Additional Comments Regarding
Specific Items in the Proposing Release
Table of Contents
I. ENUMERATED CATEGORIES OF RESTRICTED NON-AUDIT SERVICES
II. FINANCIAL RELATIONSHIPS INVOLVING AUDIT CLIENTS AND AFFILIATES
III. EMPLOYMENT RELATIONSHIPS
IV. BUSINESS RELATIONSHIPS
V. CONTINGENT FEES
VI. QUALITY CONTROLS
Additional Comments Regarding Specific Items in the Proposing Release
In an effort to be responsive to the Commission's Proposing Release, this appendix contains additional comments to the specific line-item provisions of the Commission's auditor independence rule proposal. Such comments should in no way be taken as an indication that the AICPA believes the SEC should proceed with its current rulemaking. For the reasons outlined in our comment letter, we strenuously oppose the SEC's present rulemaking and urge the Commission instead to allow the ISB process to go forward. With that in mind, we make the following supplementary comments with respect to the line-item provisions of the rule proposal.
I. Enumerated Categories of Restricted Non-Audit Services
Our comment letter addresses our overarching concerns with the proposal to ban ten enumerated categories of non-audit services. In particular, we discuss our view that it is counterproductive to issue a specific rule in this area prior to the ISB's completion of its conceptual framework project, since the conceptual framework would provide for a uniform, principles-based approach to addressing independence. In addition, we do not believe the Proposing Release has demonstrated either the necessity or the basis for extending its restrictions with respect to such enumerated non-audit services, let alone undertaken to consider the many consequences in doing so.
As indicated in the comment letter and further below, the proposed rule - either explicitly or implicitly - goes well beyond existing restrictions with respect to non-audit services (notwithstanding statements by the SEC to the contrary in the Proposing Release and elsewhere1 ) without demonstrating a basis for doing so, making it difficult to comment on the rule in a fully responsive way. In this connection, we have the following comments with respect to the enumerated categories of non-audit services, as well as the "transition period."
A. Bookkeeping or Other Services Related to the Audit Client's Accounting Records or Financial Statements
Proposed Rule 2-01(c)(4)(i)(A) reiterates the SEC's existing position in Codification Section 602.02.c that the maintenance or preparation by an auditor of an SEC audit client's accounting records, or the preparation of its financial statements, impairs independence. However, the proposed rule also would expand upon existing guidance by providing that independence would be impaired as a result of "[g]enerating financial information to be disclosed by the audit client or an affiliate of the audit client to the public,"2 regardless of whether the information constituted part of the accounting records of the company or otherwise related to the financial statements on which the auditor would opine. We do not understand how such assistance in contexts unrelated to the registrant's financial filings on which the auditor opines could possibly affect the auditor's independence - that is, the auditor's ability to exercise objective and impartial judgment with respect to the audit engagement. Moreover, we believe that it is ill-advised to broadly preclude such assistance as it relates to the registrant's financial statements. Because of the nature and/or complexity of certain required financial disclosures, such as pension liabilities, taxes, earnings per share calculations and derivatives, registrants may find it beneficial to seek guidance from their auditors who have the expertise and familiarity with such accounting principles and financial reporting standards.3 Such assistance serves investors' interests, since it would improve the accuracy of financial disclosures. However, the possibility that the Staff will view such consultation as a prohibited bookkeeping service cannot be ruled out.
Broadly speaking, the AICPA also believes that a different approach to the bookkeeping restrictions more generally is warranted, as reflected in Interpretation 101-3 of our Code of Professional Conduct (the "AICPA Code"),4 which sets forth certain bookkeeping functions that we view as appropriate. Bookkeeping in general is permitted, so long as the auditor does not make management decisions or judgments or assume management responsibilities in this regard. For example, while we concur with the SEC that an auditor should not prepare the source documents upon which accounting transactions are initially recorded or originate data evidencing the occurrence of a transaction (or authorize, execute or consummate a transaction and therefore assume a management function), we do not agree that an auditor's independence would be impaired if the auditor simply inputs into a computer the information contained in such source data or provides related data-processing services that produce the financial statement itself where the audit client has determined or approved the appropriate account classification or coding for the transaction. In such case, the auditor is simply reflecting, not creating or classifying, the source documentation on which the financial statements are based and as such would not, in our opinion, be undertaking a "managerial" or "decision-making" function, nor would the auditor's independence be at risk by reason of "auditing [the auditors'] own work" as a result of the performance of this ministerial function. On the same basis, we disagree with the SEC that independence would be impaired if an accountant simply maintains its audit client's accounting records, since the mere maintenance of the audit client's accounting records does not turn the client's records into the accountant's own work product.
The proposals relating to bookkeeping also create confusion as to the extent to which certain services would be permissible in emergency or hardship situations. For example, in the Proposing Release, the SEC proposes to strike textual description in Codification Section 602.02.c that relates to such situations involving companies going public for the first time,5 while retaining a separate but analogous exception described in Example 6 to existing Codification Section 602.02.c.ii for the unexpected resignation of a registrant's controller.6 The SEC's recognition in the latter instance that not all bookkeeping restrictions should extend to certain emergency or hardship situations should not be limited to the circumstances set forth in Example 6 and should be made more explicit either in the proposed bookkeeping rule, or in the text of Codification Section 602.02.c itself, so that the rule does not lead to unnecessarily harsh consequences. For instance, audit clients should not be precluded from seeking out the assistance of their auditors in performing certain account analyses and reconstructions when an unexpected emergency occurs (such as turnover of critical accounting personnel), so long as the client's management makes all decisions concerning significant matters of judgment in this regard.
B. Financial Information Systems Design and Implementation
Proposed Rule 2-01(c)(4)(i)(B) seeks to preclude auditors from "[d]esigning or implementing a hardware or software system used to generate information that is significant to the audit client's financial statements taken as a whole," except for "services an accountant performs in connection with the assessment, design, and implementation of internal accounting controls and risk management controls."7 Such assistance has been provided to audit clients for decades and has never been shown to impair audit effectiveness. In fact, the SEC previously has recognized that "[s]ystems design is a proper function for the qualified public accountant."8
We do not understand why the SEC now is changing its position on this topic in the absence of any evidence that such work presents a systemic problem. In reconsidering this issue, the Proposing Release does not even take into account some of the negative consequences that could flow from prohibiting such services. For example, public registrants today can call on their auditors for assistance if, as is sometimes the case, they encounter difficulty meeting deadlines for the implementation of new financial systems by the start of a new fiscal year. Under such circumstances, the registrant's auditors may well be the most appropriate service provider for implementation assistance, since they already are uniquely familiar with the client's business, personnel, systems' capabilities and financial structure. There simply may be insufficient time left for another service provider to get up to speed about the nature of the business and its existing and new systems to effectively assist with the conversion. Yet, under the proposed rule, the auditor would be precluded from facilitating a smooth computer conversion, since they would be engaging in a prohibited implementation of a hardware or software system. That simply makes no sense to us.
From our perspective, the design and implementation of financial information systems that merely reflect accounting transactions, as opposed to determining the accounting classifications for such transactions or authorizing, executing, or consummating such transactions is an entirely appropriate task for the audit firm to undertake. In this respect, the services are akin to a pipeline that simply conveys the financial information resulting from the audit client's accounting transactions.9 Accordingly, our Code permits auditors to design, install or integrate a financial information system, provided the client makes all decisions concerning significant matters of judgment in this regard.10
Nonetheless, the Proposing Release suggests that such work poses an unacceptable threat to auditor independence, with no underlying grounds for doing so, as evidenced by the exception the rule allows and the purported willingness to consider alternative approaches other than proscribing such services, such as requiring audit committees to pre-approve such services. The reasons the Proposing Release sets forth for allowing services associated with the assessment, design and implementation of internal accounting and risk management controls apply equally in the context of financial information systems design more generally. In permitting this exception to the proposed rule, the SEC notes that, "These services can be extremely valuable to companies, and they may also bring benefits to the performance of a quality audit, such as through increased knowledge of the audit client's business."11 The same statement can be made about financial information systems design and implementation generally, as well as other services that would be newly restricted under the proposed rule. In fact, should financial reporting move closer to continuous as opposed to periodic reporting, as many predict it must to remain relevant in the 21st Century, the need for, and the value that clients place on, such services can only be expected to increase. In short, there is no principled basis for curtailing financial information systems design and implementation, provided all matters of judgment and decisions with respect to such services are made by the client's management and such management oversees the projects and evaluates the adequacy and the results of the services.
Moreover, we have serious concerns regarding the application of the "significance" determinations to be made in connection with the proposed rule, which proscribes only those services used to generate information "significant" to the client's financial statements. Since the actual impact on the financial statements could not necessarily be ascertained until after the generation of the information and the preparation of the financial statements, as the Proposing Release recognizes,12 the auditor should not be penalized for making good faith estimates of the information's impact on the financial statements that subsequently might turn out to be different.
The confusion reflected in the discussion of Proposed Rule 2-01(c)(4)(i)(B) is evident from the connection sought to be drawn between the impact on the financial statements of the financial information generated from the financial information systems designed and the level of fees paid to the auditor for the service.13 Thus, the Proposing Release posits that "[w]hether a system is used to generate information that is `significant' to the audit client's financial statements may depend on the size of the engagement" in terms of the fees paid to the auditor with respect to the design and/or implementation of the financial information system.14 In our view, the level of the auditor's fees in designing or implementing such a system is wholly unrelated to whether the information generated from that system is significant to the audit client's financial statements.
More fundamentally, however, we do not think the Staff has shown justification for the restriction. No evidence is offered that the provision of such services jeopardizes auditor independence, or that "reasonable investors," knowing all the relevant factors (including preventative safeguards) would perceive such services as likely to do so. The Proposing Release fails to explain why an outright ban is preferable to reliance on more tailored safeguards (such as review of the provision of such services by the audit committee).
The negative consequences associated with Proposed Rule 2-01(c)(4)(i)(B), as with each other enumerated non-audit service identified under the proposal, need to be taken into account and are not specifically addressed either in the discussion of the proposed rule or in the SEC's more general cost-benefit analysis. The audit client could face substantial costs from the dislocation, and required transition costs to alternative providers. The anti-competitive impact, in reducing market choice, needs quantification. Practical impact examples abound. Should problems in the financial information system be detected by auditors during the course of the audit, the audit could likely be delayed longer under the proposed rule than otherwise due to the additional time that would be required to retain other service providers and sufficiently familiarize them with any problems that need to be addressed. This could result in missing public filing deadlines. No attempt is made to quantify these costs. Furthermore, whatever costs the audit client incurred under such a scenario would be passed on to the investor and increase the client's cost of capital.
In considering whether a rule should be adopted, the benefits of allowing the auditor to continue to provide such services need to be factored into the SEC's analysis. Such services deepen the audit firm's knowledge of a registrant's financial systems, which can contribute to overall audit quality. The expertise auditors gain through the provision of such services can prove invaluable during audits in testing for fraudulent activity that may be conducted through the registrant's computers. Such services can also serve to strengthen the registrant's financial information systems, thereby enhancing the reliability of the financial information reported, which benefits investors. The Proposing Release ignores this positive consequence, focusing instead on the supposed risk that an auditor would ignore his or her professional responsibility to point out financial inaccuracies or systems deficiencies in the event that the system generated incorrect data. We would submit that the benefits of allowing audit firms to apply their expertise in suggesting improvements in financial information systems far outweighs the speculative (and less probable) risk associated with such services in the event that material errors occur in isolated instances. Seen in that light, we view the nature and degree of the "self-review" associated with such financial information systems design and implementation as no different in kind than with respect to permitted systems work with respect to the design, assessment and implementation of accounting controls and risk management controls, which the SEC considered insufficient to warrant prohibiting.
C. Appraisal, Valuation and Actuarial Services
Two of the ten enumerated categories of services prohibited under the proposal include appraisal and valuation services, and actuarial services. These issues received extensive consideration by the ISB, which in September 1999 issued Discussion Memorandum 99-3, containing a comprehensive discussion of the potential independence issues raised when an auditor provides its client with appraisal, valuation and actuarial services.15 Indeed, the ISB undertook to address these issues at the specific request of the SEC16 and was scheduled to release its Exposure Draft on this issue, before delaying its release as a result of the Commission's rule proposal.17 The Commission has offered no basis for circumventing the ISB's process in this area. Our overall recommendation, consistent with our comments elsewhere, is to allow the ISB to complete its process and, after appropriate debate and deliberation, issue its new Standard.
With respect to the specifics of the rule proposal, we note that under AICPA Code Interpretation 101-3, an accountant may "[t]est the reasonableness of the value placed on an asset or liability included in a client's financial statements by preparing a separate valuation of that asset or liability" and may "[p]erform a valuation of a client's business when all significant matters of judgment are determined or approved by the client and the client is in a position to have an informed judgment on the results of the valuation."18 Under its interpretative guidance, the Staff has in the past allowed accounting firms to provide valuations of immaterial assets and to provide purchase price allocations.19 While we believe the AICPA guidance is appropriate in this area, if the SEC's proposed rule is promulgated, it should, at the very least, include an exception for immaterial valuations and for purchase-price allocations.20
The rule proposal would also result in a ban on actuarial and valuation services traditionally provided by auditors in connection with pension and other employee benefit plans (both through the rule proposal's ban on appraisal and valuation services and its ban on actuarial services). Consistent with the rules of the SECPS, we agree that accountants should be subject to restrictions in providing actuarial services to insurance companies that are audit clients, because such services are "basic to the operation and management of an insurance company," and thus may place the auditor in a management role.21 But the Commission's rule proposal provides no support for a ban on the provision of actuarial services to public companies that are not insurance companies. As the POB has recognized, actuarial services provided for public companies in connection with benefit plans, for example, are fundamentally different from services provided to insurance companies as they do not put the auditor in a management role.22 The Proposing Release has not provided any basis to diverge from this longstanding POB guidance and, accordingly, the SEC should not institute a general ban on actuarial services.23
Finally, we would note that the commentary states that the Commission would not prohibit valuation work for non-financial (e.g., tax) purposes, but does not make this exception clear in the language of the rule itself. We agree that such services should not be viewed as causing an impairment of independence and suggest that the language of the rule be clarified to except these services.
D. Internal Audit Outsourcing
In proposed Rule 2-01(c)(4)(i)(E), the SEC seeks to preclude auditors from providing extended audit services to registrants or their affiliates, except for nonrecurring evaluations of discrete items or programs and operational internal audits unrelated to the internal accounting controls, financial systems, or financial statements.24 The stated reasons for doing so are based in part on its views that the performance of such services necessarily entails the assumption of a management function.25
The AICPA Code expressly restricts members from acting or appearing to act in a capacity equivalent to management during the performance of extended audit services (which include the performance of what the SEC terms internal audit activities), as the Proposing Release points out,26 and provides detailed guidance regarding the internal audit activities a member can and cannot perform. In particular, the Code makes clear that, among other things, a member cannot (1) perform ongoing monitoring or control activities that affect the execution of transactions (such as reviewing loan originations as part of a client's approval process) or ensure that transactions are properly executed, accounted for, or both, or (2) perform routine activities in connection with the client's operating or production processes that are equivalent to those of an ongoing compliance or quality control function. 27
The AICPA Code also sets forth activities that must remain the client's responsibility that the auditor absolutely cannot assume. For instance, the client is required to designate individuals within the company, such as senior management, to assume responsibility for the client's internal audit function. As part of such responsibilities, the client is required to determine the scope, risk and frequency of internal audit activities, evaluate the findings and results arising from such activities and evaluate the adequacy of the audit procedures performed.28 In other words, the client never relinquishes control or delegates its authority over decision-making with respect to such services or their oversight. Under such circumstances, an auditor's assistance with the client's internal audit activities does not transform the accountant into an arm of the client's management. Instead, the auditor's familiarity with the client and expertise and resources simply expands and improves upon the registrant's internal audit capabilities, while providing the auditor increased knowledge of the registrant, which can only enhance the audit.
For example, let's say that a registrant suspects fraud at a remote or foreign location. The registrant's internal audit team does not have the resources or capability to conduct a fraud audit in this location (due to limited resources, language barriers, lack of familiarity concerning foreign customs, etc.). The registrant's auditors not only have the resources and expertise to conduct the fraud audit, but are in the best position to expeditiously complete the task, since they already have unique familiarity with the registrant's business. The rapid detection and elimination of occurrences of fraud is a desirable end for registrants, the audit firm, and investors. Yet, the proposed rule on internal audit outsourcing would frustrate that objective by preventing registrants from selecting their auditor to perform such services.
In another example, consider a registrant that may lose or lack in-house information technology auditors - a specialization that is increasingly in demand but which can be very difficult to staff for that same reason. If a registrant determines that its auditor is most suited to fill the gaps in its internal audit capabilities (either because of timing, expertise or for any other reason), thereby strengthening the registrant's audit capabilities, why should the registrant be prevented from engaging its auditor to do so?
The required ongoing involvement of management in connection with the auditor's provision of such services ensures that internal audit activities receive scrutiny from multiple parties, since management never relinquishes responsibility for the internal control function. Proponents of the ban expressed the view that the removal of external auditors from involvement in internal audit activities instills a system of checks and balances in that the internal audit activities receive a fresh look from the external auditors during the course of the audit. 29 However, these second reviews are assured under the above framework, while deepening the auditors' review.
If the SEC were to prohibit the performance of extended audit services by auditors, it inadvertently may result in registrants devoting fewer resources to internal audits; that work may not be internalized or reassigned. In this context, it is worth noting that there is generally no legal requirement that registrants even have an internal audit capacity.
The debate about "internal audit outsourcing" or "extended audit services" in reality is not about the scope of non-audit services an auditor may perform - it is a debate about the scope of the audit. Seen that way, it is difficult to understand the objection to a broader audit scope, which can enrich the audit, extend the auditor's responsibility and corresponding liability, and provides greater comfort to the public as to the thoroughness of the audit, so long as management is not relieved of its internal control responsibility. Banking regulators have voiced a proper concern that the institutions which they regulate retain and appropriately carry out that responsibility.30 But that concern has to do with management's retention of its responsibilities - not the independence of the auditor. In other words, the issue of whether an institution should outsource certain activities should not be confused with the issue of auditor independence. In consequence, the decision as to whether extended audit services are performed should be left to the client and the auditor.
E. Management functions
The AICPA's rules, like Rule 2-01 of the SEC, preclude members from acting in a management capacity.31 We are concerned, however, that proposed Rule 2-01(c)(4)(i)(F), which sets forth the general standard and other provisions that reflect such principles are overly broad. For example, in discussing its proposed restrictions against internal audit outsourcing, the proposing release states that the SEC believes "performing an internal audit function results in the auditor assuming a management function."32 For the reasons discussed above, we disagree with such a blanket statement, and instead have sought in interpretations and ethics rulings under the AICPA Code to identify specific activities within that area that raise such concerns.
F. Human Resources
Proposed Rule 2-01(c)(4)(i)(G) would go far beyond existing restrictions on human resource services contained in the AICPA Code and SECPS membership requirements, notwithstanding suggestions in the Proposing Release to the contrary.33 SECPS requirements currently restrict members from performing executive recruitment services or psychological testing for SEC audit clients.34 The AICPA Code also precludes members from hiring or terminating attest client employees, or from committing the client to employee compensation or benefits arrangements.35 However, proposed Rule 2-01(c)(4)(i)(G) would restrict many other services commonly provided by accountants to SEC attest clients by prohibiting:
Recruiting, hiring, or designing compensation packages for officers, directors, or managers of the audit client or an affiliate of the audit client; advising about the audit client's or affiliate of the audit client's management or organizational structure; developing employee evaluation programs; or conducting psychological or other formal testing of employees.36
In doing so, the Proposing Release overlooks many good and valid reasons why it may make sense for a registrant's auditor to perform the services that would be newly restricted, particularly in the absence of any evidence that such services pose an independence risk. For instance, in acquiring new businesses, registrants frequently need to integrate and standardize disparate benefit, severance and compensation packages for personnel. In such case, a registrant reasonably may consider its auditor to be the optimal service provider in assisting with the integration of such packages in an expeditious manner, since the auditor already is uniquely familiar with the registrant's packages and thus may most efficiently assist with the task of conforming the acquiree's packages to those of the registrant. Yet, the proposed rule would appear to hinder this objective by precluding the auditor from assisting in the design of compensation packages, even though the Staff has not shown that such services pose any threat to the auditor's independence.
The categories of activities to be prohibited under the proposed restriction are overly broad and do not necessarily even relate to the subject of the restriction - human resource activities. In many instances, activities such as advising about "management or organizational structure" or "developing employee evaluation programs" would have nothing to do with or be far removed from human resource activities, as such. For example, consulting on management or organizational structure often focuses on institutional (as opposed to personnel-specific) issues at a macro-level, such as advice about facility layout, office locations, or division or unit organization.
The Proposing Release makes the blanket assertion that the proposed restriction is necessary because assisting in "human resource selection or development" may make an auditor less likely to reveal problems or weaknesses involving a registrant's personnel that the auditor may discover during the course of an audit, where the auditor has an "interest in the success" of such personnel by virtue of having "selected, tested, or evaluated" such personnel.37 As discussed above, however, advising about organizational structure in an institutional context has nothing to do with individual client personnel. And, even if the advisory services do not have an institutional focus, an assumption should not be drawn that such services would result in the auditor identifying with any particular individual in the manner suggested by the Proposing Release. For instance, an auditor that developed generic employee evaluation materials would not necessarily know the extent to which such evaluation materials were used by registrants, including who participated in such evaluations.
Further, where the human resource services are provided to personnel whose responsibilities have no bearing on the financial statements, there is no reason to impose any restriction under the reasoning used in the Proposing Release, since the issue of any dilemmas posed from detecting failures or errors of personnel during the course of an audit does not arise. However, even if that were not the case, we are aware of no basis to exceed the existing AICPA restrictions. Certainly, the Proposing Release provides none.38
The intended scope of the proposed rule in relation to recruitment, hiring or designing compensation packages also is unclear. At one point, the Proposing Release provides that independence would be impaired "when the auditor recruits, hires, or designs compensation packages for, officers, directors, or managers of the audit client or its affiliate."39 The inclusion of the comma after "for" in the above sentence (which is absent in the text of the rule) suggests that the limitations extend solely to the recruitment or hiring of, or designing compensation packages for, officers, directors or managers. In contrast, the absence of the comma in the rule could be construed as restricting the provision of such services on behalf of such executives, such as employee recruiting services or hiring, as suggested in the subsequent paragraph of the descriptive text of the proposing release, which states that, "Assisting management in human resource selection or development places the auditor in the position of having an interest in the success of the employees that the auditor has selected, tested, or evaluated."40 In each instance, the above language with respect to "designing compensation packages" leaves open the question as to whether the restrictions extend solely to the compensation packages of such executives or to employees, as well.41 Therefore, if the rule were adopted, further clarification is necessary.
G. Broker-dealer, Investment Adviser, or Investment Banking Services
We agree with proposed Rule 2-01(c)(4)(i)(H) to the extent that it would preclude auditors from serving as a promoter, underwriter or analyst of the securities of their audit clients, or executing or recommending such securities as a broker-dealer or investment adviser.42 However, we do not believe that, in contrast to existing SEC interpretive guidance,43 auditors should be prevented from recommending other securities to their audit clients and view as completely unsubstantiated concerns expressed in this regard in the Proposing Release about an auditor's ability in this connection to objectively review the client's portfolio during an audit.44
Accountants have always provided a range of advice to clients, drawing upon their expertise with respect to financial information.45 They know and understand the client's goals and objectives and are best informed to satisfy the client's needs. So long as investment advisory or financial planning services to audit clients do not involve acting as a promoter of, or otherwise relate to, the audit client's securities and do not involve making investment decisions for the audit client or otherwise involve discretionary authority over such client's investments, they do not create any undue association with the client. For example, our rules allow members, among other things, to (1) make recommendations regarding the allocation of funds in various asset classes, depending on the client's investment objectives; (2) provide a comparative analysis of the client's investments to third-party benchmarks; and (3) review whether the client's investment account managers are pursuing the client's investment objectives.46 We are aware of no basis to object to advisory services of this nature as impairing independence.
Further, we believe the text of the proposed rule as drafted is unnecessarily confusing as to the scope of its application and, therefore, requires clarification. In particular, the drafting should be revised to eliminate any doubt that the recommendation of securities of the attest client is proscribed, regardless of whether the recipient is an audit or non-audit client. No doubt, this is what is intended. But, because the issue is addressed under Rule 2-01(c)(4)(i), which deals with non-audit services the accountant provides "to an audit client or an affiliate of the audit client," clarification is needed.
Conversely, notwithstanding the language quoted immediately above, the proposed rule should expressly make clear that it would not preclude an accountant from acting as a broker dealer, investment adviser or otherwise as a securities professional for non-audit clients, so long as the auditor does not recommend or execute transactions in securities of their attest clients. The express text of proposed Rule 2-01(c)(4)(i)(H) could be construed otherwise, thereby causing unnecessary confusion. Such a misconstruction would go well beyond existing guidance, would have nothing to do with independence in relation to audit clients and would exceed the authority of the Commission.
Furthermore, the rule should make clear that services which are permitted by proposed Rule 2-01(c)(4)(i)(H) (or under other provisions relating to non-audit services) are not restricted by the back door - characterizing them as constituting a "business relationship." It would seem obvious that an advisory service permitted by a specific rule does not also constitute a "business relationship" within the meaning of proposed Rule 2-01(c)(3). Further, a business relationship, by definition, involves third parties. But, linguistic gymnastics of this kind cannot be ruled out and clarification is in order.
We also disagree with the inclusion in the rule of a restriction against "designing the audit client['s] or an affiliate of the audit client's system to comply with broker-dealer or investment adviser regulations."47 The Proposing Release suggests that such services could result in a "self-review" problem. As is foreshadowed in a question in the Proposing Release, however, the compliance systems would not necessarily be implicated in the audit of the financial statements, as the compliance system might not involve financial information at all, but rather assistance with written supervisory procedures and work flow procedures. And, the potential for "self-review" here is no different than with respect to permitted financial information systems design and implementation work having to do with the assessment, design, and implementation of internal accounting controls and risk management controls.48 They should be permitted on the same rationale. These services afford auditors valuable insight into the client's operations and benefit investors in terms of the development of sophisticated compliance systems.
H. Legal Services
Proposed Rule 2-01(c)(4)(i)(I), which imposes a blanket restriction against the provision of any service for an audit client (or its affiliates) that, in the jurisdiction where it is provided, can only be performed by someone licensed to practice law, is unworkable and unnecessary. Since accounting firms may not perform legal services in the United States, the restriction is of relevance only in other jurisdictions. But, widespread variation exists among countries as to what services can only be performed by lawyers. The approach taken in the proposed rule, therefore, can only lead to a lack of uniformity in its application that does not make sense from a public policy standpoint. For example, an accounting firm's independence with respect to a U.S. registrant could be impaired as a result of performing a particular service for a foreign subsidiary in one country, even though the accountant's independence vis-à-vis the same U.S. registrant would not be impaired if the accountant had performed the same service in another country. We doubt that this was the SEC's intent.
Moreover, contrary to suggestions in the Proposing Release,49 the proposal would not be "consistent with current regulations" to the extent that it departs from SEC guidance developed in consultation with accounting firms in the early 1990s that has allowed non-U.S. law firms associated with global networks of accounting firms to perform certain immaterial legal services to foreign subsidiaries of SEC registrants or foreign SEC registrants where the work did not involve (1) acting in a management or general counsel capacity, (2) self-review problems, or (3) serving in publicly prominent capacities, such as acting as litigation counsel for such clients. Such guidance recognizes that not all types of legal activities pose independence risks and has been extensively relied upon by the profession.
To that end, we do not believe that it is necessary for independence purposes to impose a bright-line rule against the provision of all types of work that may constitute a "legal service" in a particular jurisdiction on the ground that legal work requires an accountant to serve as an advocate for their client. That approach fails to recognize that accountants also historically have acted as advocates for their clients in certain contexts such as tax matters,50 with widespread acceptance and no suggestion that such services would cast doubt on their objectivity in connection with auditing the client's financial statements. Likewise, not all legal services involve advocacy that could reasonably be viewed as jeopardizing the accountant's objectivity or that would result in a level of association or identity with the client such that the accountant's objectivity should be questioned. Furthermore, not all legal services that might be performed would have any bearing on the audit client's financial statements. Finally, to the extent that this rule is driven by appearance concerns, they are highly unlikely even to arise in respect of most legal services performed for audit clients outside of the United States.
The AICPA Code precludes members from serving as an attest client's "general counsel" or its equivalent,51 but does not seek to bar the provision of legal services that would not jeopardize the accountant's objectivity. As set forth in the ISB's Discussion Memorandum on this subject, which identifies alternative regulatory approaches based on concepts such as the nature or degree of advocacy involved, materiality considerations and/or the possibility that safeguards could be applied to mitigate any concerns that otherwise might arise, a more tailored approach would fully protect auditor independence without imposing a global bar on multidisciplinary professional service firms (and their affiliates), overriding in the process, differing policy choices made by other countries.52 Clearly, this issue would benefit from further study. We urge the SEC to allow the ISB to finish its work before any rulemaking on this issue is considered.
I. Expert Services
Proposed Rule 2-01(c)(4)(i)(J), which would restrict the ability of accountants to render or support expert opinions in legal, administrative, or regulatory filings or proceedings, treats a host of expert services presently performed by accounting firms as constituting impermissible "advocacy" if performed for an audit client.53 For example, the description of the rule asserts broadly that the provision of "expert services" creates at least the appearance that an accountant could be acting as an advocate.54 The Proposing Release then proceeds to raise questions about services such as the preparation of written reports or "opinions" on the application of an accounting principle to a particular transaction or the preparation of a tax opinion in relation to a transaction that might be received by third parties.55 The intended result appears to be the preclusion of numerous tax-related and other services for audit clients or their affiliates that accountants are particularly qualified to perform and have performed routinely for decades, in some cases with explicit federal and/or state approval, without any showing of any independence problems.
This absolutist approach of this part of the proposed rule demonstrates the difficulty of relying on a concept as broad and vague as "advocacy" as the basis for proscribing specific services without any evidence of actual or likely harm in terms of independence. In providing almost any service (outside the context of an attest service itself), the auditor seeks to assist the client and, insofar as third parties are concerned, therefore advance or "advocate" the interests of the client. For example, accountants frequently represent clients before the IRS56 and state taxing authorities,57 with express federal and state statutory and/or regulatory authority to do so. Yet, proposed Rule 2-01(c)(4)(i)(J) would purport to limit their ability to do so, since such representation might be viewed as rendering or supporting an expert opinion in a legal, administrative or regulatory filing or proceeding.
The passing assertion in the Proposing Release that "[t]he proposed rule would not affect tax-related services" provides little comfort in this regard, considering the lack of an express exception from the SEC's restrictions for tax services, the independence questions it poses with respect to the preparation of tax opinions and the fact that "tax services" encompass much more than simply "traditional tax preparation services," which the Proposing Release emphasizes in connection with discussing the safe harbor.58 As the SEC recognizes in the Proposing Release, clients look to experts for assistance, because of their specialized knowledge and experience.59 They should not be denied use of the specialized skills and expertise of their auditors in situations where their assistance would not cause reasonable investors to harbor doubts as to the auditor's ability to perform an objective audit.
For example, let's say that the SEC challenges the registrant's application of an accounting principle in a filing on which the auditor provided a clean audit opinion. The auditor concurs that the registrant's application of the accounting principle is absolutely right. Because of the auditor's background and stance on the issue, and because the accounting principles involved are complex, the registrant reasonably might seek the auditor's assistance in articulating and defending the use of the accounting principle before the SEC. Yet, under the proposed rule, even such seemingly natural outgrowths of the audit could be called into question, since the SEC might view such services as the rendering of an expert opinion in a regulatory filing or proceeding. Furthermore, it is questionable whether the carve out from the prohibitions described in the Proposing Release for serving as a "fact witness" would apply, since the accountant in such circumstances not only would be providing a factual recount of the judgments the accountant made during the course of the audit on this point but also would be defending and representing the client's position before the SEC.
In fact, taken literally, the SEC's proposed rule could be viewed as precluding auditors from certifying the audit opinion itself, since it could constitute the rendering of an "expert opinion" in connection with a regulatory filing. We realize, of course, that the Commission does not intend the proposed rule to bring about such a result. Nevertheless, it is an apt illustration of the failure of the proposed rule to recognize that the auditor may be perfectly suited to provide the very services that might get swept up into such blanket restrictions.
As a result, if the SEC proceeds with this rule proposal, we urge the SEC to delete this restriction and to make clear the permissibility of providing tax-related services and other expert services, including but not limited to representation of a client in tax proceedings to the extent it is legally permissible, the rendering of tax opinions in connection with transactions and the provision of certain expert advice or support services in connection with legal, regulatory or administrative filings or proceedings.
J. Transition Period
The proposed rule provides for a two year period following the effective date of the rule during which provision of the newly restricted non-audit services will not impair independence if those services were provided pursuant to a written contract in effect before the rule change and the service would not violate pre-existing SEC requirements.60 We agree that, if the SEC proceeds to issue a rule, a transition period is necessary. However, the scope of services and relationships covered by the transition period is much too narrow and in many circumstances, the transition period would be too short.
Although the transition period would apply to the ten non-audit services prohibited under Proposed Rule 2-01(c)(4)(i), it would not apply to other areas of the proposed rule that seek to impose additional and burdensome restrictions on a host of parties under provisions such as the business relationship and material indirect investment restrictions and the definition of an "affiliate of the accounting firm." There is no basis to distinguish the burden of terminating these relationships from the burden of terminating services prohibited under 2-01(c)(4)(i). Accordingly, the transition period should apply to any service or relationship that would not impair independence under existing SEC, ISB or AICPA guidance.61
With respect to the length of the transition period, we would simply note that many contracts and other agreements extend beyond two years (four- to five- year agreements are not uncommon). Therefore, we recommend that the transition period proposal allow for any existing contract or agreement to run its course in order to prevent any undue hardship to either the client, the firm or any "affiliates" impacted by the new rule.
II. Financial Relationships Involving Audit Clients and Affiliates
While we strongly support the Commission's efforts to modernize its financial relationship rules by narrowing the group of individuals within an accounting firm (including their families) who are subject to such rules, we view certain aspects of the rule proposal as overly broad and/or requiring further clarification, as discussed in more detail below. In particular, we regret that the SEC has chosen to substitute its own proposals for those of the ISB, which has devoted considerable attention to developing standards on this topic that we believe better achieve the objective of removing unnecessary restrictions with respect to certain parties and their families, while preserving investor protection.
For example, all but one of the SEC's proposed financial relationship provisions in Rule 2-01(c)(1) extend to the accounting firm (and, therefore, its affiliates), any "covered person" in the firm and his or her "immediate family." The covered persons within the accounting firm who would be subsumed within the SEC's financial restrictions include more than the individuals within the accounting firm that the ISB has contemplated including under its comparable proposals. The SEC's definition of a "covered person" in the firm, with respect to an audit client (or its affiliates) includes (1) individuals on the "audit engagement team," (2) personnel in the "chain of command" over members of the audit engagement team or concerning the conduct of the audit, (3) any professionals who provide any professional service to an audit client (or its affiliates), and (4) any other partner, principal, or shareholder from an "office" of the accounting firm that participates in a significant portion of the audit. 62 This approach disregards the ISB's determination that it is unnecessary to impose such independence restrictions on employees (and their families) who are neither on the audit engagement nor in a position to influence the audit (so long as the individual is not a managerial employee - or immediate family member thereof - who holds more than 5% of the client's voting securities or a professional employee - or immediate or close family member thereof - who exercises control over the audit client).63
While we agree that partners and managers participating on a non-audit engagement for an audit client should be encompassed within the definition of a "covered person," staff below the managerial level are not ordinarily in a position to influence the audit engagement. Such individuals should therefore be excluded from the definition, in accordance with the ISB's proposals. The ISB considers those professionals "in a position to influence the audit" to be those persons who (a) supervise or have direct management responsibility for those on the audit (i.e., the management chain of command), (b) provide technical consultation, quality control or other oversight of, those on the audit or (c) are partners or managerial employees who provide only non-audit services to the client.64 In this connection, we also disagree with the SEC's definition that the "chain of command" with respect to an audit should include "all partners, principals, shareholders, and managers who may review, determine, or influence the performance appraisal or compensation of any member of the audit engagement team . . . ."65 In today's practice environment, it is probable that members of an engagement team work with or for many different managers and/or partners throughout the world on multiple engagements each year. We do not believe that "covered persons" should include all managers and partners who contribute to the performance appraisals, which could include input from numerous persons who have no connection to the audit engagement, provided that those managers or partners cannot significantly influence the individual's annual compensation (as, for example, the ultimate decisionmaker could).
For that reason, we strongly recommend that the SEC conform its proposed rule on financial interests and family relationships to that proposed by the ISB in its Exposure Draft concerning "Financial Interests of the Auditor in, and Family Relationships between, the Auditor and the Audit Client," which was made available for the ISB's meeting on July 11, 2000. Furthermore, we have the following additional comments on specific provisions of the proposed rule with respect to financial relationships:
A. Direct Investments in an Audit Client (or its Affiliates)
Proposed Rule 2-01(c)(1)(i)(A) precludes an accounting firm, any covered person in the firm, or any of his or her immediate family from having any investment in an audit client or any affiliate of the audit client.66 An affiliate of the audit client is defined as "an entity that has significant influence over the audit client, or over which the audit client has significant influence,"67 using principles set forth in Accounting Principles Board Opinion No. 18 related to equity accounting (which includes, among other things, a rebuttable presumption that significant influence exists as a result of a 20% or more equity interest).68 This provision gives no consideration to materiality, which we believe is a relevant factor in determining whether independence would be impaired with respect to investments concerning such affiliates of an audit client. For example, if the audit client's investment in its "affiliate" were not material to the audit client and the accounting firm member's investment is not material to his or her net worth, what is the risk to independence? Accordingly, we recommend that a materiality threshold with respect to investments involving affiliates of an audit client that takes into account the materiality of the investment in the affiliate to the net worth of the investor and the materiality of the affiliate to the net worth of the audit client.
B. Material Indirect Investments in an Audit Client
Proposed Rule 2-01(c)(1)(i)(D) with respect to "material" indirect investments goes well beyond what is necessary to preserve an auditor's independence and existing guidance, notwithstanding the statements in the Proposing Release to the contrary.69 The proposed rule would classify as a "material indirect investment" those situations where the accounting firm (including its "affiliates"), any covered person in the firm, or any of his or her immediate family members (or any "group" of such persons) owns more than 5% of the equity of an entity that either has any equity interest in an audit client or in which the audit client owns any equity interest.70 In doing so, the proposals depart from longstanding SEC interpretive guidance that takes into consideration the materiality of indirect financial interests involving audit clients in relation to the net worth of both the accounting firm and the audit client,71 as well as in relation to the total assets and the consolidated income from continuing operations of the audit client that has the direct investment relationship with the entity.72 We are aware of no basis for disregarding the materiality of indirect investments in relation to the factors stated in the existing guidance.
As a result of the Proposing Release's departure from longstanding SEC guidance in this area, the proposed revision would significantly expand investment restrictions on audit firms (and their affiliates as broadly defined) and result in overwhelming compliance burdens, particularly in light of the proposed definition of "affiliate of the accounting firm."
In reality, the proposal is wholly unrealistic from a compliance standpoint. For example, how could the accounting firm even know of equity interests above 5% by affiliates in closely-held entities that may have an investor-investee relationship with audit clients? Such investments would not need to be reported on a Schedule 13D or 13G filed with the Commission. Furthermore, while a Schedule 13D or 13G is generated for investments above 5% in public companies, such reports would not enable an accounting firm to determine whether public entities in which its "affiliates" might have investments had investment relationships with audit clients at equity levels of 5% or below (since such investments would not require the filing of a Schedule 13D or 13G with respect to such investments). Should audit clients be expected to continuously inform audit firms of all their investors and investments (including the constant changes thereto), no matter what their level and whether they are immaterial to the audit client or other investor?
More fundamentally, we would replace the arbitrary and unworkable 5% test with the well understood and far more relevant concepts of "significant influence" and "control." In particular,
(1) As for investments in an entity that invests in an audit client, the rule should consider instead whether the firm or its covered persons could exercise "significant influence" over the entity (using APB No. 18 standards) and whether the entity's investment in the audit client is material to the entity, as does the AICPA Code.73 If significant influence does not exist and the entity's investment in the audit client were immaterial to the entity, independence should not be deemed impaired.
(2) As for investments in an entity in which the audit client also invests, the rule should take into account, as related provisions in the AICPA Code provide, whether the audit client and the accounting firm, or "covered persons" or their immediate family could collectively control the entity, or whether the audit client or such persons could exercise significant influence over the entity in which they have both invested, in which case independence would be impaired if such investments were material to either the audit client or such persons.74
C. Investments by the Audit Client in the Auditor
Proposed Rule 2-01(c)(1)(iv)(A) would render an accounting firm's independence impaired if an audit client (or its affiliates) has, or has agreed to acquire, any direct investment in the accounting firm (or its "affiliates" as broadly defined). Our current rules would not permit an audit client to hold any investment in its auditor, regardless of materiality.
However, we do not believe that an immaterial investment by an audit client, or one of its officers or directors, in its auditor's subsidiary would threaten the auditor's independence, provided the subsidiary does not perform attest services and the investment would not give such investors, individually or as a group, the ability to exercise significant influence over the audit firm or its owners. In the case of an affiliate over which the accounting firm exercises neither control nor significant influence, we do not see any need for such a restriction.
Interpretation 505-2 of the AICPA Code provides that if an accounting firm or its members individually or collectively control a separate business, the latter business and all its owners and employees must comply with the AICPA Code, including its independence requirements.75 Where an accounting firm or its members have an ownership interest that does not rise to the level of "control," the provisions of the Code continues to apply to any member's actions therein, but do not apply to the entity or its other owners or employees.
In addition, Interpretation 101-14 of the AICPA Code sets forth certain additional independence guidelines with respect to so-called alternative practice structures ("APS") where all or a substantial portion of a member's non-attest practice has been divested and is conducted generally by the member under public or private ownership (described in our Code as "PublicCo"), with the attest portion retained by and conducted through a separate firm owned and controlled by the member (described in our Code as "Newfirm").76 Under our guidance, independence would only be considered to be impaired with respect to an attest client of Newfirm ("Attest Client"), if the Attest Client holds an investment in PublicCo that is material to the Attest Client or allows it to exercise significant influence over PublicCo. Such restrictions recognize that the nature of the relationships in an APS structure are fundamentally different than passive investments by the member in an entity over which the member neither controls nor exercises significant influence. Under the proposed rule, PublicCo would likely be treated as an "affiliate" of Newfirm, and accordingly investments by Attest Clients in PublicCo, that would otherwise be permitted under our rules, would be considered investments in the audit firm and prohibited. We believe our rules sufficiently address any independence concerns that arise as a result of such investments and do not believe such investments should be prohibited by the Commission, or at any rate, should be left to the ISB.
D. Loans/Debtor-Creditor Relationships
Proposed Rule 2-01(c)(1)(ii)(A) precludes an accounting firm (including its "affiliates"), a covered person in the firm, or any of his or her immediate family from having any loan (including any margin loan) to or from an audit client (or its affiliates) or an officer, director, or more than 5% shareholder of an audit client or its affiliates, except for specified loans obtained from a financial institution under its normal lending procedures.77
Contrary to the suggestion in the Proposing Release, the proposed rule is more restrictive than existing guidance because the restriction would extend to a wide universe of new "affiliates of the accounting firm" and shareholders in excess of only 5% of the equity of an audit client or its affiliates (in contrast to our guidance, which extends only to "principal stockholders" of the audit client).78 Proposed Rule 2-01(c)(1)(ii)(A)(4) also omits certain existing grandfather provisions contained in AICPA Interpretation 101-5 that go beyond the exceptions contained in the SEC's proposed rule with respect to home mortgages. In particular, Interpretation 101-5 exempts home mortgages, secured loans and immaterial unsecured outstanding loans obtained under the lender's normal borrowing procedures if the loans were obtained (a) as of January 1, 1992;79 (b) prior to the borrower becoming an audit client, (c) from a non-audit client subsequently acquired by an audit client, or (d) from an audit client by a borrower who subsequently became a member subject to independence requirements with respect to the lender.80
These grandfather provisions should be retained, because the real threat to independence arises not in the mere holding of the loan but in connection with the decision-making and negotiations associated with whether or not the loan will be extended and the terms of the loan.81 Holding a loan extended in the normal course at a time when independence was not required does not make the auditor dependent on the lender. Finally, we take issue with extending the restrictions to "affiliates" and precluding loans involving more than 5% shareholders of audit clients (or their affiliates).
E. Savings and Checking, Broker-Dealer and Future Commodity Merchant Accounts
Proposed Rule 2-01(c)(ii)(B)-(D) prohibits accounting firms, covered persons or their immediate family members from having:
The rationale for these prohibitions is the fear that an auditor's judgment would be impaired if he or she has an interest in preventing the entity which maintains the accounts from failing. We agree that an exception for assets subject to FDIC or SIPC insurance is appropriate and consistent with this rationale. However, we note from the Commission's questions that it correctly raises an issue of whether there are other ways that such accounts might be protected. We believe that by raising this issue, the Commission demonstrates the problem with crafting a rule that is so specific that it may not accommodate factual situations unknown at this time, including the development of new types of insurance, whether for savings and checking accounts, broker-dealer accounts or futures commission merchant accounts. It is also unclear to us why the Commission would be concerned that a non-material balance would impair audit judgment. Accordingly, we believe that only material balances should be prohibited (i.e., where the uninsured balance is material). Finally, as we have previously stated, we do not agree with the proposal's definition of an "affiliate of the accounting firm" and would delete the reference from the rule.83
Based on these comments, our overall suggestion would be to combine Proposed Rules 2-01(c)(ii)(B)-(D) to simply state that independence is impaired when the firm, any covered person or his or her immediate family members "hold assets, including cash or securities, in a savings, checking, investment or similar account where such account is maintained by an entity that is an audit client and the failure of such entity would result in a material loss to the firm, covered persons or their immediate family members." The commentary to the rule, or the rule itself, could then note that the Commission does not believe an auditor is exposed to a loss to the extent the assets are insured by a third party, including the FDIC and SIPC.
F. Credit Cards
Proposed Rule 2-01(c)(1)(ii)(E) precludes an accounting firm (including its "affiliates"), any covered person in the firm and his or her immediate family members from having any credit card balance in excess of $10,000 owed to a lender that is an audit client or an affiliate of an audit client.84 While $10,000 is an appropriate limit (except to the extent that it purports to extend to "affiliates of the accounting firm" and certain parties that we do not view as appropriately deemed covered persons), the proposed rule, if enacted, should make clear that the limit is applied as of the due date (so that credit extensions exceeding $10,000 from time to time prior to that date will not impair independence).85
G. Insurance Products
Proposed Rule 2-01(c)(1)(ii)(F) precludes an accounting firm (including its "affiliates"), any covered person in the firm and his or her immediate family members from having any individual policy or professional liability policy originally issued by an insurer that is an audit client or an affiliate of the audit client.86 In contrast, the AICPA Professional Ethics Executive Committee has taken the position that a member may obtain insurance from an audit client, provided it is issued under the insurance company's normal terms, procedures and requirements and in the ordinary course of business with no special consideration afforded the covered person or the firm.
The proposed rule is overly restrictive and would hinder firms and their employees in securing insurance, particularly a firm's professional liability insurance (which could be detrimental to the public protection). In today's practice environment, accounting firms frequently find it necessary to rely on multiple, major insurers, making it inevitable that at least some could be audit clients of the firm. By precluding such situation in the context of audit clients, the rule effectively could prevent audit firms and insurers from lessening their professional liability risk exposure by inhibiting diversification of their insurance portfolio.
In addition, the rule should permit covered persons and their immediate family members to hold group insurance policies with an audit client. We fail to see the threat to independence if, for example, the covered person held a health insurance policy with an audit client that was obtained through his or her spouse's employer's group plan. In some cases, these arrangements might be the only reasonable alternatives available for the covered person, so an unnecessary proscription could cause significant hardship.
At a minimum, existing policies should be grandfathered. For example, the rule could be revised to prohibit these individuals from obtaining any insurance policy while he or she is a covered person (or an immediate family member thereof). In any event, the rule should not extend to "affiliates" of the accounting firm.
H. Investment Companies
Proposed Rule 2-01(c)(1)(ii)(G) precludes an accounting firm (including its "affiliates"), any covered person in the firm and his or her immediate family members from having any investment in, among other things, a non-audit client entity that is part of an "investment company complex" which includes an audit client.87 An "investment company complex" is defined to include (1) an investment company and its investment adviser or sponsor, (2) any entity controlled by, under common control with or controlling the investment adviser or sponsor, or (3) any investment company or entity that would be an investment company but for certain exclusions in the Investment Company Act of 1940.88 The proposed definition is too far reaching and goes beyond what may be required to safeguard independence.
For example, the proposed rule should not extend to all non-fund entities under a parent that has multiple types of subsidiaries that do not provide any services to mutual funds within an investment company complex. Instead, it would be more appropriate to require independence from those related non-fund entities in the investment company complex that are integral to the operation of the funds. For instance, the parent of an investment adviser might be a holding company that is also the parent of a broker-dealer, a bank, or an insurance company, none of which performs any services for any of the mutual funds in the investment company complex. Although the investment adviser has a relationship with the funds in the complex thereby requiring independence when auditing a fund, the broker-dealer, bank, or insurance company clearly have no such relationship and are audited by another firm. Independence is not threatened by individuals in the audit firm or the audit firm itself maintaining accounts, obtaining loans or having other financial relationships with those non-integral entities.
Furthermore, considering that the proposed definition of an "investment company complex" would include non-client sister funds, the proposed rule would unnecessarily preclude certain "covered persons" who are not on the engagement team or in the chain of command from investing in a non-client sister fund. There is no evidence that these individuals (e.g., those employees who provide non-audit services to the audit client or the spouses thereof) would have any influence over the audit of a client fund. Therefore, permitting those individuals to invest in non-client sister funds does not pose an additional threat to independence given that those individuals would not be investing in an audit client of the firm.
I. Definition of an "Office"
The proposed definition of "covered persons," which in part determines who is subject to the above financial interest and other rules, includes "any other partner, principal, or shareholder from an `office' of the accounting firm that participates in a significant portion of the audit."89 The term "office" is further defined as a "distinct sub-group within an accounting firm, whether distinguished along geographic or practice lines."90 While we can appreciate the difficulty in defining this term, the proposed definition is unworkable and does not provide helpful guidance in determining what would be considered an "office" in today's practice environment.
Instead, we support the more descriptive guidance as set forth in the ISB's Exposure Draft on Financial Interests and Family Relationships.91 The ISB's proposed determination of an "office or practice unit" pragmatically takes account of the way in which the practice is conducted, considering the firm's operating structure and the partner's reporting channels. We believe that the ISB's guidance will be helpful to firms when implementing the standard. Specifically, the ISB guidance states that:
[T]he identification of the relevant `office' or practice unit is based on the facts and circumstances, including the firm's operating structure, and requires judgment. In a traditional geographic practice office (one city location with one managing partner in charge of all operations - audit, tax and consulting), that location should be considered to be the office. In addition, if there are smaller, nearby `satellite' offices managed under the primary city office, broadly sharing staff, etc., those locations should also be considered part of the primary office. On the other hand, many firms are now structured more on an industry specialization or line-of-service basis, and manage offices on that basis. For example, if a financial services group were a separate practice unit, and were operated that way with limited contact with personnel of other local units, that may represent a separate office for purposes of this standard. Substance should govern the office classification, and the expected regular personnel interactions and assigned reporting channels of an individual may well be more important than his or her physical location.92
Proposed Rule 2-01(c)(1)(iii) sets forth two limited exceptions with respect to the financial relationship provisions contained in Proposed Rule 2-01(c)(1)(i)-(ii). Specifically, notwithstanding the financial relationship restrictions set forth in the aforesaid provisions, an accountant's independence will not be deemed impaired:
(1) with respect to a financial interest acquired through an unsolicited gift or inheritance and disposed of no later than 30 days after the right of disposal arises; and
(2) if the accountant did not audit the client's financial statements for the fiscal year immediately preceding acquisition of the interest, and is independent before the earlier of (a) accepting the audit engagement, or (b) commencing any audit, review or attest procedures (including planning the audit of the client's financial statements).93
With regard to the "inheritance and gift exception," the exception is appropriate and practicable. In certain cases (e.g., the financial interest is immaterial, disposition of the interest would result in a significant penalty, or the individual was restricted from disposing of the interest for an extended period), however, the individual should be allowed to recuse himself or herself from the engagement or the chain of command, rather than dispose of the financial interest. We also recommend that the 30-day divestment period not begin to run until the affected person has both actual knowledge of the gift or inheritance and the right to dispose of it.
The other exception noted in (2) above also appears reasonable, and we would encourage its adoption if a rule is enacted.
III. Employment Relationships
In July of this year, the ISB issued its Standard No. 3 on Employment with Audit Clients and, until the Commission released its rule proposal, was also preparing to issue its Exposure Draft 00-3 with respect to family relationships between the auditor and the audit client. These ISB pronouncements address in a more comprehensive fashion many of the employment relationship issues covered by the Proposing Release. In each instance, the ISB process has been thorough and thoughtful, involving the consideration of the comments of all interested parties over an appropriate period of time. While we are fully supportive of efforts to modernize the rules governing auditor independence in the area of employment relationships, we are aware of no reason why (and the Proposing Release gives none) the proposed rule differs (albeit in limited respects) from the standard developed by the ISB. In addition to this overall objection, we have specific comments on certain provisions relating to employment relationships.
A. Employment Relationships with Client
Proposed Rule 2-01(c)(2) sets forth the various employment relationships that impair an auditor's independence. It uses the defined term "accounting or financial reporting oversight role" to describe prohibited employment relationships by family members. The definition of "accounting or financial reporting oversight role," in turn, is defined as a "person [who] is in a position to, or does influence the contents of the accounting records or financial statements or anyone who prepared them."94 The proposal then includes a nonexhaustive list of positions that would be considered to meet this definition, including "a member of the board of directors or similar management or governing body, chief executive officer, president, chief financial officer, chief operating officer, general counsel, chief accounting officer, controller, director of internal audit, director of financial reporting, treasurer, vice president of marketing, or any equivalent position."95
It is not clear to us why it is necessary to include in the rule the phrase "or anyone who prepared them." Individuals with control over accounting and financial issues would presumably be captured by the term "person [who] is in a position to, or does influence the contents of the accounting records or financial statements" and by the list of positions. We suggest the phrase "or anyone who prepared them" is unnecessary and, to avoid confusion, should be deleted.
For the most part, the specific positions listed in the definition of "accounting or financial reporting oversight role" are appropriate and provide helpful advice to practitioners. We have two concerns, however. First, we do not believe the vice president of marketing should be included in this list. While we understand that the vice president of marketing, or someone in a similar position may have some influence over sales and related expenditures, that position would generally not carry the specific responsibilities described in this definition. Second, while we believe (with the exception of vice president of marketing) the proposal has identified those positions that represent an appropriate "accounting or financial reporting role," the inclusion of the phrase, "or any equivalent position" will only result in confusion and be interpreted differently by different stakeholders. Accordingly, if a rule were to be issued, we propose the following alternative language:
. . .means that the person is in a position to, or does influence the contents of the accounting records or financial statements,
or anyone who prepares them, such asi.e., when the person is a member of the board of directors or similar management or governing body, chief executive officer, president, chief financial officer, chief operating officer, general counsel, chief accounting officer, controller, director of internal audit, director of financial reporting, treasurer, vice president of marketing,or any equivalent positionholds one of these specific positions under an alternative title.
Proposed Rule 2-01(c)(2)(ii) would prohibit a close family member of a covered person from being employed by an audit client or its affiliate in an "accounting or financial reporting oversight role."96 While we support the concept underlying this provision, we favor a tiered approach reflected in the latest draft of the ISB's proposed standards in this area which relates the restriction to the level of independence risk (depending on whether the individual serves on the engagement team or has the ability to influence the engagement and the relationship of the relative to the auditor (an immediate family member or close relative, i.e., parent, non-dependent child, or sibling)).97 Under this approach, close relatives of partners not included in the office or practice unit participating in a significant portion of the audit would not be prohibited from being employed in key positions with the audit client.
B. Employment at Audit Client of Former Employee of Accounting Firm
Proposed Rule 2-01(c)(2)(iii) addresses the independence risks raised when a former partner or equivalent owner or employee of the accounting firm is employed by an audit client.98 While we agree that risks to independence may exist when former owners of the accounting firm or their equivalents are employed in significant positions at an audit client, this concern generally does not arise when a non-managerial firm employee becomes employed at the client. It is highly unlikely that such individuals would have any influence over the firm or the engagement team. They should be excluded.
The proposed rule should allow for appropriate and necessary safeguards as set forth in ISB No. 3, Employment with Audit Clients, and AICPA Ethics Ruling No. 77, Individual Considering or Accepting Employment With the Client [ET § 191.154-.155]. For example, ISB No. 3 would require a special review of the subsequent audit to ensure that the engagement team exhibited the requisite objectivity.99
Consistent with the AICPA's current rules,100 the provision of the proposed rule requiring settlement of financial arrangements (for example, upon retirement) should exclude amounts which are immaterial to the firm, because there is no significant risk that a former firm employee would be able to influence the outcome of an audit in such a circumstance. In addition, requiring settlement could result in significant tax and other penalties being imposed on the firm and/or the former employee.
C. Employment at Accounting Firm of Former Employee of Audit Client
We agree that independence may be impaired if a former officer, director or employee of an audit client becomes an owner of the accounting firm and is involved in the audit of his or her former employer, since the individual may not possess the necessary objectivity to audit, or supervise the audit of, something that he or she has prepared while in the client's employ. However, if the individual does not participate in the audit of the financial statements for any period covering his or her employment with the client, the risks of an independence impairment would be sufficiently mitigated. At the same time, we believe a potential risk of independence impairment exists with respect to all accounting firm professional staff previously employed by the client if they participate on the audit engagement and, therefore, this provision should be broadened to apply to all firm employees (i.e., not only partners, shareholders and principals of the firm) and regardless of the position previously held with the client.
Finally, we recommend that the phrase, "and is not in a position to influence [the audit]" be deleted from the proposed rule as it is unnecessary and confusing. Any potential risks to independence are mitigated provided the former employee does not participate on the audit. Also, we question whether a former employee of a client who is hired by the firm as a partner and who resides in the office that performs the audit would be considered to be in a "position to influence the audit" for purposes of this rule. We do not believe that a risk to independence exists under such circumstances and believe the proposed rule should be clarified to make clear that such individuals would not be included within the scope of the prohibition.
IV. Business Relationships
The SEC's proposed rule with respect to business relationships would expand Section 602.02.g of the Codification to include all shareholders with an equity interest greater than 5% of the audit client (in addition to officers and directors thereof) and officers, directors, and shareholders of more than 5% of the equity of any entity which has a 20% or more investor/investee relationship with the audit client.101 Such sweeping new restrictions would dramatically constrict the parties with which accounting firms could engage, even though many such parties at most have only very attenuated ties to audit clients. In consequence, they would impose excessive and unduly burdensome compliance requirements analogous to the proposed rule on material indirect investments. We view independence risks as extremely remote in such circumstances and, therefore, consider the reach of such provisions unnecessarily broad.
The proposed rule should be revised to make clear that the provision of non-audit services not otherwise proscribed by the rule constitutes a "professional service" that is not subsumed within the proposed rule's restrictions. In addition, not all business relationships with audit clients should be proscribed if they are immaterial. For example, the AICPA's corollary rules preclude members from having material "cooperative arrangements" with an audit client, such as material joint ventures, prime/subcontractor arrangements, or distribution or marketing arrangements.102 The inclusion of a materiality standard in the context both of all business relationships (direct and indirect) sufficiently mitigates whatever independence risk would be posed.
V. Contingent Fees
Proposed Rule 2-01(c)(5) would render an accountant's independence impaired if the accountant or the accountant's firm (and, therefore, any "affiliate" of the accounting firm) provides any service to an audit client, or an affiliate, for a contingent fee, or otherwise receives a contingent fee from an audit client or affiliate of an audit client.103 As the commentary to the proposal states, for the most part, the new rule codifies restrictions already in place under AICPA rules, except, of course, that the scope is much broader because of the proposal's "affiliate" definitions.104
Unlike the AICPA's current rule, however, the proposed definition of "contingent fees" may include "value added" billing, a term which is not further defined within the rule proposal. A value-added arrangement typically reflects the type of service rendered, the ways that other service providers charge for the service, and the value derived by the client for the service. Such an arrangement is no more prone than other types of fee arrangements to create an incentive for an accounting firm to impair its independence, achieve a particular result, or reach a particular conclusion.105 Further, a value-added arrangement is discretionary, thereby distinguishing it from a contingent fee agreement. We do not believe there is a basis to expand the current prohibition beyond contingent fees. Additionally, such restraints on compensation arrangements constitute an unwarranted restraint of trade.
VI. Quality Controls
The AICPA has consistently promoted efforts to make the existence of accounting firm quality controls an integral part of any auditor independence framework. All AICPA members that perform attest services must maintain quality controls, regardless of whether they serve SEC registrants or non-public entities. We would suggest that the safe harbor provision be amended to require that public company audits be by auditors subject to peer review under specified guidelines.106 In that way compliance with the AICPA's quality control standards and the SECPS membership requirements regarding independence and quality controls, or their equivalent, will qualify the firm under the proposed rule.107
Since the purpose of the "Quality Control" safe harbor is to protect accounting firms that have appropriate controls, the focus of the safe harbor should be on the firm's knowledge. Accordingly, the safe harbor should apply when the accounting firm (not the "covered person") does not know the circumstances giving rise to the lack of independence and corrects the impairment promptly after becoming aware of it. Of course, this would not diminish a covered person's professional responsibility to inform the firm promptly upon learning of an independence violation or the responsibility of the firm to keep instances of such violations to the absolute minimum. In addition, such a modification to the proposed rule would be consistent with the Commission's rules in other areas. For example, the Commission has recognized in its regulation of the broker-dealer industry that the broker-dealer is liable for its employee's violation of the securities laws only if it "failed reasonably to supervise" that employee.108 In other words, a broker-dealer is not liable if, with an appropriate system of controls in place, it is reasonable in not knowing of its employee's violations.109
|1||See Memorandum from Lynn E. Turner, Chief Accountant, SEC, to Arthur Levitt, Chairman, SEC, at 2 (July 17, 2000) (attached to Letter from Chairman Levitt to Senator Evan Bayh, July 17, 2000) (stating that eight of the 10 non-audit services to be expressly prohibited under the SEC's proposed rule "already are deemed to impair an auditor's independence under existing rules of the Commission or the SEC Practice Section of the AICPA").|
|2||See Revision of the Commission's Auditor Independence Requirements, 65 Fed. Reg. 43,148, 43,192 (proposed July 12, 2000) (to be codified at 17 C.F.R. pts. 210 and 240).|
|3||See Testimony of New York State Society of Certified Public Accountants, before the SEC, Hearing on Auditor Independence - September 13, 2000, at 1 (visited Sept. 23, 2000) <http://www.sec.gov/ rules/ proposed/s71300/testmony/golden1.htm> (stating that "the financial accounting sophistication of some SEC clients is insufficient to completely satisfy the details of certain accounting standards and that these clients expect their accountants to advise them in these situations and provide some assistance"); Testimony of Dom Esposito, Chief Executive Officer, Grant Thornton LLP, before the SEC, Hearing on Auditor Independence - September 13, 2000, at 2 (visited Sept. 23, 2000)<http://www.sec.gov/rules/ proposed/s71300/testmony/esposi1b.htm> (commenting that clients frequently require assistance with the computation and disclosures associated with earnings-per-share calculations and stock compensation).|
|4||See AICPA Code, Interpretation 101-3 [ET § 101.05]. Exhibit 6 to this submission contains copies of AICPA rules, interpretations and related guidelines referenced herein.|
|5|| Specifically, the language of Section 602.02.c. to be deleted provides that:
In some cases, the recordkeeping by the accountant may be limited in extent or mechanical in nature and a strict application of the recordkeeping prohibition may cause an unreasonable hardship on companies going public for the first time. When no question relating to recordkeeping exists in the latest full year certified and the accounting services were routine or mechanical in nature, the Commission may, in some cases, not raise a question as to independence regarding the earlier periods during which the accounting services were performed. See Codification of Financial Reporting Policies § 602.02.c., 7 Fed. Sec. L. Rep. (CCH) ¶ 73,263, at 62,890 (1998); see also 65 Fed. Reg. at 43,190.
|6||Example 6 indicates that an accountant's independence was not impaired where the accountant provided assistance in closing the books of a registrant for the year, where the registrant's comptroller unexpectedly resigned at the end of the year, so long as the work performed did not involve making managerial decisions. See Codification of Financial Reporting Policies § 602.02.c.ii., example 6, 7 Fed. Sec. L. Rep. (CCH) ¶ 73,264, at 62,891 (1998).|
|7||See 65 Fed. Reg. at 43,192.|
|8||See Accounting Series Release No. 126, 37 Fed. Reg. 14,294, 14,296 (July 19, 1972).|
|9||Since such services relate to the establishment of financial information systems to be used on an ongoing basis, they bear no particular or unique relationship to any financial statement.|
|10||See AICPA Code, Interpretation 101-3 [ET § 101.05]. Additionally, this provision of the Interpretation provides that auditors may customize a prepackaged accounting or information system, provided the client makes all management decisions, and provide the initial training and instruction to client employees on a newly implemented information and control system. However, the Interpretation precludes auditors from supervising the client's personnel in the daily operation of the information system or managing the client's local area network system.|
|11||See 65 Fed. Reg. at 43,168.|
|12||See id. (stating that "Since materiality determinations cannot be made before financial statements are generated, the accounting firm by necessity will need to evaluate the general nature of the information rather than only system output during the period of the audit engagement").|
|13||See id. at 43,169.|
|14||See id. (emphasis added).|
|15||See ISB, Discussion Memorandum 99-3, Appraisal and Valuation Services, at ¶ 5 (Sept. 1999) [hereinafter ISB DM 99-3].|
|16||See Letter from Lynn Turner, Chief Accountant, SEC, to William T. Allen, Chairman, ISB (Jan. 7, 1999).|
|17|| See Highlights of July 11, 2000 ISB Meeting, Independence Standards Board Issues Employment Standard and Defers Action on Current Exposure Drafts (visited Sept. 21, 2000) <http://www.cpaindependence.org/|
webview.php3?doc_id=press+release+from+7-11-00+meeting>. Although the ISB has not yet released its Exposure Draft for public comment, the latest draft of the Exposure Draft was discussed and made available for the July 11, 2000 Meeting of the ISB. See ISB, Draft of Appraisal and Valuation Services - Exposure Draft (July 2000) [hereinafter Exposure Draft 00-2].
|18||See AICPA Code, Interpretation 101-3 [ET § 101.05].|
|19||See, e.g., Letter from John Riley, Associate Chief Accountant, SEC, to Senator Robert W. Kasten, Jr., at 2 (Aug. 30, 1990) (stating that "the [SEC] staff has not objected to the auditor assisting in the allocation [of a purchase price], since the total value to be allocated was determined through arms-length negotiations between the client and the seller," but that the staff would consider independence to be impaired if the auditor "appraises or values a material acquired company") (emphasis added).|
|20||In its Exposure Draft made available in connection with its July 11, 2000 meeting, the ISB indicates that it would adopt a materiality standard. See Exposure Draft 00-2, at ¶ 2 n.3. The Proposing Release suggests that the Commission may be concerned that it will not be possible for an auditor to make a materiality judgment before entering into the appraisal or valuation service engagement. See 65 Fed. Reg. at 43,169-43,170. However, we have no reason to believe this has been a serious concern in the past, or that it will be in the future. In most circumstances, an auditor will know ahead of time if an engagement is likely to be material to the company's financial statements, and any concern in this area could be remedied by making clear that an auditor's independence will not be impaired, if it reasonably believed at the time it entered into the appraisal or valuation service engagement that the service would not be material to the company.|
|21||See AICPA, SEC Practice Section Reference Manual, Organizational Structure and Functions of the SEC Practice Section § 1000.35, Appendix A (April 2000) [hereinafter SECPS Manual].|
|22||See Public Oversight Board, Scope of Services by CPA Firms, at 51-52 (1979). The POB also concluded that to the extent use of the accounting firm's own actuaries to provide actuarial services to the audit client resulted in self-review, it was "quite limited" and not of concern. See id. at 50-51.|
|23||In its Exposure Draft 00-2, made available in connection with its July 11, 2000 Meeting, the ISB indicates that its standard would not apply "to situations where firm actuaries value a firm audit client's pension, other post-employment benefit, or similar liabilities." See Exposure Draft 00-2, at ¶ 2 n.3. In the discussion section of the draft explaining its decision not to prohibit such services, the ISB explains that: (i) "virtually no respondents chose to comment on such services - positively or negatively [which] [t]he Board interpreted . . . as indicating a lack of concern"; (ii) that such services had not been the focus of the SEC Staff's request to the ISB with respect to appraisal and valuation services; (iii) that the nature of such services are "qualitatively different from other appraisal services'' and do not result in a delegation of the management function to the auditor; (iv) that the POB had concluded that such services should be permitted; and (v) that the Board was not aware of any new matters since the POB issued its report that would change the POB's conclusion. See id. at ¶¶ 19-20.|
|24||See 65 Fed. Reg. at 43,170.|
|27||See AICPA Code, Interpretation 101-13 [ET § 101.15].|
|29||Such a concern was expressed by some parties during the Commission's public hearings on the rule proposals. See, e.g., Testimony of John D. Hawke, Jr., Comptroller of the Currency, before the SEC, Hearing on Auditor Independence - July 26, 2000, at 6-11 (visited Aug. 16, 2000) <http://www.sec.gov/rules/extra/audmin.htm>.|
|31||See AICPA Code, Interpretation 101-1 [ET § 101.02].|
|32||See 65 Fed. Reg. at 43,170.|
|33||See id. at 43,171 n.171 (which states that, "This proposal is consistent with SECPS Manual § 1000.35") (emphasis added).|
|34||See SECPS Manual, § 1000.35, Appendix A.|
|35||See AICPA Code, Interpretation 101-3 [ET § 101.05].|
|36||See 65 Fed. Reg. at 43,192.|
|37||See id. at 43,171.|
|38||Furthermore, in light of the aforesaid differences between the SEC's proposed and our existing rules, we disagree with the SEC's characterization that the proposed rule is "consistent" with ours. See id. at 43,171 n.171.|
|39||See id. at 43,170-43,171.|
|40||See id. at 43,171.|
|41||It is worth noting that the question the SEC asks in this connection in the descriptive section about this proposal refers to "compensation arrangements of the company's executives." See id. However, neither the preceding language in the description about such services nor the text of the proposed rule itself necessarily limits the restriction to such instances.|
|42||See AICPA Code, Interpretations 101-1 [ET § 101.02] and 101-3 [ET § 101.05].|
|43||See Codification of Financial Reporting Policies § 602.02.e.iii., 7 Fed. Sec. L. Rep. (CCH) ¶ 73,271, at 62,903 (1998).|
|44||See 65 Fed. Reg. at 43,171.|
|45||See AICPA, Serving the Public Interest: A New Conceptual Framework for Auditor Independence, at 17-20 (Oct. 20, 1997).|
|46||See AICPA Code, Interpretation 101-3 [ET § 101.05].|
|47||See 65 Fed. Reg. at 43,192.|
|48||See id. at 43,168, 43,192.|
|49||See id. at 43,172.|
|50||See 5 U.S.C. § 500(c) (1994); see also Circular 230 of the U.S. Treasury Department, 31 C.F.R. § 10 et seq. (1999).|
|51||See AICPA Code, Interpretation 101-3 [ET § 101.05].|
|52||See ISB, Discussion Memorandum 99-4, Legal Services, at ¶¶ 27-32 (Dec. 1999).|
|53||See 65 Fed. Reg. at 43,192.|
|54||See id. at 43,172.|
|55||See id. at 43,172-43,173.|
|56||See 5 U.S.C. § 500(c) (1994) (which expressly authorizes certified public accountants to represent a person before the IRS upon filing a declaration that they have satisfied certain requirements of the IRS and are authorized to act on behalf of the person they are representing); see also Circular 230 of the U.S. Treasury Department, 31 C.F.R. § 10 et seq. (1999) (concerning the representation of clients by attorneys, certified public accountants, enrolled agents and certain other persons before the IRS).|
|57||For example, section 2014(1) of New York's Tax Law, which governs appearances before the Division of Tax Appeals, authorizes public accountants and certified public accountants, among others to make such appearances. See N.Y. Tax Law § 2014(1) (2000); see also N.Y. Comp. Codes R. & Regs. tit. 20, §§ 2390.1(a)(1), (f) and 3000.2(a) (1999) (which also discuss accountants' ability to appear before New York tax authorities).|
|58||See 65 Fed. Reg. at 43,172-43,173.|
|59||See id. at 43,172.|
|60||See id. at 43,192.|
|61||The Staff has recently asserted that eight of the ten non-audit services restricted under the Proposing Release "already are deemed to impair an auditor's independence under existing rules of the Commission or the SEC Practice Section of the AICPA." See Memorandum from Lynn E. Turner, Chief Accountant, SEC, to Arthur Levitt, Chairman, SEC, at 2 (July 17, 2000) (attached to Letter from Chairman Levitt to Senator Evan Bayh, July 17, 2000). As we have noted, this statement is incorrect because in many instances, the proposed rule would broaden restrictions beyond their current boundaries. Given this difference of opinion with respect to the scope of the new restrictions, it concerns us that in applying the Transition Period, practitioners and the Commission Staff may not always agree which services "would not impair the auditor's independence under pre-existing requirements."|
|62||See 65 Fed. Reg. at 43,194.|
|63||See ISB, Draft of Financial Interests of the Auditor in, and Family Relationships between, the Auditor and the Audit Client - Exposure Draft, at ¶¶ 2, 10-11 (July 2000), made available for the ISB's July 11, 2000 ISB Meeting [hereinafter Exposure Draft 00-3].|
|64||See id. at ¶ 2.|
|65||See 65 Fed. Reg. at 43,193.|
|66||See id. at 43,191.|
|67||See id. at 43,193.|
|68||See APB Opinion No. 18, The Equity Method of Accounting for Investments in Common Stock, at ¶ 17 (2000).|
|69||See 65 Fed. Reg. at 43,160 n.131 (stating that the term "material" is used in the proposed rule in the same "sense that it has been used in [the SEC's] current independence rules").|
|70||See id. at 43,191-43,192.|
|71||See Codification of Financial Reporting Policies § 602.02.b.i., 7 Fed. Sec. L. Rep. (CCH) ¶ 73,258, at 62,886 (1998).|
|72||See Codification of Financial Reporting Policies § 602.02.b.iii., 7 Fed. Sec. L. Rep. (CCH) ¶ 73,260, at 62,887 (1998).|
|73||See AICPA Code, Interpretation 101-8 [ET § 101.10].|
|74||See AICPA Code, Interpretation 101-8 [ET § 101.10], 101-1 [ET § 101.02] and ET § 191.160-161. Note also that under ET § 191.212-213, a member's independence can be impaired when a member or a member's firm has significant influence over an entity that has significant influence over an audit client.|
|75||See AICPA Code, Interpretation 505-2 [ET § 505.03].|
|76||See AICPA Code, Interpretation 101-14 [ET § 101.16]. For example, in an APS situation, assets of an existing CPA practice ("Oldfirm") may be sold by its owners to a public entity ("PublicCo") whose subsidiaries may perform nonattest professional services. The owners and employees of Oldfirm might become employees of PublicCo in connection with the provision of non-attest professional services, while providing attest services through Newfirm, an attest-services only entity controlled by the CPAs. In this connection, Newfirm may enter into an agreement to lease employees, office space, equipment, and certain back-office functions such as billing and collections from PublicCo for a negotiated amount. Because of the close alignment in many APSs between persons or entities included in Newfirm and other persons and entities at or controlled by PublicCo, we require restrictions beyond those required in a traditional firm structure. Specifically, we treat as Members, subject to all of our independence rules, individuals so closely associated with an owner or person in a managerial position at Newfirm that such individual can "directly control" the owner's or manager's activities ("Direct Superiors"). In addition, we apply certain restrictions on financial and employment relationships to certain individuals one or more levels above Direct Superiors and to certain entities related to PublicCo.|
|77||See 65 Fed. Reg. at 43,191.|
|78||See AICPA Code, Interpretation 101-5 [ET § 101.07].|
|79||This date reflects the effective date of Interpretation 101-5.|
|80||See AICPA Code, Interpretation 101-5 [ET § 101.07]; see also id. Interpretation 101-9 [ET § 101.11] (defining member for independence purposes to include parties such as the accounting firm, its partners, employees and contractors participating in the audit engagement, other than clerical staff, individuals with a managerial position located in an office participating in a significant portion of the audit engagement, and entities controlled by one or more of such parties).|
|81||In this connection, it is worth noting that the AICPA's grandfather provisions would not apply if the terms of the loan change in any manner not provided for in the original loan agreement subsequent to the time when independence was required under the scenarios described in (a)-(d) above. See AICPA Code, Interpretation 101-5 [ET § 101.07]. This provision provides that changes in the terms of the loan encompass situations such as a new or extended maturity date, a new interest rate or formula, revised collateral, or revised or waived covenants.|
|82||See 65 Fed. Reg. at 43,191.|
|83||It is hard to conceive that an auditor's judgment would be impaired because her bank, broker-dealer or futures commission merchant was an affiliate of an audit client, particularly if the entity's investment in the audit client were immaterial and thus could not conceivably result in the entity's failure.|
|84||See 65 Fed. Reg. at 43,191.|
|85||It is no longer unusual for credit card holders to charge college tuition, income taxes, automobiles, home improvements, vacations, etc. in excess of $10,000 for convenience, frequent flyer miles, cash rebates and the like, and pay off the balance on the next due date.|
|86||See 65 Fed. Reg. at 43,191.|
|88||See id. at 43,194.|
|91||See Exposure Draft 00-3, at ¶ 16.|
|93||See 65 Fed. Reg. at 43,191.|
|94||See id. at 43,193 (emphasis added).|
|95||See id. (emphasis added).|
|96||See id. at 43,191.|
|97||See Exposure Draft 00-3, at ¶ 2.|
|98||See 65 Fed. Reg. at 43,191.|
|99||The Proposing Release does question whether a "cooling off" period would be appropriate. As explained in the commentary to ISB Standard No. 3, this approach was examined closely by the ISB and found to be flawed in many respects. We agree with the ISB's analysis.|
|100||See AICPA Code, Interpretation 101-2 [ET § 101.04].|
|101||See 65 Fed. Reg. at 43,191-43,192.|
|102||See AICPA Code, Interpretation 101-12 [ET § 101.14].|
|103||See 65 Fed. Reg. at 43,192.|
|104|| The proposed rule contains an exception that the Proposing Release suggests is equivalent to the AICPA's position that a contingent fee does not encompass fees fixed by courts or other public authorities, or, in tax matters, fees based on the results of judicial proceedings or the findings of governmental agencies. In this connection, AICPA Interpretation 302-1 [ET section 302.02] contains additional, instructive guidance by explaining that a contingent fee "determined based on the results of judicial proceedings or the findings of governmental agencies" is permissible if "the member can demonstrate a reasonable expectation, at the time of a fee arrangement, of substantive consideration by an agency with respect to the member's client." See AICPA Code, Interpretation 302-1 [ET § 302.02].
However, other provisions of the proposed rulemaking make the application of these exceptions somewhat meaningless given that the context in which such contingent fees arise is where accountants appear before state and federal bodies - particularly, the IRS and state tax agencies - to advocate on behalf of clients with respect to tax issues. As discussed earlier in this appendix and in our Comment Letter, such expert and advocacy services could be banned by the proposed rule as prohibited non-audit services.
|105||As former Ernst & Young Chairman Ray Groves noted in his July 26, 2000 testimony to the Commission, "[t]here are a number of occasions when audit and non-audit fees can very properly reflect `value added' for the services provided without any impairment of independence. For example, beating deadlines and discovering or preventing major problems are two situations that may deserve a `value added' fee element. It does not impair independence to reward a professional who excels in his or her performance, or who exceeds reasonable expectations." See Testimony of Ray J. Groves, former Chairman and CEO, Ernst & Young, before the SEC, Hearing on Auditor Independence - July 26, 2000 (visited Sept. 20, 2000) <http://www.sec.gov/rules/proposed/s71300/testmony/groves1.htm>.|
|106||The NASD has such a requirement for its listed companies. See NASD Rule 4310, Qualification Requirements for Domestic and Canadian Securities, at Subsection (28) (2000), which states that each issuer "must be audited by an independent public accountant that . . . (ii) is enrolled in a peer review program and within 18 months receives a peer review, that meets acceptable guidelines." In describing such "acceptable guidelines," the subsection then provides, among other things, that the peer review "should be comparable to AICPA standards included in Standards for Performing on Peer Reviews, codified in the AICPA's SEC Practice Section Reference Manual" and "should be subject to oversight by an independent body comparable to the organizational structure of the Public Oversight Board as codified in the CPA's SEC Practice Section Reference Manual."|
|107||The AICPA's requirements have been significantly revised in recent months. The Quality Control Inquiry Committee of the SEC Practice Section is working toward a system where any SEC Practice Section member firm with a partner who is the subject of an ethics investigation will be given the choice, during the pendency of the investigation, of dismissing the auditor, placing him or her on probation (and away from audits of public companies) or "double teaming" the audit. This enhanced procedure goes well beyond any current AICPA, or even SEC sanction. See Letter from Michael Conway, Chair, SECPS Exec. Comm., to the Managing Partners of the SECPS Member Firms - April 2000 (visited Sept. 11, 2000) <http://www.aicpa.org/members/div/secps/inmerefinal.htm>.|
|108||See Securities Exchange Act of 1934 § 15(b)(4)(E), 15 U.S.C. § 78o(b)(4)(E) (1994).|
|109|| See id. The statute states that:
no person shall be deemed to have failed reasonably to supervise any other person if -
(i) there have been established procedures, and a system for applying such procedures, which would reasonably be expected to prevent and detect, insofar as practicable, any such violation by such other person, and
(ii) such person has reasonably discharged the duties and obligations incumbent upon him by reason of such procedures and system without reasonable cause to believe that such procedures and system were not being complied with.