September 25, 2000
Mr. Jonathan G. Katz
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549-0609
Dear Mr. Katz
Re Proposed Revision of the Commission's Auditor Independence Requirements (File No. S7-13-00)
We appreciate the opportunity to comment on the proposed Revision of the Commission's Auditor Independence Requirements (the Release). This response supplements the public testimonies of our partners Stephen G. Butler, our Chairman and CEO; J. Terry Strange; and John M. Guinan. It has three components:
We firmly believe that quality, objectivity, and integrity are the hallmarks of the accounting profession. KPMG invests millions of dollars every year to support our professional quality control initiatives and ensure that our audits comply with the highest professional standards. We whole-heartedly support all cost-effective efforts to improve the standards governing audits and independence. However, we believe that the Release, if adopted, will profoundly harm the accounting profession and the quality of audits. It will damage the financial reporting infrastructure and those who depend on its effectiveness.
We believe that the Release is not a sufficient base for rulemaking in accordance with adequate due process. While the appearance to investors of sound capital markets is crucial, appearance itself is a faulty basis for public policy. The public interest demands that law and regulations rest on solid evidence, sound research, and a careful study of costs and benefits. The Release lacks those basic requirements. Further:
Because of the Release's many significant weaknesses and the time pressures that have been imposed on its progress, the SEC should call a halt to this rulemaking effort. The ISB should continue its work to develop its conceptual framework, resume its efforts to modernize outdated regulations on investments, employment, family relationships, and to address the provision of legal services and appraisal and valuation services, and take up other scope of services issues with appropriate consideration of all the evidence and the various interests involved.
Undermining the ISB
No one aware of the SEC's role in forming the ISB can easily understand the SEC's resistance to allow that institution to perform its mandate set forth in FRR 50. FRR 50 clearly states that the "Commission intends to look to the ISB to provide leadership not only in improving current auditor independence requirements, but also in establishing and maintaining a body of independence standards applicable to the auditors of all Commission registrants." Indeed, the Commission declared that it will " consider principles, standards, interpretations, and practices established or issued by the ISB as having substantial authoritative support for the resolution of auditor independence issues."
On July 12, 2000 the ISB issued a press release announcing its suspension of work on its projects on financial interests and family relations, employment with audit clients, and appraisal and valuation services. The Board had concluded that in view of the rulemaking undertaken by the Release, "issuing its own documents at this time would not be productive." These projects had been at the exposure draft stage.
The Release does not explain why the SEC staff took over projects the ISB worked on or developed proposed rules that would otherwise preempt much of the ISB's decision making. However, the circumstances suggest an explanation that cannot be ignored. The Release includes provisions eliminating outdated requirements that were similar to those the ISB was poised to adopt. Since the SEC and ISB agreed that updating such requirements was necessary, there is no obvious or published reason to preempt the ISB's projects. A desire to depart from the ISB's standards in some particulars is therefore not an acceptable explanation for this rulemaking initiative, especially given the SEC's power to refuse to accept ISB standards it finds unacceptable and to retain or substitute its own. It is therefore impossible to ignore that one effect of the SEC's preemption of the ISB's projects is to hold modernization of the independence code hostage to both the nonaudit services prohibitions of the Release and the provisions as to "affiliate of the accounting firm," "affiliate of the audit client", and "business relationships" in the Release.
As arguments below make clear, the proposals on nonaudit services cannot stand on their own; nor can those of affiliates and business relationships. They are unsupported and unsupportable. This makes doubly disappointing the SEC's packaging of those proposals with modernization of rules almost universally agreed to cry out for reform.
The Release violates the spirit of the procedures under which the SEC is supposed to operate in a fundamental way. The Release's comment period is too short to allow interested parties the time necessary to study the complex details and adequately evaluate their potential consequences. The Release provides no rationale for this sudden rush to fundamentally overhaul the rules and the structure of the profession overnight. Hundreds of questions are asked of respondents; hundreds more need to be answered. It is troubling and perplexing that the Commission should propose such a detailed and definitive revision of the rules in a release that, at the same time, asks so many questions. The number and varied nature of the questions demonstrates the difficulty and complexity of these issues as well as the complicated nature of the new economy and the changes in the profession that the Commission is trying to regulate. Because of such difficulties, complexities, complications and changes, we have not been able to complete our responses to the more than 300 questions and requests for comment in the Release during the short comment period.
The unseemly haste occurs at a time when the argument for a slower pace is buttressed by changes now working themselves through. Reforms in audit committees and in auditors' disclosures to audit committees were recently put in place with the objective of adding safeguards to auditor independence, safeguards designed to cover the provision of non-audit services to audit clients as well as other matters. The full effects of these reforms on risks of compromised independence remain to be seen, but the reforms could render proposals in the Release unnecessary. Furthermore, we are also in the midst of changes in the structure of accounting firms. Several large firms have announced their intention to divest themselves of their consulting practices. One has already made the sale. These events will change the environment in which non-audit services are provided to audit clients and could have great bearing on the case for the SEC's non-audit-service proposals. Finally, with respect to the proposals on matters other than non-audit services, as we have noted, the ISB had those issues under consideration and had made steady progress on them. Standards similar to the proposed rules in many respects were in the offing. In light of all these conditions, it defies good sense, as well as the spirit of due process, to have a rulemaking exercise that short-changes the time needed to evaluate the Release's arguments and provisions thoroughly and to respond fully to the Release.
Evidence Cited in the Release
The "Historical Perspective of the Provision of Non-Audit Services" (II.C.2.(a)), contains much of the ostensible justification for the proposals. Findings are omitted from cited sources, and recent findings are ignored. Moreover, contrary arguments on the issue of appearance of independence are not presented and rebutted. The Release should present both sides of the issue. Granted, this is not a discussion memorandum or an academic presentation, although we believe the interested public would have been better served by a concept release before a rule proposal was issued. The SEC is also obliged to consider the costs and benefits of the rule. Arguments that there are no benefits, or are detriments, from restricting non-audit services bear on the evaluation of costs and benefits. Research findings that show no harm from the performance of non-audit services or show benefits are relevant for the same reason.
The "Historical Perspective" section quotes from the transmittal letter in the 1979 report of the Public Oversight Board (POB) about the possibility of damage from non-audit services, but omits the report's conclusion that no damage was found from performing those services. The same transmittal statement says, "We do not believe that otherwise lawful and productive economic activity should be prohibited unless such prohibition is clearly in the public interest and no other measures are available." Moreover, the POB rejected the offer by leaders of accounting firms to curtail the provision of certain non-audit services and held that "There are many potential benefits to be realized by permitting auditors to perform MAS [Management Advisory Services] for audit clients that should not be denied to such clients without a strong showing of actual or potential detriment."1
Section II.C.2(a) also cites the report of the Kirk Panel,2 but the citation does not indicate any problem. It refers only to a "potential" problem. Similarly, the passage's reference to the AICPA Special Committee on Financial Reporting says it found "that non-audit service relationships could `erode auditor independence'" (emphasis added). Neither report advocated new rules of prohibition, and the Kirk Panel explicitly denied their desirability: "The Panel has found no evidence of a need for actions by the SEC or by the AICPA to add to or amend the extensive existing body of rules and regulations relating to auditor conflicts of interest."3
The same is true of the citation from the GAO's 1996 review of the accounting profession, which concluded on this issue: "We continue to believe that measures that would limit auditor services or mandate changing auditors are outweighed by the value of continuity in conducting audits and the value of traditional consulting services."4 The GAO agreed with the Kirk Panel's recommendation to improve the role of the audit committee. Fairly recently, such improvements have been made. Therefore, there is no implication from what was said in the GAO report that action is now needed.
The "Historical Perspective" section concludes by citing the Earnscliffe research commissioned by the ISB. Again selective quotation gives a misleading impression, although the quotation itself talks about a future challenge. In other words, again there is talk only of a potential, future problem. That is not evidence of a current problem. Moreover, the "Historical Perspective" section omits the finding that participants in the study had a positive view of auditors, their independence, and their work. "The vast majority of respondents believe," the report stated, "that auditors are currently performing audits, [sic] which meet a high standard of objectivity and independence." The report also concluded that: "Most [participants] felt that auditors of public companies perform a valuable function and do so in a way which reflects a high degree of integrity, competence, and independence."5
The Release cites the growth in consulting services at accounting firms, but the overall growth in such services does not create a new condition for the relationship between auditors and their clients. Decades ago, consulting services were material to accounting firms' operations. Independence is measured on an audit-by-audit basis. If non-audit services affect audit independence, they would have affected individual audits at the earlier levels as well as at the current levels that resulted from recent market demand for consulting services. The Release also cites the change in the percent of clients who paid fees for consulting services in excess of the audit fee. But that simply means there are more audits in which that situation exists. It does not make it more likely that the size of consulting fees will compromise auditor objectivity on a particular audit.Moreover, if providing consulting services in excess of the audit fee were believed to affect audit independence, the publicly reported fact of the fee levels would have led to a ban in prior years.6 Non-audit services were provided to clients even before the creation of the SEC; in fact, they have been provided to clients for over a century, so their being provided today in greater amounts does not change whether or on not they are compatible with independence. We believe they are compatible with independence with appropriate safeguards.
The Release omits the relevant findings of the Public-Oversight-Board-appointed Panel on Audit Effectiveness, a group brought into being at the request of the SEC and composed of distinguished persons. The Panel's study of auditing was probably the most intensive ever performed. The so-called "quasi peer reviews," studies of actual audits, revealed no connection between the performance of non-audit services and impairment of independence ("The Panel is not aware of any instances of non-audit services having caused or contributed to an audit failure or the actual loss of auditor independence"7). This absence-of-harm finding confirms a well-known, already demonstrated generalization. Moreover, on about a quarter of the engagements subjected to review under the Panel's "quasi peer review" program where non-audit services were provided, the reviewers concluded the services had a positive impact on audit effectiveness.8
The Release also omits Panel members' arguments against prohibition of non-audit services that apply to all further regulation of the provision of non-audit services. The opponents of a ban said they were reluctant to change the rules in the absence of any compelling evidence of a problem. They said the Panel had identified no new issues related to consulting services. They questioned whether the public interest is served if auditors are expected to identify problems but have to decline if asked to help solve them. They pointed out that recent measures have changed the situation, particularly ISB Standard Number 1 and the SEC's proxy statement disclosure requirements. They also argued that non-audit services are not performed for managerial interests at variance to those of the shareholders.9 These arguments could be used in opposition to the non-audit-service proposals in the Release, but they are not cited or rebutted.
The recent study of non-audit services by Benito Arrunada is omitted.10 Arrunada concludes:
[T]he provision of non-audit services reduces total costs, increases technical competence, and motivates more intense competition. Furthermore, it does not necessarily damage either auditor independence or the quality of non-audit services.... [A] Auditors should be allowed to provide all kinds of services and/or to self-regulate such provision. Regulation, if any, should focus on client diversification and should help the market to act as the main disciplinary agent.11
If the SEC disagrees with Arrunada's arguments, it should address and rebut them.
The Release's "Framework" --The Fact-Appearance Dichotomy
The Release and the proposed rules represent a radical departure from the current SEC rule in a number of ways, but most significantly in adopting a specific requirement that an auditor be independent in appearance as well as fact. The current Rule 2-01 does not incorporate an appearance standard. It is entirely based on the fact of independence. The Release separates the appearance of independence from the fact of independence. It argues that an appearance standard of independence in and of itself serves the purpose of allowing judgments to be made in the absence of anyone's ability to inquire "into the auditor's actual state of mind." Here is the full statement:
[T]he appearance standard serves an important legal purpose. It supplements an inquiry into the auditor's actual, subjective state of mind with an objective test: whether reasonable persons, knowing all the relevant circumstances would perceive that an auditor is independent. As the words connote, the appearance standard confines the inquiry into what is apparent and does not require an inquiry into the auditor's actual state of mind.
There are four fundamental problems with this elevation of the appearance of independence into a separate requirement, all of which are unresolved in the Release. (1) Appearances alone do not guarantee, or even contribute to, audit quality because appearances can be misleading. (2) Despite the assertion in the Release that it constitutes an objective test, the formulation of the appearance standard in the proposed rule looks to subjective criteria to measure independence which will lead to arbitrary and capricious application. (3) Evidence to date shows the investing public, in fact, perceives no appearance problem. (4) Requiring both the fact and appearance of independence when the fact of independence is treated as an inaccessible state of mind, and appearance is measured by subjective criteria, means that no auditor can ever reliably conclude that he or she will be considered independent by the SEC with respect to a given audit client.
(1) Appearance of independence for its own sake is not a suitable objective of the independence rules because an auditor who appears independent but is not misleads investors and violates auditing standards. Appearances at odds with the facts are the chief characteristic of fraud. There are no conditions under which it is desirable for an auditor to appear independent and not be independent in fact. In other words, the appearance of independence does not contribute to audit quality or improve the quality of financial information in the marketplace.
This problem inherent in the proposed appearance standard is not overcome by the Release's assertions about the need to generate "confidence" in the marketplace as an end in itself. Confidence in the securities markets can be either good or bad for investors, the economy and the public interest. The less that that confidence is grounded on economic facts and the more it rests on appearances and perceptions, the more it leads to speculative securities trading and economic instability. Reliable financial statements, audit quality, and actual auditor independence should lead to confidence in the market, not an over-reliance on the perception of these things. Investors are concerned by and are harmed by audit failures, which appearances and perceptions do not guard against. The SEC's attempt to impose a "Caesar's wife" standard on the auditing profession by insisting on appearances apart from the fact of independence is not in the public interest. The SEC's concern for a generalized faith in the market might be understandable if there existed a crisis of confidence among investors today. But that is simply not the case, and the Release does not claim that it is.
Research on investor attitudes also shows that the proposed approach is flawed. Relying on investors and their subjective perceptions to evaluate appearances is not an operable concept. We know from research performed for the ISB that investors do not know about the rules,12 and they have participated in ISB independence standard setting in numbers suggesting their interest in independence standards is unlikely to change in the future. Investors also are unaware of the personal relationships and interests of the audit team and cannot be expected to be aware of them. Their level of interest reflects not only a sensible division of labor, but also what is practicable. The ISB issued a standard, with the SEC's support, to require auditors to share potential independence issues with the audit committee, which presumed that audit committee members did not already possess such information. In light of what that says about everyone's understanding of audit committee members' knowledge of facts affecting auditor independence, it stands to reason that persons further removed from the audit do not know these things. They trust those responsible for the auditor's independence, including the auditors themselves. If investors take no interest in independence standards or the conditions that make for independence, lack the facts to evaluate independence, and are otherwise unequipped to evaluate it, an appearances standard of independence can have no substantive meaning.
(2) The second major problem with the proposed rule on appearance of independence is that it creates a subjective standard which will lead to inconsistent and even arbitrary applications of the rule. As the quotation above indicates, the Release, at least in this section, posits that independence is a state of mind. However, if one cannot penetrate into the auditor's state of mind, it makes no sense to create a standard based on asking others to do so or to hypothecate investors who might. Thus the difficulty identified by the SEC in the Release, that the state of mind cannot be penetrated or measured, is just as much a problem for the appearance of independence approach as for the fact-of-independence approach.
The Release does not define the appearance of independence, so it cannot be clear on what it is that investors perceive that the SEC is proposing to measure when the rule is applied. The Release may be assuming that independence is the equivalent of objectivity, the most frequently cited state of mind intended to signify independence. However, if independence means objectivity, there is no reason for the term "independence." Using the more common and unmistakably understood term "objectivity" would make matters clearer to all participants in the financial reporting process. Adoption of the appearances criterion as formulated in the Release will give the SEC the power to be the arbiter of both what constitutes the "appearance of independence" in the minds of investors, as well as whether a particular situation is such that, in the minds of investors, that appearance is lacking.
The problem of the subjective nature of the standard is aggravated by the fact that the Release does not use the appearance formulation quoted above from the commentary -- with its notion of "reasonable persons, knowing all the relevant circumstances" (emphasis added) -- in the text of the actual rule. Using an "all relevant circumstances" test (like that used in the current Rule 2-01) would be a step in the right direction toward a more objective rule yielding consistent results. The actual rule proposal uses instead the concept of the perceptions of "reasonable investors." The switch is significant for understanding the criterion at work. The reasonable person fully aware of all the relevant facts and circumstances is a variation of the legal concept for arriving at the fact of liability in light of available facts. In that scenario the reasonable person is hypothetical, not real. The criterion is a device to arrive at difficult-to-determine facts in what seems a fair manner. The "perceptions of reasonable investors" literally refers to what actual investors have subjectively perceived or are alleged to have perceived based on what (limited) facts they have, not to a hypothetical reasonable person knowing all the relevant circumstances. Reasonable investors are not aware of all the relevant facts and circumstances. As noted above, available research shows that they do not know independence rules, take almost no interest in independence standard setting, and are and must be unaware of the relationships and interests of the audit team. They are and must be equally unaware of the internal safeguards in place at accounting firms other than published standards. They do not know about the auditor's independence by perceiving the things that the independence standard setter must consider in order to reduce the risk of compromised objectivity.
Adopting the rule as formulated in the Release without grounding it in an objective criterion such as an actual risk assessment in light of all relevant circumstances will lead to findings of independence impairment based on the Staff's "Gut" reactions that a situation is one that would be perceived by investors (without all the relevant information) as indicating a lack of objectivity, even if the Staff subjectively does not think objectively is actually threatened.
(3) The third flaw in adopting the appearance standard is that there is no empirical evidence that investors think one is necessary. We have good reason to believe that auditors are now viewed as independent professionals. The research performed by the Earnscliffe organization for the ISB showed that most participants in the study had a positive image of the competence and objectivity of auditors.13 Thus, accepting the SEC's premise on the appearance of independence would lead to rejecting the non-audit proposals in this Release.
(4) The fourth problem created by the proposed rule is that the Release provides no guidance to members of the profession on how to assure that they are deemed independent by the SEC. The Release treats both independence of mind and independence of appearance as separate, equally important objectives. But if, as shown above, independence in appearance cannot be reliably and objectively determined in advance under the proposed standard, the question then arises whether the rule's required independence in fact can ever be demonstrated by an auditor to the SEC's satisfaction. It cannot because in the Release it is characterized as an inaccessible state of mind. For these reasons, as well as because of the flaws in the appearances approach already noted, requiring both independence of mind, or objectivity, as well as independence in appearance means no auditor can ever be certain in advance that his or her conduct and relationships will not be deemed to impair independence.
The literature on the concept of auditor independence also supports avoiding an "appearance of independence" formulation like that in the Release. As readers of the ISB's Conceptual Framework Discussion Memorandum know, there are many different ways to define independence. KPMG offered the following definition of independence to the ISB: "Audit independence is an absence of self-interests that create an unacceptable risk of material bias with respect to audit decisions." In arriving at this definition we were influenced by the SEC's and the profession's rulemaking over the decades. SEC rules have generally prohibited interests that are considered threats to objectivity. For example, the reason direct investments by auditors in their clients is prohibited is not because of how it "looks," nor because it guarantees that an auditor will be biased. Rather, it is a determination that the situation creates too great a risk to objectivity. Defining independence in terms of the risk of threatened objectivity is therefore consistent with most of the SEC's rulemaking over the years. In fact, it may well be what the Release is trying to achieve, but the proposed rule, as drafted, fails to do so.
Adoption of a risk-based definition, such as the one proposed by KPMG, would save the SEC from the defects of its treatment of independence in the passage above. Were the treatment to become a requirement, it would impose a major cost and achieve no worthy objective. Mandatory requirements for auditor independence that are incapable of achievement will sooner or later damage confidence in the auditor's role. In the meantime it would create hardships and costs as professionals attempt to demonstrate that they comply with what cannot be complied with.
The Release's "Framework" -- "Principles"
The Release sets out what it terms "principles." They are not explained, and they, like the appearance-of-independence criterion, are unaccompanied by a definition of independence.
The "principles" are otherwise vague and indeterminate. To say that an accountant is not independent if he or she "has a mutual or conflicting interest with the audit client" and to apply the language literally is to render no auditor independent. It would be impossible to have no mutual or conflicting interest. The two ideas (mutual and conflicting interests) are opposites covering all possible types of interests. If management is honest and shares with the auditor an interest in reliable, informative financial reporting, the auditor is arguably not independent. If the auditor comes across an indication of financial statement fraud, the act of pursuing it arguably renders that auditor's interests in conflict with those of the client, thereby making that auditor not independent of the client. The "principle" is not even limited to matters that could affect the audit. If client management and the auditor support the same political party and presidential candidate, it could be argued that the auditor is not independent. These outcomes cannot be intended consequences of the "principles." The same is true of the "principle" on advocacy. When the auditor signs an audit report with a clean opinion, has that auditor in any way become an advocate of the client? When the auditor accompanies a client to a conference with the SEC staff, is that auditor an advocate? Would agreement or disagreement with the position of the SEC staff determine whether the auditor was an advocate of the client in such a conference? The "principle" on auditing one's own work is also vague and indeterminate. When the auditor proposes adjustments and they are made, is the auditor then guilty of auditing his or her own work when giving a clean opinion? The "principle" equates independent preparation of information by an auditor with managerial preparation of such information. An investor is protected when an independent party performs a calculation in the same way that the investor is protected by the audit. In both cases the numbers reflect the input of a competent party who cannot benefit from what the financial statements say.
One of the reasons the principles are problematic is that they are given as absolutes. They are not stated in terms of an unacceptable risk that the auditor will suffer a material impairment of objectivity (be materially biased). The effect is to create an incompatibility between the principles and the rules. The audit fee is a financial interest, yet it has been accepted as compatible with independence and objectivity since independence rules were first formulated. In the complicated world of the audit process lines have to be drawn short of absolute absence of all possible influences on objectivity. They always have been so drawn, even by the SEC. They can never be drawn in total conformity with absolutes. Therefore, those who draw up principles of independence will either state them in terms of independence risk (or a surrogate) or establish incoherence between what it means to be independent according to the principles and what it means to be independent according to the requirements for audit independence.
The nebulous formation of the principles creates requirements that are impossible to fulfill, subject to arbitrary application, and fraught with risks of inadvertent noncompliance. It is not in the public interest for auditors to find it impossible to know whether they are in compliance with independence rules. The rule proposal contains a catch-all provision to the effect that meeting requirements of the specific restrictions in part (c) of the proposed rule may not be enough.14 In other words, the SEC would always be able to say without reference to specific requirements of section (c) of the rule that it believes the accountant has not been in compliance with the "principles." No regulatory body should be entrusted with such boundless authority of undefined scope.
Applications of the Release's "Framework"
The Release comprises a top-to-bottom overhaul of the independence rules. It contains hundreds of specific questions and requests for comments, exactly how many is difficult to determine. Our general response to several of the questions are noted below. We have included more detailed responses in the attached Exhibit.
The myriad shortcoming of the Release are undoubtedly owing in part to the haste with which it was assembled, but they also appear to be owing to a desire to extend current independence rules in a variety of inadequately considered ways in response to what the Commission staff seem to believe are problems not addressed by the current rules. The result is a hodge podge of poorly conceived restrictions that will have undesirable consequences if implemented.
Affiliates and indirect investments
Adoption of the Release's definition of "affiliate of the accounting firm" would expand the entities that would be required to adhere to independence rules, creating hardships with no positive effects on the objectivity and quality of audits and no benefit to the public interest. The "accounting firm" to which independence rules would apply would include all entities that meet the Release's definition of affiliates of the accounting firm, including, among others (a) any person or entity five percent or more of whose outstanding securities, partnership units, or other interest entitling a person to vote are directly or indirectly owned, controlled or held by the accounting firm (thereby capturing investees of the firm or its pension plan in which direct and indirect investments aggregate 5% or more of voting shares), (b) any joint venture or other undertaking in which the accounting firm participates and in which the parties agree to any form of shared benefits, including any form of shared revenue, income, or equity appreciation, and (c) any entity that provides non-audit or other professional service to one or more of the accounting firm's audit clients, and in which the accounting firm has an equity interest in, has loaned funds to, or shares revenue with, or with which the accounting firm or any covered person in the firm has any direct business relationship. Alliances with other companies to deliver services or to perform certain projects jointly are commonplace; indeed they are a key feature of the way services are delivered in the so-called "New Economy." Acceptance of this definition would effectively prohibit accounting firms from entering these types of business relationships for the delivery of non-audit services in the New Economy and cripple their competitiveness in the marketplace. Yet no realistic threat to independence from audit clients is caused by these relationships.
The proposed "affiliate of the accounting firm" definition results in the expansion of the scope of the proposed independence rules with the proposed prohibition against an accounting firm or any covered person of the firm owning more than five percent of an entity (a) that has an ownership interest in an audit client(no matter how small, say, one share), or (b) in which the audit client has an ownership interest (again, no matter how small). Under this definition, a firm's independence would be impaired if a covered person had an investment of greater than 5% in a limited partnership or fund in which a client had also invested, no matter how inconsequential the client's investment, or which invested in a client's securities, again, no matter how inconsequential that investment. Few, if any, reasonable investors can possibly believe that independence rules on indirect investments need go that far.
The Release proposes to change the definition of "affiliate of the audit client" from an entity controlled by or controlling the audit client, as currently defined in Regulation S-X, to "an entity that has significant influence over the audit client, or over which the audit client has significant influence." In the past, materiality was considered in determining whether independence issues were raised by investments in or non-audit services provided to (a) equity-method investees of audit clients , or (b) investors with equity-method investments in audit clients. Under the proposed definition of "affiliate of the audit client," providing prohibited services to an audit client's immaterial equity-method investee that is audited by another firm would impair the independence of the accounting firm that provided the services. Again, we believe that few would find need or reasons for independence rules to have such reach.
The proposed restrictions on business relationships illustrate the expansion of entities to which the independence rules would apply at its most convoluted. An accountant would not be independent if the accounting firm (including affiliates of the accounting firm), or any covered person in the firm "has any direct or material indirect business relationship with an audit client, an affiliate of an audit client, or with an audit client's or an affiliate of an audit client's officers, directors of record or beneficial owners of more than five percent of the audit client's or affiliate's equity securities." The net is cast too far. The problem is exacerbated further by the lack of any definition of the nebulous term "business relationship." The cumulative effect of these proposals would be a completely unwarranted expansion of the entities for which an accounting firm could not provide audit services, further crimping the ability of the firms to compete in these markets, with no real reduction in risk to auditor objectivity.
Investments and family employment relationships for individuals
We applaud the efforts of the SEC, the ISB, and the AICPA to modernize the independence rules related to investments and employment of relatives of individuals in the accounting firm by developing an "on the engagement" or "covered person" approach to these rules. However, the Release's treatment of "covered person" expands the notion unreasonably in several ways. For example, the "audit engagement team" would include "all persons who consult, formally or informally, with others on the engagement team during the audit, review, or attestation engagement regarding technical or industry-specific issues, transactions or events." If, as an example, a senior staff accountant on an engagement were to call a staff accountant in a separate office for advice on a matter related to the engagement, perhaps because the senior staff accountant remembered from a firm training session that the staff accountant had particular experience and knowledge, the staff accountant would, before responding, have to determine whether her and her husband's investments included shares in the audit client.
Also, under the Release, any partner, principal or shareholder of the accounting firm from an "office" that participates in a significant portion of the audit would be considered a "covered person," where "office" is defined to include "a distinct subgroup within an accounting firm, whether distinguished along geographic or practice lines," and "whether constituted by formal organization or informal practice." This is too vague and sweeping to be capable of implementation or predictable application.
"Covered persons" include those in the "chain of command," defined in the Release to include "all persons having any supervisory, management, quality control or other oversight responsibility," and "all partners, principals, shareholders, and managers who may ... influence the performance appraisal or compensation of any member of the audit engagement team" (emphasis added). Words such as "all," "any," and " may ... influence" are too vague and sweeping to be capable of consistent application and are far too inclusive.
We support the approach utilized in the ISB's exposure draft on Financial Interests and Family Relationships, which strikes a more reasonable balance on these definitions.
In the Release's proposals concerning non-audit services, the framework of the general standard and four principles is used to justify prohibitions based on subjective perception of what might appear to possibly create bias. The proposals contain comments about how non-audit services "may... alter relationships between auditors and their audit clients," and "may give rise to a mutuality of interest between the auditor and his client," and how investors "may perceive" that a problem exists. This is a shaky and unacceptable foundation for rule-making. The Release also completely fails to acknowledge how the provision of certain non-audit services improves an audit client's financial reporting capability and increases the quality of the audit and the reliability of the client's financial statements. Specific examples include the following:
Other proposals dealing with non-audit services have similar weaknesses. However, the examples cited above adequately illustrate the careless use of a flawed framework to generate unjustified prohibitions and possibly unintended consequences.
The Argument for Disclosure
The Release notes in support of its proposed additional disclosure requirements that "Investors should have enough information to enable them to evaluate the independence of a company's auditors." The disclosure of non-audit services is a single feature of whether or not the auditor is independent. "Enough information...to evaluate the independence of a company's auditors" would encompass much more than information about non-audit services. It would entail the independence requirements and the full disclosures made to the audit committee under ISB Standard No. 1. And since the disclosures would originate with the auditor and be designed to evaluate that auditor's independence, "enough information" would logically have to include the documentation to evaluate the validity of the disclosures (investment portfolio information and so forth) and the safeguards in place. It is difficult to understand how the disclosure of non-audit services would enable investors to make an informed decision about auditor independence more capably than the audit committee can using the disclosure required by ISB Standard No 1.
Experience with the earlier, subsequently rescinded non-audit-services disclosures required by Accounting Series Release No. 250 suggests that the disclosure proposals in this release would not achieve any worthwhile objective. Empirical analysis showed that the ASR 250 disclosures on the provision of non-audit services had no effect on auditor approval ratings.15 Moreover, in rescinding ASR 250, the SEC stated:"[T]he rule is being rescinded because the Commission has concluded that it is not generally of sufficient utility to investors to justify continuation of the disclosure requirement....[C]laims of shareholder interest in the non-audit service disclosure and [some commentators'] allegations about accountants' independence and fair competition are outweighed by the absence of evidence that investors want or use the disclosure."16
We note that the Release omits the points in the paragraph above from its explanation of the decision to rescind ASR 250.
Proposal to Regulate Accounting Firms' Quality Control
The Release contains provisions openly designed to compel the adoption of independence quality controls and to require unreasonable sanctions should a firm's system of quality controls be considered less than acceptable. In other words, they are a substantive regulation of quality control, not a form of defining independence. We believe that these provisions are not only an unnecessary and undesirable extension of regulatory reach, but that they also fall outside the scope of the SEC's express legal mandate.
The intent to regulate is clear in this passage:
Paragraph (d) of the proposed rules establishes a limited exception for accounting firms that maintain certain quality controls and satisfy certain conditions. We are proposing this exception to encourage accounting firms to adopt internal quality controls that ensure the independence of the firm's auditors. In addition, we are proposing this section so that accounting firms that have appropriate controls will not be deemed to lack independence when the particular auditor did not know, and was reasonable in not knowing, the circumstances giving rise to the impairment.
The last sentence contains a self-sufficient criterion for excusing an instance of inadvertent noncompliance - that the auditor did not know and was reasonable in not knowing. The public interest is ill served when a person who did not know and was reasonable in not knowing about a regulatory violation and who promptly corrected the situation upon gaining knowledge is nevertheless made by the regulator to suffer for it. This is for the simple reason that it is impossible to think that a violation of an independence rule of which an auditor is unaware could lead to bias or compromise of the auditor's objectivity. But to this self-sufficient criterion is added the requirement to have what the SEC deems an adequate system of quality controls over independence. Moreover, the release specifies the characteristics of such a system, thereby setting requirements for quality control. Even the related questions are evidence of the SEC's intent: "We request comment on whether these are the appropriate elements of an effective quality control system....Are there other quality controls that should be required?"
The SEC's authority to regulate auditors and particularly to set requirements for quality control was treated in a 1979 memorandum from Ralph Ferrara, then General Counsel of the SEC, to Clarence Sampson, then Chief Accountant. Sampson had requested Ferrara's views on "the Commission's authority `to regulate accountants who practice before the Commission'" and in particular " "`the source and nature of the Commission's authority to compel accountants to meet certain standards requiring such things as quality control policies and procedures and peer review.'" Ferrara pointed out that "[T]he statutes administered by the Commission do not expressly authorize the Commission to promulgate professional standards or to oversee the practices of the accounting profession." His memorandum goes on to say that express authority is given to define accounting terms, including what it means to be independent, and to prescribe accounting for filed reports.17
There is a close relationship between the quality control provision and the design of the SEC's proposals on other matters in the Release. Put simply, the vaguer and more impossible the rules are to comply with, the greater the risk of inadvertent non-compliance and the more the SEC's exception for quality controls becomes vital to accounting firms. Thus the proposed rules themselves, as adjuncts to the explicit exemption, are beyond the SEC's legal mandate because they are part and parcel of the regulation of auditing firms' internal quality controls, rather than merely defining independence. This can be inferred from the last sentence of the quotation above, which forces one to ask, "Why should an auditor attempting to comply with the proposed general principle and specific rules reasonably not know about an infraction?" The answer is that the Release's proposed requirements are so vague, so unbounded, so indeterminate that no reasonable auditor could ever be certain of being compliant.
Even if the proposal did not exceed the SEC's legal mandate, the quality controls provisions are unnecessary and counter-productive. We, and the profession, agree that the accounting firms should have appropriate quality control systems in relation to auditor independence requirements, and there is in place an extremely rigorous self-regulatory system of audit quality, including strenuous requirements for auditor training and continuing education, peer reviews that focus on independence issues and compliance systems, professional practice specialists in the firms, second partner reviews, and a highly developed professional disciplinary mechanism. Accounting firms are currently investing millions of dollars in enhancing their independence training and compliance systems. The SEC Practice Section of the AICPA has recently adopted strict additional requirements for firm quality control systems. Disincentives to compromised auditor objectivity are enormous; compromise would be a potential career-ending event for the individual and would create potential liabilities to the firm far exceeding any one-time consulting fee. These plus the accounting firms' inherent concern for the public interest, the importance of integrity and reputation to the value of their reports, and the activity of professional organizations, such as the AICPA, compel the development and maintenance of appropriate quality controls.
By the manner in which it has issued this Release and in the substance of the Release , the SEC is undercutting the very entities that it is encouraging to take on expanded responsibilities for auditor independence, namely, the ISB, POB, and audit committees. There is no reason to undercut these groups, and none is given in the Release.
In our view, the SEC lacks the legal authority to adopt the rule as proposed. No statute grants the SEC the sweep of authority over the accounting profession that the proposal presumes, including the authority to regulate based on "appearances," and the SEC's power is limited to the power Congress has chosen to grant it - as even the SEC's own regulations acknowledge.
Lack of a global perspective
The SEC, by the manner and substance of this release, has similarly undercut the cause of international standards and the bodies working to create them. Auditor independence rules are one component of international standards, and the independence rules for auditors of SEC registrants affect auditors around the globe. The damaged parties are among those for whom the SEC has repeatedly expressed its support in the effort to develop a high quality global financial reporting structure.
The proposals in the Release do not reflect any consideration of foreign business practices, independence standards, and auditor responsibilities. The proposed rules are designed to address situations specific to the U.S. There is no attempt to consider differing situations in foreign countries, foreign approaches to auditor independence, or current attempts to develop global auditor independence standards. This is a major omission.
We refer you to the submission of our European affiliates, which addresses many of the national differences that are not considered in the Release.
Costs and Benefits
The analysis of the costs and benefits of the proposed rules fails to show that benefits exceed the costs. No empirical evidence shows that non-audit services damage audit quality, auditor objectivity, the auditor's appearance before investors, or investors' confidence in auditors or financial statements .
Since there is no empirical evidence that independence or audit quality have been harmed by performance of the non-audit services that would be prohibited, there can be no benefits to independence or to audit quality from the prohibitions. Similarly, since there is no empirical evidence that investors' confidence in auditors (appearance of independence) has been harmed by performance of the non-audit services that would be prohibited, there can be no benefits to investors' confidence or to auditors' appearances from the prohibitions.
The above is stated solely from the perspective of the absence-of-harm finding. However, as noted above, the Panel on Audit Effectiveness found benefits to audit quality from performing non-audit services. We firmly believe that audit quality is enhanced by both the greater knowledge of client operations that results from provision of non-audit services and the expanded expertise and sensitivity of auditors trained to be knowledgeable about business and risk issues beyond traditional accounting and auditing. We also believe that the ability of the audit firms to attract top talent will be impeded by rules that unnecessarily constrict the ability of the accounting firms to provide non-audit services and expand their business. The accounting firms have been dynamic participants in the growth of the service economy, and their dynamism and creativity in responding to that growth have made them attractive career choices. The proposals in the Release would stifle this dynamism and creativity and reduce the attractiveness of accounting as a career.
It has become a commonplace that the New Economy is rapidly generating demands for new and expanded business information on a virtually real-time basis, and that public companies will need new attestation and other services from their accounting firms to meet this demand for reliable, timely information. Information needs of investors are changing; new reporting models are under consideration. Accountants will need new skills to meet these demands. The accounting firms will need to be able to attract people with the skills and analytical abilities to deal with the new environment, and will need to develop their own internal skill and service capabilities and draw on other companies with complementary skills. If adopted, the Release will undermine the ability of the accounting firms to meet these needs. It will severely curtail their abilities to enter into strategic alliances, develop and provide non-audit services, and attract the appropriate intellectual firepower. Denying the accounting firms the capabilities that they need to respond to the information needs of the New Economy serves nobody's best interests.
The ability of the accounting firms to offer non-audit services and grow their revenues helps generate the capital for investment in audit tools and techniques necessary in an increasingly challenging business environment that will continue to expand its demands for attest services on non-traditional information used by investor and others. Hampering the ability of the accounting firms' to generate the capital necessary to meet those demands can only harm the public interest.
We must also presume that clients and their shareholders benefit from auditors' provision of nonaudit services. Voluntary purchases over a long period indicate this, and so do the advantages audit firms can sometimes bring to providing such services because of their knowledge of the client's operations.
Many of the proposed rules are too vague to be applied consistently, a failing that should disqualify any proposal by any regulatory body. The costs from difficulties caused by the proposed rules' nebulousness are not considered in the Release's passage on costs and benefits. They would affect audit committees as well as auditors. Audit committees receive from auditors, in accordance with ISB Standard No. 1, a report of all matters the auditor believes bear on the firm's independence. Because of the vague rules proposed in the Release, it would be impossible for audit committees to evaluate the information and would be difficult for auditors to provide it on a consistent basis.
Some costs are impossible to weigh, but the Release will surely damage the quality of future audits, and hence negatively affect the public interest if it is not withdrawn. What is the cost of reneging on the agreement with the profession to ceate the ISB, an agreement that was the SEC's idea and pursued vigorously by it, thereby straining the trust between the profession and the Commission that has been a benefit to the financial reporting process? Of upstaging the ISB's conceptual framework project? Of exceeding the SEC's legal mandate under the securities laws by proposing quality control requirements? Of forcing the adoption of independence quality controls that must be inefficient because there is no way to be certain of compliance with the Release's proposed rules? Of weakening audits because audit firms, shorn of non-audit services, would be less attractive to talented graduates? Of reducing audit firms' sources of revenues from appropriate services and therefore the capital they need to improve audit technology? Of greater costs for registrants who purchase non-audit services in a less competitive market without benefit of providers who are familiar with their business, a feature that can lower the cost and add to the effectiveness of non-audit services? Of the loss of improvements in the quality of financial reporting owing to various non-audit services that auditors in the past provide but would now be prohibited? Of the harm to international standards from adopting rules that will make harmonized independence requirements virtually impossible to achieve?
The Release starts from a flawed and inadequate conceptual base; deals with a bewildering array of complex issues that should be broken into more manageable components for proper consideration, debate, and resolution; establishes an unreasonable time-table ; contains a myriad of suggested applications that are harmful to the profession, audit clients, and investors and are incapable of consistent application; results in regulatory overreach that is harmful to the private-sector organizations that the SEC encourages; and ignores the international dimension. It is blind to counterarguments and to findings of respected studies, and so loosely worded that it would create arbitrary power. It harms the ISB, and disregards commitments undertaken when the ISB was created in response to the SEC's initiative. In these and other ways, the Release threatens the Commission's reputation for fairness, integrity, and good sense. We repeat our recommendation that the Release be withdrawn and the ISB be permitted to resume its work.
If you have any questions about our response, please contact John M. Guinan at 212-909-5449 or firstname.lastname@example.org.
Very truly yours,
Model Conceptual Framework of Auditor Independence
The primary purpose of this conceptual framework is to arrive at a language for discussing auditor independence and to describe how auditor independence should be maintained. The framework is intended for all parties interested in auditor independence. It is particularly intended for use by those responsible for maintaining auditor independence. Those who take on this responsibility include standard setters, regulators, firms, and individual auditors. Those who participate in setting independence standards take on the same responsibility.
The Definition of Independence
The definition of the term independence is the beginning of the conceptual framework. If the term is not used consistently in discourse on the subject, precise communication will be impossible and the orderly maintenance of independence will suffer. The definition below is what should be understood by "independence" in all subsequent passages in this conceptual framework.
Audit independence is an absence of self-interests that create an unacceptable risk of material bias with respect to audit decisions.
This definition is based on the paramount importance of the auditor maintaining his or her objectivity when examining financial statements. Bias is a negative way of expressing objectivity. The "self-interests" mentioned in the definition could be of any kind. They could be psychological (for example, the emotional influence of a relative in top management) or economic (for example, ownership of shares in the auditee), provided they had the stated effect on bias in making audit decisions. Matters that do not have such an effect, and only such matters, would be excluded.
The definition expresses both the likelihood that bias will occur (an unacceptable risk) and the magnitude of the bias that might occur (material bias). These terms correspond to precision and reliability in statistical theory.
This definition is consistent with the way most independence rules have been set. Most independence rules in the past have prohibited self-interests that presented unacceptable risks of material bias. The rules never attempted to ban all self-interests that threaten objectivity, which would be impossible. Indeed, any pretense to banning all bias-threatening self-interests would be misleading.
The definition of independence is the first concept in this framework. That is, the term is an abstract idea. It has been treated separately from other concepts because it is essential to understanding them. It is the foundational idea of this conceptual framework.
For purposes of coherent discourse on independence, it is necessary to define terms in addition to independence and to explain their relationships. The terms should be assumed to retain the defined meanings throughout this conceptual framework.
Threats to auditor independence are conditions and circumstances that can create objectivity-impairing (that is, bias-causing) self-interests. Thus, the threats are what can create self-interests incompatible with independence as it has been defined. Note that the capacity to create such self-interests is not the same as actually creating them. The term "threats" expresses this distinction.
Objectivity-impairing self-interests can arise from activities (for example, taking on the role of auditee management) or relationships (for example, a family member in the top management of the auditee), or financial holdings (for example, financial interests in an auditee). No set of categories designating the conditions and circumstances mentioned in the definition limit the threats. All conditions and circumstances, regardless of how they might be designated, are threats to auditor independence if they can create objectivity-impairing self-interests.
Safeguards are controls that mitigate or eliminate threats to auditor independence. Safeguards include prohibitions, restrictions, and other policies and procedures put in place by standard setters, regulators, or auditing firms. The defining characteristic of a safeguard is whether or not it mitigates or eliminates threats to auditor independence, not whether it meets some definition of a control.
Independence risk is the risk that self-interests will create material bias in making audit decisions. Because bias-threatening self-interests arise from threats and are mitigated or eliminated by safeguards, the level of independence risk is determined by the balance of threats and safeguards.
Independence risk can range from zero to 100 percent. Along this spectrum of risk is a level that is unacceptable. The aim of persons responsible for audit independence should be to maintain an acceptable level of independence risk. A level of independence risk is unacceptable if bias-creating self-interests will affect the outcome of the audit. It is impossible to ascertain when this level has actually been reached. For practical purposes, those responsible for auditor independence estimate effects from threats and safeguards and arrive at a level of independence risk they believe best approximates the acceptable level.
Independence risk is closely related to audit quality. This is because an acceptable level of independence risk contributes to the likelihood of objective auditing, which in turn contributes to reliable financial statements. An acceptable level of independence risk therefore enhances the likelihood of a quality audit.
Audit independence and the concepts and principles defined here are only part of the story of what makes for audit quality. Auditors must be competent, must have integrity, and must apply effective audit procedures. All these matters, and others, make audit quality more likely. Audit independence, then, is not sufficient in itself to create that outcome.
The following principles are intended to apply to all steps by all parties for the sake of auditor independence.
1. The purpose of auditor independence is to make it more likely that audits improve the reliability of financial statements.
This principle locks auditor independence into the service of audit quality. It thereby also locks auditor independence into the public interest. Reliable financial statements help investors and creditors make better decisions in allocating their capital. In this way, quality audits play an influential role in the effectiveness of capital markets, and effective capital markets are essential to our economy.
2. Parties responsible for auditor independence shall take prudent steps to maintain an acceptable level of independence risk.
Principle 2 follows from principle 1. Because of the consequences for the capital markets, the economy, and the public interest, parties responsible for auditor independence should take action in the cause of acceptable levels of independence risk. However, the precise level of unacceptable independence risk cannot be ascertained. It is subject to estimates. No more is practicable in these circumstances than what is prudent.
3. When considering the need for action to modify independence risk in response to a threat to auditor independence, parties responsible for auditor independence shall evaluate the threat in terms of the level of independence risk it generates and the effectiveness of relevant safeguards that mitigate or eliminate the threat.
4. Parties who cannot influence an audit do not affect independence risk.
5. When considering the need for action to modify independence risk, parties responsible for auditor independence shall weigh the related costs and benefits.
Principles 3, 4 , and 5 give meaning to the mandate for prudent steps to maintain an acceptable level of independence risk in principle 2. It is impossible to arrive at public-interest steps to maintain an appropriate level of independence risk without evaluating the net effect of relevant threats and safeguards. This in turn is not possible without identifying the parties whose conditions and circumstances affect independence risk. No steps would be prudent if they were not based on a best-efforts estimate of the threats to independence and the safeguards in place and that might be put in place; if they ignored the costs and benefits of the policy options under consideration; or if they fell on parties who could not affect independence risk.
6. Standards, policies, and practices for maintaining an acceptable level of independence risk shall be consistent with one another.
Standards, policies, and practices to control independence risk would not be equally consistent with these principles if they were not consistent with one another. It serves the public interest to encourage compliance by consistency and to avoid the disrespect bred by inconsistency.
1 Public Oversight Board, Scope of Services by CPA Firms, American Institute of Certified Public Accountants, 1979. The letter is bound at the front of the book. The second quotation is on page 4.
2 Advisory Panel on Auditor Independence, Strengthening the Professionalism of the Independent Auditor, Public Oversight Board, September 13, 1994.
3 Ibid, p. 7.
4 General Accounting Office, The Accounting Profession, September 1996, GAO/AIMD-96-98, p. 56
5 Earnscliffe Research & Communications, Report to the United States Independence Standards Board: Research into Perceptions of Auditor Independence and Objectivity, November 1999, p. 8 and p. 46, item 2.
6 The data has long been reported to the AICPA's SEC Practice Section and been publicly available at the Section.
7 The Panel on Audit Effectiveness, Report and Recommendations, Exposure Draft - May 31, 2000, par. 5.7.
8 The Panel on Audit Effectiveness, Report and Recommendations, Exposure Draft - May 31, 2000, par. 5.17.
9 Ibid, pars. 5.39-5.58.
10 "The Provision of Non-Audit Services by Auditors: Let the Market Evolve and Decide," International Review of Law and Economics, 19:513-531, 1999.
11 Ibid, pp. 527-528.
12 Earnscliffe, November 1999, "Outside of those who were or had been auditors, very few people had any significant knowledge about the safeguards that exist within the audit firm. Most had a sense that there were laws and regulations governing the question of independence, but few had a clear picture of what they were, who mandataed them, and how rigorously they are applied," pp. 19,20. Earnscliffe, July 2000, Phase II, "Other than those with auditing experience, few had any detailed knowledge about the safeguards that exist today..[of the "Investing Public"] Few had any detailed knowledge of what an audit consisted of, or the safeguards to ensure that it was done in an independent fashion, but the tendency was to assume that auditors and auditees, more often than not, shared a desire to present accurate financial information," pp.9,44.
13 Relevant citations from the Earnscliffe research are given above in the section titled "Misuse of Evidence."
14 "An accountant is not independent under the standard in paragraph (b) of this section [the four principles plus the fact or appearance requirements] if, during the audit and professional engagement period, the accountant has any of the financial, employment or business relationships with, provides any of the non-audit services to, or receives a contingent fee from, the accountant's audit client or an affiliate of the audit client, as specified in paragraphs (c) (1) through (c)(5) of this section, or otherwise does not comply with the standard of paragraph (b) of this section." The italicized language creates an open-ended, totally undefined requirement.
15 G. William Glezen and James A. Millar, "An Empirical Investigation of Stockholder Reaction to Disclosures Required by ASR No. 250, Journal of Accounting Research, p, 859, 1985, cited in Harvey L. Pitt and David E. Birenbaum, Serving the Public Interest: A New Conceptual Framework for Auditor Independence, October 20, 1997, p. 53.
16 ASR No. 304. Quoted in Pitt and Birenbaum, p. 54.
17 The memorandum is reprinted in Securities Regulation and Law Report, No. 532, December 12, 1979.