Ray J. Groves
15 West 53rd Street
New York, NY 10019
My statement and comments represent my personal views, which are based on my experiences in the following positions:
I share the Commission's belief that there is a need to "modernize" auditor independence requirements. I agree with many of the Commission's proposals, I could agree with some others provided some modifications were made, and there are a number of proposals with which I disagree. Specific comments follow.
The General Standard for Auditor Independence
I could agree with proposed principle no. 1 if one word were deleted. I agree with principles nos. 2 and 3. I disagree with principle no. 4.
Principle no. 1 - I agree that "conflicting interest with the audit client" can impair independence, but do not agree that every "mutual" interest with the audit client can impair independence. The meaning of "mutual" is far too broad for it to be used as a principle in this context. "Mutual interests" occur in many everyday matters, including legislation, industry associations, politics, chambers of commerce, charities, and school boards, without impairing independence.
For example, from 1985 (when I was Chairman of the AICPA) until 1995, I was involved in tort reform efforts that culminated in the "Private Securities Litigation Reform Act of 1995". These efforts involved a number of coalitions that included accounting firms and the audit clients of some of those firms. This "mutual interest" had no bearing on independence. Another example: when a company distributes its audited financial statements to shareholders, the company and its auditors have a "mutual interest" in the integrity of those statements.
Principles nos. 2 and 3 - I agree that auditor independence is impaired when the auditor "audits the accountant's own work" or "functions as management or an employee of the audit client".
Principle no. 4 - I disagree that auditor independence is impaired when the auditor "acts as an advocate for the audit client". Throughout my 40-year career, and for many years before that, it has been accepted practice for auditors to be advocates for their clients in tax matters. The AICPA Code of Professional Conduct and its predecessors have long acknowledged tax advocacy. A professional cannot provide tax services without being an advocate, nor would a company want to engage a professional to perform tax services who could not act in this capacity. It would be difficult for CPA firms to attract and retain top-quality tax professionals with these restrictions. As an independent director of SEC registrants, I believe the registrant and its shareholders are well served by auditor involvement in tax matters. But if the auditor could not act as an advocate in tax matters, my assurance level would be substantially diminished.
There is also a need for advocacy on accounting matters. In meetings with the Commission staff as an auditor, I have been asked whether I advocated a particular accounting method or practice of an audit client, for example.
There also are other service areas that may include advocacy (e.g. legislation) that, in my view, do not impair independence. Therefore, I believe that a different approach to advocacy is needed in the proposed rules.
I agree with most of the proposals related to individuals, except that I would prefer retaining the current proscription of direct investments in an audit client by all partners, principals, and shareholders of an accounting firm.
The proposal that an accounting firm could not purchase professional liability insurance from an audit client seems unfair. Very few insurance companies underwrite accountants' liability insurance. To eliminate some of the limited choices could result in either less insurance or, because of the reduced number of competitors, higher premiums for the firms that audit these insurers.
I agree with most of these proposals, except that I do not believe that it is necessary to change the Commission's long-standing practice of permitting a retired partner to become a director of an audit client after retirement, without the need for a "Rabbi Trust" for unfunded pension benefits, unless the retired partner was closely associated with the audit client, in which case a two-year waiting period is required. The current practice has served the public interest well, and the Commission should not propose rules that could make it more difficult for retired partners to become directors. There is a need for audit committees to draw upon the experience and counsel of retired audit partners. This was acknowledged in the "Report and Recommendations Of The Blue Ribbon Committee On Improving The Effectiveness of Corporate Audit Committees" (1999).
The nature of U.S. business relationships has changed in recent years, and is likely to continue to change. Companies are concurrently becoming suppliers, customers, competitors, and joint venture partners with one another. Not long ago such relationships were unheard of. Just as the Commission has encouraged capital markets to develop in new ways, it should allow market forces to develop relationships between auditors and their audit clients that reflect changes in the way business is conducted, but do not impair independence.
Certain of this Release's proposed definitions, e.g., "Affiliate of the Audit Client", would even further restrict business relationships. With respect to investments made by audit clients in non-audit clients and vice versa, the current rule only requires that the auditor be independent of the non-audit client if 1) the audit client investor's investment is greater than 5% of its assets or income, or 2) the audit client investee is material to the non-audit client investor. The proposal deletes this 5% materiality test and substitutes a "significant influence" test. A very small investment (less than 1% of assets) by an audit client could result in a significant influence in the non-audit client investee. For example, if IBM, Cisco, or Microsoft have investments in much smaller companies that are less than 5% of their income or assets, but represent a more than 20% interest in the investees, then the auditors of IBM, Cisco, and Microsoft would have to be independent of each of their client's investees. And the auditors of the investees would have to be independent of the investor (IBM, Cisco, Microsoft) as well.
As for the definition of "Affiliates of the Accounting Firm", it seems extreme to me that if an accounting firm owned as little as 5% of a non-audit client, that company would be subject to all of the independence rules, compliance with which the accounting firm probably could not control in many cases.
Before commenting on this subject, I would like to acknowledge that while others are sincerely concerned by the potential for impairment when an audit firm performs a large amount of non- audit services, I do not share this view. I have never observed any impairment of independence caused by the performance of non-audit services for an audit client, and those with this concern have never been able to cite an example of impairment of audit independence to me.
I agree that the SEC's independence requirements should "apply to all persons at an accounting firm who provide non-audit services to audit clients".
A. Bookkeeping or other services related to the audit client's accounting records or financial statements.
I agree with this proposal. I also agree with Footnote 160 which states that the SEC's current 1% of total audit fee exception would continue, although I suggest that 2-3% would be a more practical size test.
B. Financial information systems design and implementation.
I could agree with this proposal if there were a consensus on the definition of the two permitted categories of IS services - (1) "audit client's internal accounting and risk management control systems" and (2) systems that are not "significant to the audit client's financial statements taken as a whole". Because these permitted services and perhaps others would not impair independence, they can be monitored by the audit committee.
C. Appraisal or valuation services, fairness opinions, or contribution-in-kind reports.
I could agree with this proposal if the following sentence, which is in the Release but not in the proposed rule, were included: "Our proposals do not prohibit an accounting firm from providing such services for non-financial (e.g., tax) purposes".
I do not believe that the SEC should proscribe these services by accountants in other countries that permit such services to be performed by accountants.
D. Actuarial services.
I agree with this proposal as it seems to follow the current SECPS rule.
E. Internal audit outsourcing.
I could agree with this proposal with one revision. Limited amounts of internal audit assistance (vs. complete outsourcing) should be permitted for an audit client that maintains an effective internal audit department, but wishes to use its external auditor for specific functions (e.g., computer auditing) or for a specific location (e.g., an overseas subsidiary). Before the advent of complete outsourcing, this type of limited assistance was provided without raising independence concerns. Companies have a hard time maintaining adequate IS internal auditing personnel and hiring internal auditors fluent in foreign languages, so external auditor assistance can be necessary to them, served as an independent director for a company where such services were provided by the external auditor, with the approval of the audit committee. I would not object to a size test for such limited assistance, although I do not believe it is necessary.
F. Management functions.
I agree with this proposal.
G. Human resources.
I agree with this proposal to the extent it follows the current SECPS rule, which is titled "Executive Recruiting Services". However, consultation on compensation and organizational structure are not proscribed by the current SECPS rule, and should not be proscribed by the SEC. Indeed, audit clients often request the auditor's consultation on such compensation issues as stock options due to their growing accounting and tax complexitiessome created by the SEC. And as an auditor, I have been asked on a number of occasions about the organization and reporting of an audit client's financial department, without impairing my audit independence.
H. Broker-dealer, investment adviser, or investment banking services.
I could agree with this proposal except for the prohibition on the design of the audit client's "system for regulatory compliance". It is in the best interests of the securities markets to draw on the auditor's regulatory expertise in designing systems that comply with securities regulations. An audit committee can make a distinction between designing a system for regulatory compliance and designing and installing a complex multinational SAP package. As a result, the auditor could clearly be permitted to do the former, but not the latter.
The proposal should also make clear what is meant by the term "securities professional". I believe that there are a number of activities undertaken by corporate finance professionals at accounting firms, and the absence of a clearer definition of the term will leave those professionals unsure as to the permitted scope of their services.
I. Legal services.
In view of the ABA's recent reaffirmation of the rule against fee-sharing between lawyers and non-lawyers, this may be a moot issue. I would not, however, close the issue forever. The creativity of the law and accounting professions may someday lead to an organization structure that provides the safeguards or firewalls that would serve both the lawyers' and accountants' responsibilities to clients.
I do not believe that the SEC should proscribe legal services by accountants in other countries that permit such services to be performed by accountants.
J. Expert services.
I do not agree with this proposal. It is not good public policy to deny the public access "in legal, administrative, or regulatory filings or proceedings" to the accounting, audit, tax, and industry knowledge and expertise of certain auditors.
The Release proposes a transition period of two years for non-audit services. The Commission Release does not address a transition for the other proposals. For some of the proposed changes in Employment Relationships and in other areas, I recommend that a "grandfather" clause be given serious consideration.
For Quality Controls and some other proposals, a longer transition period may be necessary outside the U.S.
I could agree with this proposal only if the words "value added" were deleted. There are a number of occasions when audit and non-audit fees can very properly reflect "value added" for the services provided without any impairment of independence. For example, beating deadlines and discovering or preventing major problems are two situations that may deserve a "value added" fee element. It does not impair independence to reward a professional who excels in his or her performance, or who exceeds reasonable expectations.
I agree with the proposal, except to note the timing issue mentioned above in connection with the transition period.
Proxy Statement Disclosure
I disagree with this proposal. If the Commission issues a lengthy list of non-audit services that repair audit independence, then why require disclosure of services that do not impair independence? Requiring this disclosure would seem to imply that the auditor, the registrant, or its audit committee cannot be trusted to adhere to the SEC's rules.
If the Commission decides not to designate the specific non-audit services that impair audit independence, then proxy-statement disclosure of non-audit services would be reasonable. This is the situation in the United Kingdom, where non-audit services in total (not by each individual service) are disclosed.
And, if you will permit me to express a long-held personal belief, requiring disclosure of a list of unnecessary information is yet another example of the rampant "disclosure overload" in U.S. financial reporting.4
Because of the wide scope and dramatic changes included in this proposal, I encourage the Commission to allow the time necessary for the most affected parties, registrants, and their auditors to properly assess the potential financial and economic impacts of these proposals, as they also may be dramatic.
Ray J. Groves
|1||Ernst & Young|
|2||Current board memberships are: Allegheny Technologies Corporation, American Water Works Company, Boston Scientific Corporation, Electronic Data Corporation, Marsh & McLennan Companies, Inc., and Nabisco Group Holdings, Inc. Former board memberships were: Consolidated Natural Gas Company, Dominion Resources, Inc. and LAI Worldwide, Inc.|
|3||Legg Mason Merchant Banking, Inc., a wholly owned subsidiary of Legg Mason, Inc.|
|4||See Wall Street journal, August 4, 1994, "Here's the Annual Report. Got a Few Hours?", and Financial Executive, May/June 1994, "Financial Disclosure: When More is Not Better", by Ray J. Groves.|