reporting.
We agree that there is a threat to auditor independence when an auditor´s compensation is directly linked to fees the auditor earns or receives from the audit client charged for non audit services. The argument set forth in the proposed rule is that receiving compensation for selling non audit services to the same audit client might impair the auditor independence.
If, however, the SEC intends to retain the proposed rule without major changes, it should be clarified that the rule only applies to direct compensation received from the same audit client. Audit firms may have worldwide or regional pools by which profit from non-audit services may be allocated to partners without reference to the non-audit fees that individual partners may have generated. These pools are usually funded by a great number of non-audit engagements with various clients. There is no connection between the auditor of a specific client and the non-audit fees charged to that client. Therefore the independence of the auditor with respect to that specific audit client is not impaired. For this reason, we emphasize that the proposed rule should be clarified as not applying auditor compensation received from such a pool.
4. Expanded Disclosure of Fees Paid
Pursuant to section H. of the proposed SEC rules, registrants will be required to disclose fees for each of the two most recent fiscal years for the following categories of professional fees paid: (1) Audit fees, (2) Audit related fees, (3) Tax fees, and (4) All other fees. In addition, registrants will be required to describe in subcategories the nature of the services provided that are categorized as audit-related fees and all other fees.
We support the idea that an auditor should be able to demonstrate that his or her independence has not been compromised by providing non-audit services to an audit client for which the remuneration received is disproportionate to the fees for the financial statement audit. This public disclosure requirements should enable a reasonable and informed third party to take a view on the extent of any imbalance between audit and other fees.
While we support the proposed requirements to disclose the fee categories audit fees, tax fees, and all other fees, we do not consider the category "audit related fees" useful, because - although the SEC has included some examples of services, the kinds of services which the SEC consider to be audit related remains unclear. One of the characteristics of audit related services is their close relationship to audit services. For example, German auditing standards require an assessment of the reporting entity's internal control system as part of an audit of financial statements. Pursuant to the proposed SEC rule, internal control reviews will be subsumed under the category audit related services. From that point of view it is not evident, into which category (audit related or audit?) the assessment of the reporting entity's internal control system in the course of an audit of financial statements would be classified.
We are of the opinion, that the services defined by the EU Commission in its Recommendation ensures a clear and definable categorisation of services that should be disclosed. Therefore, we suggest that the SEC ought to adopt the following categories: (1) audit, (2) other assurance services, (3) tax advisory services and (4) other non-audit services.
Dr. Veidt Prof. Dr. Naumann