Jonathan G Katz
|
7 September 2000
tcs/l-sec/lm
Direct Line - 44 20 7951 3480
Direct Fax 44 20 7951 3344
We have pleasure in enclosing three copies of a response by the UK practice of Ernst & Young to the Securities and Exchange Commission's Proposed Rule: "Revision of the Commission's Auditor Independence Requirements".
This response has been prepared in consultation with the North American practice of Ernst & Young and is intended primarily to supplement their submissions and representations to the Commission. It is designed principally to highlight issues arising for auditors in other jurisdictions as they seek to interpret application of the Rule. These issues are becoming more significant as the number of foreign SEC registrants increases and there are instances where differences in local regulation or business practice provide safeguards in relation to auditor independence which might not apply in the North American environment.
Like many other regulators and accounting firms outside North America, we in the UK strongly support reliance on a robust framework which clearly sets out the principles underlying auditor independence, in appearance as well as fact, together with guidelines and examples. We particularly value the ability of such a framework to allow established principles to be applied in new circumstances, as opposed to the greater certainty targeted by rules which seek to be comprehensive. The value of this adaptability is all the greater in the modern economy, where the pace of change is increasing and globalisation presents varying commercial environments. Nevertheless, we appreciate that the clarity of highly specific rules is particularly valued in the North American environment and Ernst & Young's practice there, like many other American accounting firms, brings a different perspective.
In other respects, we believe that our response is fully aligned with that of our North American colleagues at Ernst & Young and, where we have restricted our comments, it is because we endorse their approach and have nothing specific to add from the overseas perspective. In particular, we are wholeheartedly in accord with the recent address by their Chairman to the American Accounting Association.
We should be happy to be involved in further deliberations on this very important topic. Any comments or queries should be addressed to our Chairman, Nick Land, who can be reached on (44) 20 7951 3002 or at nland@cc.ernsty.co.uk.
Yours faithfully
Response to the Securities and Exchange Commission's Proposed Revision to its Auditor Independence Requirements
The need for change
We welcome the Commission's initiative to amend its rule regarding auditor independence. We agree that changes in the profession and demographic changes in society at large require modernisation of the rule, particularly in relation to financial interests in audit clients.
We believe that another factor which deserves to be more specifically acknowledged is the increasing globalisation of business, which means that a higher proportion of entities governed by the rule have their primary jurisdiction outside the United States of America. Clearly the fundamental principles of independence are unaffected by this, but the Commission's proposals refer in various instances to specific US circumstances or legislation in explaining their thinking, and this could usefully be challenged to appeal to the more fundamental underlying principle.
In this context, we suggest that the Commission should seek as far as possible to align its approach and its definitions with Section 8 of the Code of Ethics for Professional Accountants issued by the International Federation of Accountants (IFAC). We appreciate that this is not straightforward, given that the relevant Section is itself in the process of substantial amendment and the timetable for comment on the current exposure draft is very similar to that for comment on the Commission's proposals. Nevertheless, we suggest that the large and increasing number of accountants outside North America affected by the rule would be much assisted in their efforts to apply the Commission's requirements by such an alignment and in due course by an authorised summary by the Commission of the impact of its rule over and above IFAC requirements.
Rules and frameworks
The IFAC exposure draft referred to above adopts an overall framework in relation to risks (or threats) to independence which is already quite widely recognised. It then seeks to ensure that safeguards are put in place by accounting firms as necessary in order to mitigate and manage these risks. Nevertheless, it acknowledges and specifies certain risks which "cannot be resolved by any safeguards other than the refusal to perform the assurance engagement".
We find this a very helpful formulation, stressing the responsibility of the reporting accountants, whilst underpinning it with firm rules. It also makes it easier to interpret what is required to maintain independence in the new circumstances which constantly arise in today's rapidly evolving business environment.
Our fear is that the Commission's "preference for narrowly drawn rules", as noted in the Executive Summary in Section I, can result in insufficient prominence being given to general principles when assessing specific circumstances. The existence of a series of rules which appear to be designed to address every conceivable set of circumstances tends to encourage the reader to adopt a legalistic approach and conclude that independence is achieved when no breach of any specific rule can be found, even when a reasonable investor might consider independence to be obviously threatened.
For instance, few could argue that it is acceptable for a long-standing personal friend of a company's chief executive to be appointed as the partner responsible for that company's audit. Nevertheless, it is impractical to draw up a rule to cover this case without also prohibiting a whole variety of other relationships which are not laden with the same significance.
A similar problem underlies responding to many of the supplementary questions posed throughout Section III of the proposal. In some cases, the special circumstances identified do appear to offer a potential threat to independence, but we would argue that the appropriate response is not to extend the specific rule (and thus trap many circumstances where there is no realistic threat to independence), but to appeal to general principles.
We also believe that the Commission could benefit further from recognising explicitly the role of safeguards in mitigating the risks of impairing auditor independence. The linking of expectations with the quality controls of accounting firms and the increased emphasis on the role of audit committees are important steps in this direction. However, we consider that improvements in the governance of both auditors and their clients reduce the need to rely on "bright line" prohibitions or very detailed guidance and the rule could have been adapted to acknowledge this.
The general standard for auditor independence
Like many others outside North America we believe that a framework such as the general standard should receive greater prominence as the primary point of reference when the specific applications do not provide a conclusive ruling. (We acknowledge that this viewpoint is not shared by many of those in North America, who are more accustomed to working with detailed rules and interpretations and are concerned about the uncertainties created by radical change of this kind.)
We therefore consider it particularly important that the significance of any general standard is readily comprehensible to the international community and any implications of its differences in wording from the IFAC framework of "Self-Interest Risk", "Self-Review Risk", "Advocacy Risk" and "Client Influence Risk" are properly understood.
We recognise that the two elements of "Self-Review Risk" within that framework, auditing one's own work and taking decisions for management, are arguably of sufficient importance to deserve separate emphasis. However, it is less clear from an international perspective why no specific reference is made to "Client Influence Risk", the possibility of excess familiarity or vulnerability to intimidation. This would also be responsive to challenge as to whether "mutual or conflicting interest with the audit client" would reach areas such as employment by the client of close family members.
We would also suggest that some readers might find it unclear whether this formulation of "mutual or conflicting interest" would catch the situation where a very significant proportion of an accounting firm's or office's fees emanated from one audit client. For this reason, we believe that "Self-Interest Risk" is a more appropriate description of the threat to audit independence than "mutual interest". It is also more specific in focusing attention particularly on those issues which could risk influencing the auditor when considering the audit opinion. It is natural for audit firms to wish to use their knowledge to contribute to the success of the client, and to be appropriately remunerated, and this could in many cases be argued to create some mutual interest, albeit one of no relevance to the financial statements to be audited.
While the prohibition on "functioning as management" is crucial, we do not believe that "functioning as an employee" has any useful meaning in today's economy, save the receipt by an individual of a regular wage or salary, which is appropriately dealt with under "Self-Interest". In today's extended enterprises, many roles previously undertaken by employees are now dealt with by outsourcing, sub-contracting, joint venture or other consortium, arrangements. In fact we could argue that the only roles necessarily undertaken by direct employees today are those involving managerial decisions.
Finally, we believe that the interpretation of "advocate" within the rule is potentially much wider than "Advocacy Risk" as defined in the IFAC framework. We consider the IFAC formulation to be sufficient to safeguard auditor independence in this respect.
The new definition of "covered persons in the firm"
We support the move towards restricting the number of partners and employees who are affected by the independence requirements in respect of financial, employment or business relationships with an accounting firm's audit client.
We accept that for most such relationships, it is appropriate to define quite widely the class of persons ("covered persons in the firm") who could potentially be in a position to influence the conduct of the audit. Subject to our more detailed comments below, we believe that the definition set out in proposed rule 2-01(f)(13) is essentially reasonable for these purposes. We also support the definitions for "close family members" and "immediate family members".
However, for some of the relationships described as "other financial interests in audit client" [rule 2-01(c)(l)(ii)], we believe that the threats to independence arising through category (iv) of covered person (any other partner, principal, or shareholder from an "office" of the accounting firm that participates in a significant portion of the audit) are remote. For these relationships, we suggest that a more restricted class of persons (say, "involved persons") could, if necessary, be subject to the impact of the independence rule.
Our suggestion is based on three factors:
In these circumstances, we submit that there could be a real risk that the difficulties arising when any major financial services company considers changing its audit firm might be so great as to restrict competition.
We also believe that the definition of "chain of command" is too widely drawn in its inclusion of managers who may "influence the performance appraisal or compensation of any member of the audit engagement team". In many cases, this definition will be sufficient to bring into the net a huge number of staff, some perhaps with no more than two years' experience (given that "manager" is undefined), who prepare assessment reports on other clients for relatively junior members of the audit engagement team. Furthermore, the restrictions would apply even in an office responsible for a part of the audit which would otherwise be deemed insignificant.
We suggest that the prospect of such individuals having any influence over the conduct of an audit is extremely remote, relying on the existence of three factors, two of which are quite implausible:
We submit that it is sufficient to include in the chain of command only those managers who are directly responsible for the overall review and determination of the career progression or compensation of any member of the audit engagement team.
Finally, we note that the discussion of the definition of covered persons in section III.I.10 of the paper suggests that "all other professional employees from an office of the accounting firm that participates in a significant portion of the audit" should be included. We assume that this definition is erroneous because it conflicts both with the detailed formulation in proposed rule 2-01(f)(13)(iv) and with the summary of this rule in section III C, both of which confine the restriction to "partner, principal or shareholder", appropriately in our view.
Investment in audit client
We share the concerns of Ernst & Young in North America about the unnecessarily restrictive impact on investment by accounting firms which results from the application of proposed rule 2-01(c)(1)(i) to indirect investments, together with the definition of affiliates.
Turning to the impact of the rule on covered persons, we find it regrettable that the effect of rule 2-01(c)(1)(i)(C) is to disbar most partners in major accounting firms from serving as trustees for prestigious trusts with a large and varied board of trustees and an extensive portfolio of diversified investments. In the UK, most major charitable endowments are established in this way. We believe that many such trusts would benefit from the involvement of these accountants and, in the circumstances described, independence is not threatened. It would be valuable if the Commission could find some way of identifying "prestigious trusts" meeting these criteria and exempt them from this requirement.
With regard to rule 2-01(c)(1)(i)(B), we appreciate that the 5% threshold has been selected by reference to the Commission's existing disclosure guidelines, but lower thresholds already exist in other jurisdictions (in the UK, for instance, the figure is 3%) and a further reduction could be appropriate in recognition of the fact that this rule is focused on individuals rather than institutions.
We are concerned about difficulties in interpreting the Commission's rules in relation to collective investment vehicles in the light of the varying structure and characteristics of such vehicles in different jurisdictions. We believe that provided the individual is not in a position to have any influence over investment policy and the firm does not audit the vehicle or any affiliate, a holding of less than 5% of equity should be permissible. Please also refer to our concerns expressed in the next section about the definition of an "investment company complex".
Finally, we refer back to our earlier comments on "Rules and frameworks". It is not difficult to construct other situations, not covered by the specific rules, where a reasonable investor might be concerned about auditor independence. For instance, all five examples presented by the Commission at the end of section III C1(a) could certainly fall into this category if "Partner A" were the lead audit partner. But the issues apply equally if the major investor is a close friend as they do for a brother-in-law, sister-in-law or grandchild. We believe that the solution is not to expand the specific rules, but to refer to the principles enshrined in a framework such as that proposed by IFAC.
Other financial interests in audit client
We believe that proposed rule 2-01(c)(1)(ii) is in many respects too restrictive in its interpretation of what can realistically constitute a threat to independence. For the reasons set out above in our discussion of "the new definition of covered persons in the firm", we consider that threats to independence are negligible in the case of many normal arm's length contracts between an individual and an audit client, because the financial statements do not affect their value to the individual. For those intimately connected with the audit, there are unusual cases where it is possible to envisage circumstances which might affect their perception of this value, so some of the rules could be applied to a more restricted class of individuals within the accounting firm, perhaps designated "involved persons". Alternatively, or in addition, the rules should be applied only to those interests which are clearly of significance to the individual concerned.
These comments apply particularly to routine relationships with major financial institutions, where the number of arrangements affected by a proposed change of auditor or new SEC listing for a business from a foreign jurisdiction might be sufficient to have an arbitrary effect on decision making. Examples within rule 2-01(c)(1)(ii) are:
(A) restrictions on loans obtained from a financial institution under its normal lending procedures, terms and requirements should be relaxed;
(B) restrictions on savings and checking accounts should be relaxed;
(E) restrictions on credit card balances should be relaxed - not only is $10,000 a relatively low figure, but it is particularly surprising that there is no provision to exempt balances which are promptly paid in accordance with the card's standard terms;
(F)(1) we can see no reason why the restriction on insurance products should apply to property and casualty business, which has the characteristics of normal consumer contracts;
(F)(2) long term life and pension products, where the main objective is savings rather than protection, present particular difficulties because there can be very significant costs to withdrawing from such products before maturity.
In addition to this general concern, we have three specific concerns arising within this part of the rule.
Firstly, the restrictions imposed by rule 2-01(c)(1)(ii)(G) seem unrealistic and arbitrary in the way that an "investment complex" is defined, so that a relationship with one element can be deemed to affect independence from another element with which the actual links are very tenuous. We do not believe that a reasonable investor could consider independence to be impaired if a covered person in an accounting firm which audited one investment company held an equity investment of less than 1% in another investment company with the same sponsor, provided the accounting firm was not also responsible for the audit of the sponsor or any affiliate.
The rule would also be particularly hard to apply in other jurisdictions, where investment vehicles have different structures and characteristics. For instance, in the United Kingdom, a popular structure for an investment company is the Stock Exchange listed investment trust, each of which is linked with both a management company and a financial adviser. Many management companies also choose to use a number of different audit firms for their different investment trusts. Since most such investment companies and their advisers are audited from London financial service specialist offices of accounting firms, the application of a rule such as 2-01(c)(1)(ii)(G) in this context could lead to considerable difficulty for a large number of partners in major accounting firms in finding diversified investment vehicles in which they would be permitted to invest. Furthermore, any changes in audit arrangements would have major consequences among this category of partners.
We are already concerned in the United Kingdom that many investment vehicles may be affected by this rule because their manager or investment adviser is an affiliate of an SEC registrant. We would appreciate clarification on the extent to which the rule could affect investment in UK entities by potential "covered persons" in situations where the accounting firm audits no SEC registrant within the complex. For instance, are there circumstances where rule 2-01(f)(16)(i)(C) could cover UK investment vehicles, so that a firm which audited a UK investment trust managed by an affiliate of an SEC registrant investment adviser (audited, as is the affiliate, by a different accounting firm) could be considered to have its independence impaired in respect of other UK investment trusts from the same stable? Would it make a difference if the UK investment trust's auditor was also responsible for the audit in the US of an entity that would be an investment company but for the exclusions referred to in rule 2-01(f)(16)(i)(C)? The effects of the rules on investment company complexes appear to us to be arbitrary, extremely difficult to monitor and unnecessarily restrictive.
Secondly, the exception in respect of new audits in rule 2-01(c)(1)(iii)(B) should be extended to new registrants from foreign jurisdictions, even where there has been no change of auditor, provided the relevant IFAC requirements have been complied with.
We also suggest that a similar exception could be considered in relation to the past provision of non-audit services.
Thirdly, the proposed rules on insurance policies are likely, unless modified, to have a significantly adverse effect on the operation of the market for global professional indemnity insurance. Comparatively few insurers are prepared to offer terms at the level required by the Big Five global firms and the economic effect on each of them of being prevented from contracting with their audit firm could be sufficient to cause some to withdraw from the market, thus exacerbating problems for the accounting firms in spreading their risk. Even if the necessary changes can be achieved, the relevant insurers will thereafter be severely restricted in their ability to consider changing auditors.
Furthermore, to the extent that auditing one's insurer does threaten independence, the risk would come in relation to claims made by the accounting firm (combined with financial weakness in the insurer). The transitional period would need to be very long to accommodate the run-off of existing arrangements.
One potential consequence might be for the relevant insurers to look outside the Big Five for their accounting firm. We believe that this could present some issues to be addressed in an industry that is complex, highly specialist and truly global.
Employment and business relationships
Our principal concern about proposed rules 2-01(c)(2) and (3) is that the prohibition of staff secondments is unnecessarily restrictive at a time when secondments are regarded as a valuable means of developing staff. We consider that, provided the secondee does not subsequently have any involvement in the audit and does not perform a role involving the provision of services prohibited elsewhere in the rules, there is no threat to independence.
In addition, we do not understand why the restriction on business relationships extends to relationships with shareholders holding 5% or more of the audit client's equity securities. Most such shareholders would not fall within the definition of "affiliate of the audit client", even under the rule as currently proposed, and should not therefore present any threat to independence.
Definition of affiliates
With respect to the proposed definitions for affiliates, we fully share the concerns of Ernst & Young in North America, as recently expressed by their Chairman.
Non-audit services
In our comments on the "general standard for auditor independence", we noted that it was natural for audit firms to wish to use their knowledge to contribute to the success of the client and the Commission has in turn acknowledged this in section III D1(b)(ii) of its proposals. While auditing remains a commercial private sector activity, auditors are driven to demonstrate value to their clients and an important component of the perceived quality of their work lies in their insight into the quality of the audit client's people, processes and systems and their suggestions for improvement. To be valuable, these contributions must not only be insightful, but must demonstrate an understanding of what is efficient and effective in the client's circumstances.
The line between advice and implementation is not always an easy one to draw, and there are circumstances when even implementation under appropriate management supervision presents no real threat to independence. We believe that all parties would benefit from greater clarity of definition as to the principles which should be applied in considering when any service potentially impairs independence. We feel that dealing with each prohibited service separately risks inconsistency and tends generally to be more restrictive than is necessary when other safeguards are taken into account.
Nevertheless, we accept the principle that certain non-audit services are inconsistent with the perception of independence, even if the audit client accepts ultimate responsibility for the work that is performed or decisions that are made. However, just as materiality is always relevant in the audit of financial statements, so we believe that its relevance should be acknowledged here. Where services relate to activities or business units that are clearly immaterial to the financial statements, and involve a fee that is clearly immaterial to the audit fee, the work has no impact on any of the audit processes and does not constitute a threat to independence.
We appreciate that materiality levels need to be set low to ensure that the relaxation is not abused, but we believe that the current position gives rise to particularly onerous and unnecessary restrictions on registrants starting up businesses in foreign jurisdictions. In such cases, while only a small initial team is in place, it is natural for companies to look for outside assistance and to look to their auditor's international network to give some assurance as to quality. The operations are typically not subject to any independent audit requirement for the purposes of the group financial statements, so they are of no audit significance.
A second general point under this heading concerns the past provision of prohibited non-audit services to a new audit client registered with the SEC or to a new foreign registrant. Where these services were provided before the change in auditor or in status was in prospect, we suggest that exceptions to rule 2-01(c)(4) should be permitted, analogous to those in rule 2-01(c)(1)(iii)(B). We would particularly appreciate guidance on any requirement for the lapse of time between the provision of such services and the ability to accept audit appointment without impairing independence.
In relation to bookkeeping or other services related to the audit client's accounting records or financial statements, we believe that our comments above on materiality are particularly relevant. We suggest that the example of an overseas start-up given above would clearly not give rise to a perceived lack of independence in terms of the discussion in section III D 1 (b)(i).
So far as financial information systems design and implementation is concerned, we agree with the recognition in the proposed rule that auditors' insights about their client's systems can be extremely valuable in diagnosing, assessing and advising on ways in which internal controls can be strengthened.
While appraisal and valuation services can jeopardise audit independence in relation to material valuations for use in financial statements we note that auditors do need to be in a position to advise their clients on the suitability of bases and assumptions. We also believe that valuations which are immaterial to the group financial statements (e.g. those undertaken in a foreign jurisdiction in accordance with local requirements) should be permitted. We also note that the proposed IFAC guidance permits valuations by audit firms, unless they involve a "significant degree of subjectivity".
However, we do take issue with the position taken by the Commission on fairness opinions and contribution-in-kind reports. We would contend that, where these are issued publicly and the auditors are accepting responsibility to the company as a whole or its shareholders, as is commonly the case in many jurisdictions, these constitute audit services and it is expected, and in some jurisdictions required, that the entity's audit firm provide them.
In these circumstances, we accept that, in performing subsequent audits, the auditors could well end up reviewing their own past audit work. But, since that work consisted only in reviewing and opining on reports and statements made by others, the situation is equivalent to that of reporting on financial statements in two successive accounting periods, the independence implications of which could be addressed only by requiring all registrants to change their auditors annually! We urge that the Commission should reconsider its definition of audit services to include fairness opinions and contribution-in-kind reports where the auditor is accepting responsibility to the shareholders.
Actuarial services are delivered in different ways in different jurisdictions, but we accept the principle that an insurance company audit client should not generally use its accounting firm to provide management with primary actuarial capability.
We acknowledge that there may be reasonable investors who would regard complete internal audit outsourcing as a threat to the independence of an audit firm, on the grounds that no one member of management, otherwise uninvolved in the internal audit function, can be competent to evaluate the effectiveness, outputs and technical quality of the internal audit function. We appreciate the difficulty of drawing the line in this area, but we are concerned that the formulation of rule 2-01(c)(4)(i)(E) effectively prohibits all types of recurring internal audit evaluation. We suggest that, provided a competent and experienced internal audit manager is employed to set and manage the overall programme and to take responsibility for the implementation of internal audit findings, independence would not be affected by using the external audit firm to undertake specific reviews on a recurring basis.
We suggest that such an approach could be particularly relevant in overseas locations, especially if the company's internal audit function has primarily a domestic focus. Even if there is no internal audit function, we believe that internal audit work by the external audit firm should be acceptable on materiality grounds at remote locations, recognising that internal auditors can be regarded as part of a company's system for monitoring internal accounting control (a function for which some companies seek to rely on their external auditors) rather than as part of the system of accounting control itself.
We accept that the performance of management functions potentially impairs auditor independence, although we would urge that the expression "act as an employee" is no longer of relevance in this context and should be excluded for the reasons set out earlier when discussing the general standard.
The wording of the proposed rule for human resources appears to be more restrictive than those for other non-audit services and we cannot understand why this should be so. This is the only rule where the giving of advice by the audit firm is prohibited without qualification. With the understanding of human resource issues receiving more emphasis in performing audits and potentially a management letter issue, it is surprising and unnatural that the audit firm should be prohibited from giving advice on management or organisational structure. We urge that this restriction should be reconsidered.
We would also suggest that, provided the audit firm does not perform management's function in determining employee compensation or implementing evaluation programmes, there is no risk to their participation in the effective design of compensation packages (often tax-led, especially in the case of expatriate employees), development of employee evaluation programmes or advice on compensation policies and practices. Given that the audit firm would not administer individual tests or evaluations, in none of the above cases would the auditor have any interest in the success of specific employees. Nor would there be any direct impact on the financial statements.
We appreciate that recruitment services are more likely to impair independence in relation to Board members, senior operating executives and financial staff, although even in these cases audit firms can usefully advise on technical competence. Nevertheless, we believe that even the recruitment of, say, a marketing director should not be perceived to have any impact on independence. We suggest that the roles for which recruitment services are restricted should be aligned with those where close relatives of covered persons are not to be employed, as set out in rule 2-01(c)(2)(ii).
With regard to broker-dealer, investment adviser or investment banking services, we are concerned that investment banks provide a wide range of services in different jurisdictions and, in much of Europe, many such services are also provided by accounting firms. The services include a broad range of advisory work on corporate finance, mergers and acquisitions and due diligence and they do not present any risk in relation to recommending transactions in an audit client's securities.
We are satisfied that our independence in providing these services can be assessed appropriately by reference to the framework of principles. However, we would appreciate confirmation that the title of this rule is not intended to imply that every service which is typically provided by a global investment bank is presumed to be prohibited, unless otherwise indicated.
With regard to legal services, we note that the effect of the proposed rule is likely to vary significantly between jurisdictions.
With regard to expert services, we do not believe that an audit firm should be disbarred from providing advice to a client in respect of a contentious issue, particularly when its audit work has provided a deep understanding of the issues. Nor do we consider that it would be any threat to independence to allow the firm's specialised experts to ensure that the advice given to the audit client was of the highest quality. If either of these activities were to be deemed to constitute "supporting" an expert opinion, then we should be concerned about the restriction of activities which do not appear to us to impair independence. What, for instance, would be the position of an audit firm which advised its client that it might be unwise to institute proceedings in a claim which that client had contemplated? Would that be caught under this rule?
Furthermore, we consider that there is a real risk of prejudice if the proposed SEC rule prevents an auditor carrying out work that would otherwise be accepted by the Court in which the service would be provided. The Courts in all jurisdictions are alive to the vital importance of independence and already have clearly defined procedures, which often include full disclosure.
We would also appreciate guidance on how broadly the description "regulatory filings or proceedings" should be drawn in the context of jurisdictions where regulators (particularly in the financial services industry) look to accounting firms to carry out regulatory work on their behalf, routinely reviewing agreed aspects of the entity's activities and reporting privately to the regulator on them (at the client's cost). It is common, and possibly in some cases legally required, for this review and report to be carried out by the entity's audit firm and to be regarded as an audit service, although the report is not usually public. Could this activity be interpreted as an expert service impairing independence? We believe that the complex set of checks and balances that exist in the US cannot be assumed to be the most appropriate procedures for other jurisdictions where very different legal and regulatory practices may apply with equal effectiveness.
Finally, we note that tax services are not subject to the restrictions and assume that this applies to tax services in other jurisdictions.
Alternatives
We are strongly of the opinion that the prohibition of all non-audit services to audit clients would reduce the quality of auditing in today's business environment.
Many specialist businesses require a depth of understanding within the audit engagement team to appreciate their risks and the controls, checks and balances and monitoring necessary to manage them. This has been particularly relevant in the financial services sector, especially as new products have continually been introduced. However, it is also becoming increasingly important in the telecommunications industry and in the businesses spawned by the "knowledge industry" and the spread of e-commerce.
The accounting firms have responded by using specialists within their audits. The ability to offer a range of advisory work experience has been crucial to their success in attracting and retaining such specialists. We have no doubt that the introduction of a bright line between audit and non-audit services would result in most or all such specialists leaving the accounting firms and the quality of auditing suffering accordingly.
It has been suggested that expertise of this nature could be retained through the ability to provide non-audit services to non-audit clients while maintaining a more restricted audit role. We do not find this alternative credible in an environment where companies select and remunerate their auditors; audit clients will be reluctant to engage accounting firms whose experts they admire for fear that the intimate knowledge gained of their business and its issues can only be used for the benefit of their competitors.
Indeed, we would go further and suggest that it is a characteristic of any high quality and well-motivated individual to wish to play an advisory role in improving the business of an audit client where weaknesses are found, especially if these are weaknesses in control. To disbar all auditors from this function would significantly reduce its attraction as a career and adversely affect audit quality.
We do not consider that the "exclusionary rule", as described, would materially alter this perspective. In our view, there are many cases where the best interests of the company and its shareholders would be served by retaining its audit firm for non-audit services, but the pressure on companies not to use their audit firms for non-audit services would nevertheless be high, and the bureaucratic consequences of doing so would be a further deterrent. We therefore fear that many of the audit committees who believe that their auditors' intimate knowledge of their business is an important asset in relation to many of these services would be reluctant to take a stand. Furthermore, the disclosure and filing requirements can also be an important deterrent in relation to the confidentiality requirements of due diligence and other services in regard to changes in the company's strategic positioning. We believe that some major entities might well seek to justify the use of their auditors for a range of non-audit services under the "exclusionary rule", but the impact of this would be unlikely to be sufficiently great or predictable to prevent the prospective loss of audit talent described above.
We recognise that the Commission's suggestion of rules to identify services that would not impair audit independence seeks to address the issues identified above. However, if it were to be applied in conjunction with the "bright line" approach that has been described, we believe that it would not be adequate to offset the adverse impact on audit quality. In a constantly changing market, we suggest that any attempt at a rigorous definition of "services that are a natural outgrowth of the audit process" is doomed to failure, and risks excluding non-audit services which would clearly not impact independence.
If, on the other hand, a rule of this type were included within the new rules as currently proposed, it could be helpful in their interpretation, provided the list of "permissible" services were not to seek to be exhaustive.
On the question of whether the comparative amount of the non-audit fees is relevant to the issue, .we do not believe that it is appropriate to set a maximum level for non-audit fees (excluding tax services) by reference to audit fees, or by any other method, because the timing of such services will inevitably have an arbitrary impact on occasion and because the new proxy disclosure requirement (on which we comment below) is adequate to ensure appropriate oversight, prospectively by the audit committee and retrospectively by the Commission and shareholders.
Transition
We have no comment to make on the proposed transition provisions, although we would suggest that these need to be extended to cover business relationships as well as non-audit services.
Contingent fees
We do not believe that the definition of contingent fees for assurance services in proposed rule 2-01(c)(5) should be widened to include fees that are substantially below the fair market value of services provided, because this is not readily capable of verification and may, particularly in relation to tax services, cover arrangements completely unrelated to the occurrence of future events.
Indeed, it is not obvious to us why contingent fees are not permitted in relation to services which do not give rise to the provision of third party assurance. If it has been determined that the service itself passes the tests under the general standard, which means that the auditor has no mutual interests with the audit client and is not auditing his own work, then why should the fee arrangements affect the position? In relation to taxation services in particular, the arguments put forward in section III D1(xi) seem equally applicable in relation to contingent fees.
Quality controls
We welcome the formal introduction of a limited exception for firms that maintain certain quality controls and satisfy certain conditions. Subject to some comments below, we agree that the proposals are appropriate, although we suggest that it would also be helpful to smaller accounting firms if rule 2-01(d)(3) indicated which of the recommended features of a quality control system would be required to give reasonable assurance in their case. We are also concerned about the practicalities of extending the relevant systems to affiliates which are not controlled or strongly influenced by the accounting firm, and suggest that consideration should be given to modifying the requirements in these cases.
We agree that in principle these quality controls should apply to foreign firms, but an extended transitional period is likely to be required, given the numbers of jurisdictions involved. We also believe that the exception should be extended to a firm that has adopted the specified quality controls, but did not know and was reasonable in not knowing that a partner or employee lacked independence, and the lack of independence was cured promptly after the firm became aware of it. We do not consider that this extension runs any real risk of abuse, since the requirement for a firm to be "reasonable in not knowing" will be robustly interpreted in those cases where the partner or employee concerned was aware that he or she lacked independence.
Our main concern on the detailed requirements of the quality system relates to the need for procedures to audit, on a test basis, the completeness and accuracy of information submitted by employees and partners. We believe that there are many jurisdictions where this could be interpreted as an infringement of civil liberties and might be unenforceable, certainly without a change in the standard contract of employment. At best, this would need an extended transitional period and potentially a requirement for the monitoring procedure to be carried out by an organisation independent of the accounting firm itself.
We also note that it will be very difficult for firms to enforce the requirement for their professionals to report promptly any employment negotiations with an audit client.
"All relevant circumstances"
We have no comments on proposed rule 2-01(e), assuming this does not entitle the Commission to rule on auditor independence in relation to an audit client which is not itself SEC registered (although it is an affiliate of an entity which is listed, or part of the same investment complex), so long as the relevant accounting firm is not responsible for the audit of any related entity which is SEC registered.
Proxy disclosure requirement
In our experience, some disclosure of the nature as well as the cost, of non-audit services rendered is likely to be valuable to, investors seeking to inform themselves on auditor independence. However, we strongly believe that it would be unnecessarily onerous for many of the largest companies to provide a specific description of every individual engagement, and that combining services that are very similar in their nature into a small number of categories would also present a clearer picture to the reader.
We are also somewhat concerned at the emphasis on advance approval by the audit committee of any engagement for non-audit services. It is common for audit committees to meet no more than three times a year and this should not allow the decision-making process to be delayed whenever the audit firm is a potential provider of non-audit services. We suggest that there will be many cases where retrospective approval by the audit committee will be quite appropriate - where the services clearly give rise to no independence issue (e.g. conventional tax services), where the services are regularly recurring or where, in the case of new services, the chairman of the audit committee is quite satisfied that there is no threat to independence.
Finally, we consider that the lesser of $100,000 and 25% of the audit fee is an appropriate de minimis level which would meet the needs of reasonable investors to satisfy themselves of auditor independence, given that they already have the safeguard of outright prohibition of many non-audit services and the assurance that other material non-audit services are subject to review by the audit committee and advance approval where appropriate.