Request for Rulemaking Concerning Definition of Independent Auditor and Limiting Services Accounting Firms May Provide to Audit Clients
December 11, 2001
Jonathan G. Katz
Re: Petition for rulemaking
Dear Mr. Katz,
The American Federation of Labor and Congress of Industrial Organizations (the "AFL-CIO") hereby petitions the Securities and Exchange Commission (the "Commission") to undertake a rulemaking proceeding to amend the rules governing auditor independence to revise the definition of an independent auditor and limit the services accounting firms may provide to their audit clients. We also ask the Commission to require additional proxy statement disclosure regarding the role of the audit committee in approving both audit engagements and non-audit consulting agreements with the audit firm. As shown by the scandal currently unfolding at Enron Corporation, investor confidence in the U.S. capital markets requires that auditors be, and be perceived as, truly independent from their clients.
The AFL-CIO is a federation of trade unions that represent 13 million working men and women who participate in the capital markets as investors through defined benefit and defined contribution plans as well as through mutual funds and individual accounts. Our member unions sponsor benefit plans with over $400 billion in assets, and our members are participants in public employee and collectively bargained single-employer plans with over $5 trillion in assets. Our union-sponsored funds alone are the beneficial owners of approximately 3.1 million shares of Enron stock, through both actively-managed and passive (or indexed) portfolios.
Independent auditors occupy a central position in promoting confidence in the integrity of the financial reporting system and U.S. capital markets. Because the Commission requires that financial information filed with it be certified or audited by independent auditors, auditors are, as the Commission recently stated, the "gatekeepers" to the public securities markets.1 Auditors work not only for their clients, but also for the investing public.
The role of the independent auditor is once again in the spotlight, as it was following relevations of accounting fraud at Sunbeam, Cendant and Waste Management. Now, the stunningly rapid failure of Enron Corporation, where there is evidence that Enron's auditor, Arthur Andersen, knew about and identified accounting errors but did not insist on their timely correction, focuses attention on the factors that might lead a company's auditor to sign off on misleading financial statements. Foremost among these is a dependence on a company and its management that can serve to undermine an auditor's objectivity.
Independence can be compromised in various ways. The provision of certain kinds of non-audit consulting services to audit clients may create economic incentives that can lead a firm to devalue the audit services and focus on retaining the client, even at the cost of making inappropriate audit judgments. In 2000, Arthur Andersen received more non-audit fees than audit fees from Enron. A "mutuality of interest" not conducive to independence may develop from the provision of certain kinds of non-audit services or from the employment by an audit client of former employees of the auditor. Certain services result in the auditor acting as management or an employee of the client. Finally, auditors may not be able to audit objectively work performed by the audit firm itself under a consulting agreement.
Over the past several decades, the proportion of audit firms revenues derived from non-audit services, such as internal audit, information technology, financial advisory and appraisal and valuation services, has grown steadily. At the five largest public accounting firms, revenues derived from non-audit services grew from 13% of total revenues in 1981 to half of total revenues in 2000.2
The 2000 Commission Rulemaking
Citing these threats to independence and their potential effect on capital formation, as well as the increased pressure on companies to make or surpass analyst earnings estimates, the Commission undertook last year to revise its rules governing auditor independence. With respect to the provision of non-audit services to audit clients, the Commission solicited comment on three alternative approaches: banning the provision of such services altogether, imposing limits on the provision of those non-audit services deemed most likely to impair independence, and requiring only additional disclosure.3
Although a number of commenters and those testifying at the Commission's public hearings favored a ban on non-audit services, there was also significant opposition, mainly from the accounting profession, to any substantive reform. As a result, the final regulations reflected a compromise in which auditors could provide those non-audit services that posed a danger to independence, but only under certain circumstances. (The proposed limitation on providing expert testimony were dropped in its entirety.) A compromise was also reached regarding the additional disclosure required of registrants regarding the non-audit services provided by their auditors and the involvement of their audit committees with respect to auditor independence issues.
In light of subsequent developments, however, we ask the Commission to revisit some of the issues raised in the 2000 rulemaking, and to consider some new reforms, in order to strengthen its auditor independence safeguards. As discussed more fully below, both substantive reform and additional disclosure are necessary to preserve confidence in our capital markets.
The Rules on the Provision of Non-Audit Services Should be Strengthened
We believe that the Commission's final rules give too much flexibility to audit firms to provide non-audit services that could compromise the firms' objectivity and create economic incentives that may undermine the effectiveness of audits. A December 5, 2001 Washington Post article highlighted the pressures on individual auditors to "cross-sell" non-audit services to audit clients, recounting a case in which a Coopers & Lybrand accountant's performance review varied according to the amount of such services he was able to sell. That case involved Phar-Mor, which later filed for bankruptcy protection following revelations of accounting fraud; a jury found that Coopers, Phar-Mor's auditor, had committed fraud.
We believe that in some cases the sheer amount of the consulting services may create perverse incentives. During testimony in connection with the 2000 rulemaking, much was heard about the "loss leader" phenomenon, in which firms submitted artificially low bids, not consistent with providing high quality audit services, as a way to establish a relationship with a client and sell audit services. The audit then makes up an even smaller proportion of the total revenue stream from the client. And here, the danger not only lies in the auditor's impaired judgment. Anecdotal evidence suggests that executives of some companies encourage audit firms to undertake non-audit consulting as a way of obtaining leverage for the company over the audit process.
Certain non-audit services pose a more significant threat to an auditor's independence than others. The Commission recognized this in the 2000 rulemaking, when it prohibited firms from providing certain services, like bookeeping services. However, the Commission determined that audit firms could continue to sell information technology and internal audit consulting services to audit clients, as long as certain requirements, designed to lodge ultimate responsibility for the systems with the client, are satisfied. We believe this was a mistake.
The provision of information technology and internal audit services raise several serious problems. First, in cases where an information technology project is unsuccessful, a company may not be permitted to capitalize the costs of the project on the balance sheet (thereby creating an asset), but rather is required to expense them, thus reducing income. An accounting firm that botched the consulting job will be less likely, we think, to be assertive with management about the need to expense the item.
Similarly, if the auditor discovers, during the course of an audit, a theretofore undiscovered problem with software or an internal audit system the auditor designed and installed, the auditor is in the uncomfortable position of having to inform the client about the audit firm's own error. Finally, in a real sense the audit firm is auditing it own work because assessing the reliability of the numbers generated by an information technology or internal audit system is a part of the audit function.
We believe that the conditions imposed on audit firms in connection with information technology and internal audit consulting services are easily manipulated and do not mitigate the danger that the auditor and client will come to view the auditor as an extension of management and that the auditor will experience difficulty in vigorously auditing its own work.
Attention should be focused on another kind of consulting service, one that was not raised in the 2000 rulemaking but that has been brought to the fore by the Enron debacle. Enron's restatement of several years' worth of financial statements stemmed in part from the acknowledgment by Enron that the financial results of off-balance-sheet special purpose entities ("SPEs") set up by Enron-and in some cases managed by Enron officers-should have been consolidated with Enron's own results. In one case, Enron conceded that consolidation was necessary because the SPE had been inadequately capitalized when it was established.
Enron paid Arthur Anderson $27 million in 2000 for non-audit consulting services, including fees for "business process and risk management consulting." We are concerned that this category may include consulting regarding the transactions pursuant to which one or more of the erroneously non-consolidated SPEs were established. Such an arrangement would, we think, create an unacceptable conflict of interest, requiring Arthur Andersen's audit personnel to question the judgment of its consultants on a matter which could-and eventually did-have a major impact on Enron's financial results. We urge the Commission to consider amending Rule 2-01 of Regulation S-X to provide that an independent auditor may not design and/or structure a transaction the audit firm must pass on in connection with the audit.
Auditors Should be Rotated
Currently, audit firms must rotate the audit engagement partner every seven years, in order to remove the risk of over-familiarity with the client. However, the engagement partner may remain in a relationship management position with respect to the client, which mitigates the effect of partner rotation.
We believe a more sensible approach is to require mandatory rotation of audit firms every seven years. Such rotation would provide a number of important benefits. First, a new audit firm would bring to bear a skepticism and fresh perspective that a long-term auditor may lack. Second, auditors tend to rely excessively on prior years' working papers, including prior tests of the client's internal control structure, particularly if fees are a concern.4 Relatedly, longtime auditors may come to believe they understand the totality of the client's issues, and may look for those issues in the next audit rather than staying open to other possibilities. Finally, an auditor may place less emphasis on retaining a client relationship even at the cost of a compromised audit if it knows the engagement will end after several years.
In our opinion, the benefits to shareholders, lenders and the investing public from requiring rotation of auditors outweighs the additional cost that may be entailed in connection with a new auditor becoming familiar with the client. We urge the Commission to consider revising Rule 2-01 of Regulation S-X to provide for mandatory auditor rotation.
Additional Disclosure Should be Required
We also think that additional disclosure regarding the involvement of the audit committee in entering into the audit engagement and pre-approving non-audit consulting arrangements would enhance the effectiveness of audit committees and provide valuable information to investors. The Commission originally proposed in 2000 to require disclosure of whether the audit committee, before any disclosed non-audit service was rendered, approved and considered the effect on independence of such service. Only the latter disclosure was included in the final rule.
Requiring disclosure about the audit committee's role with respect to both the audit engagement and non-audit consulting contracts would advance important goals. Disclosing whether the audit committee, rather than the registrant, entered into the audit engagement would give investors information about whom the auditor views as its audit client. Commentators have noted that an auditor that views a registrant's management as its client is less likely to challenge that management in the context of an audit.
Similarly, investors would be better informed about the extent of the audit committee's involvement if the Commission required disclosure regarding audit committee pre-approval of consulting arrangements. The Panel on Audit Effectiveness organized by the Public Oversight Board, which was convened on the request of the Commission and issued its report last year, recommended that audit committees pre-approve non-audit services that exceed a threshold arrived at by the committee. Disclosure will assist investors in determining whether a registrant has implemented that recommendation.5
We urge the Commission to consider taking the steps proposed herein as soon as practicable. It is vital, we think, in light of recent events, to assure the investing public of the integrity and reliability of the audited financial statements of U.S. public companies. We believe that the reforms we propose to the auditor independence and audit committee disclosure rules can be an important step in that direction.
If you have any questions regarding this petition, please do not hesitate to contact Damon Silvers at 202-637-3953. We look forward to discussing this with you further.
Very truly yours,
1 Revision of the Commission's Auditor Independence Requirements, Exchange Act Release No. 43602 (Nov. 21, 2000) (adopting release).
2 Revision of the Commission's Auditor Independence Requirements, Exchange Act Release No. 42994 (June 30, 2000) (proposing release).
3 See id.
4 See Richard G. Brody & Stephen A. Moscove, "Mandatory Audit Rotation," The National Publc Accountant 32 (May 1998).
5 The Panel on Audit Effectiveness Report and Recommendations, sec. 5.30 (Aug. 31, 2000).