3 September 2002
Jonathon G. Katz, Secretary
Securities and Exchange Commission
450 Fifth Street, NW
Washington, DC 20549-0609
|Re:||File No. S7-24-02; Framework for Enhancing the Quality of Financial Information|
through Improvement of Oversight of the Auditing Process
Dear Mr. Katz:
The Audit Subcommittee of U.S. Advocacy Committee1, which is a standing committee of the Association for Investment Management and Research (AIMR),2 appreciates the opportunity to comment on the SEC's proposals to enhance the quality of financial information through improving the oversight of the auditing process.
Although the recently ratified Sarbanes-Oxley Act of 2002 (the Act) addresses many of the proposals outlined in the SEC's framework for improving the oversight of the audit process, we believe some areas still remain open for comment. These areas include (1) the composition of the new Public Company Accounting Oversight Board (the Board), (2) the Board's duties as an overseer of audit firms and registered public companies, and (3) funding for the Board. The Act gives the SEC the power to appoint and designate the initial term of the five Board members, after consultation with the Chairman of the Board of Governors of the Federal Reserve System and the Secretary of the Treasury. Moreover, the SEC has the authority, vis-à-vis the Board, to promulgate rules governing auditor independence and the auditing standards, which must be used to perform audits of companies registered with the Board.
In a recent Advertorial, AIMR outlined several ways to fix a damaged financial reporting system by placing more emphasis on investors' needs rather than the interests of corporations. In addition, AIMR stressed the need for aggressive and consistent enforcement of all financial reporting rules to ensure high quality financial disclosures, and in turn, restore public confidence. No set of financial reporting standards, regardless of quality, is worth anything without enforcement.
Moreover, companies need to improve the quality of financial disclosures to include transparent and lucid (i.e., plain English) discussions and analyses about their business activities, results of operations, and financial condition. These disclosures should also be free of "boilerplate" phrases that provide little, if any, substantive and meaningful information. Another area of improvement involves the role of auditors and the perception of independence. Auditors must disclose any current, or potential, conflicts of interest regarding their role as an auditor for a company, including any non-audit services provided and the fees received for such services, as well as any forward agreements entered into before the audit opinion is issued.
Finally, we recommend that the Board and the Financial Accounting Standards Board (FASB) work together to establish and maintain high quality auditing and accounting standards. These standards, when applied properly and consistently, must reflect the true economic substance and reality of today's business activities and transactions. In other words, the economic substance rather than the legal form should be the underlying principle for accounting and reporting requirements. For example, special purpose entities, employee stock options, and executory contracts in most cases represent true liabilities and obligations of the company. However, under current accounting standards such items are not recognized and reported on the company's financial statements. Such omissions cause distortions and, thus, mislead investors and other users of this financial information about the true economic condition and performance of the company.
The following comments and recommendations address the composition and funding of the Board and its authoritative powers to oversee the auditing process, including standard setting, financial reporting and disclosures.
Composition of the Board
We are most concerned about having sufficient investor protection through an effective enforcement of current financial disclosure and auditing requirements. Therefore, it is essential that members of the Board possess a considerable, if not a thorough and in-depth, understanding of financial reports, as well as the auditing process that attests to the fairness and faithful representation of these reports.
Under Section 101(e)(1) of the Act, the five members of the Board will comprise "prominent individuals of integrity and reputation who have a demonstrated commitment to the interest of investors and the public, and an understanding of the responsibilities for and nature of the financial disclosures required by issuers under the securities laws and the obligations of accountants with respect to the preparation and issuance of audit reports with respect to such disclosures." Moreover, the Act permits only two members of the Board to have a CPA designation.
Today, many financial transactions and activities are complicated and diverse in nature, requiring comprehensive and vigorous accounting and auditing standards to ensure that they are presented properly in the financial statements. Based on these elements and the criteria in the Act that stipulate the composition of the Board, we are concerned about whether knowledgeable individuals will be selected to fill the slots for members, who do not have a CPA designation. As such, the selection of these members must be thoughtful with respect to the candidates' credentials, experience, and integrity given the responsibilities of the Board. Additionally, we believe that at least one Board member should represent someone from the investment profession, who has extensive and proven experience as a portfolio manager and/or analyst (i.e., a professional user of financial reports, who is experienced in making well-informed investment decisions).
Authoritative Powers of the Board
Under Section 107 of the Act, the Board is empowered to oversee and enforce the auditing process as a "registered securities association" by the authority of the SEC. Therefore, the Board's ability to be an effective overseer and enforcer of financial reporting and auditing standards rests ultimately in the hands of the SEC.
Oversight of the Auditing Process
Users (investors, creditors, and analysts) must have credible and reliable information about a company's financial performance and financial condition. This high quality information is essential for the efficient operation of financial capital markets, including the proper allocation of capital to those investments, which create the greatest returns commensurate with the level of risks and uncertainties. Thus, the overall stability and strength of these markets depends on the integrity and ethical behavior of all market participants, including auditors, companies, analysts, and regulators. In particular, external auditors who are independent and objective play a critical role in maintaining the credibility of the financial information disseminated by companies within U.S. capital markets.
Therefore, effective oversight of the auditing process is paramount in ensuring that audits are performed in accordance with generally accepted auditing standards (or GAAS) and that users of financial statements can rely upon an auditor's unqualified opinion in making informed investment decisions. The need for effective governance has become more important to financial statement users as a result of (1) high-profile accounting irregularities and fraudulent financial reporting practices by companies, (2) consolidation of accounting firms, (3) acquisition of accounting firms by other service enterprises, and (4) type of services provided by accounting firms.
How can effective oversight be achieved and maintained? We believe that the Act has established the framework for an effective oversight of the auditing process. However, without the consistent application and effective enforcement of the financial reporting and auditing requirements, the objectives of the Act will not be achieved. The Board must have sufficient powers and resources to do its job, which is to protect the interest of investors, creditors and other users who rely on the audited financial statements. In the following comments, we elaborate further about our thoughts, regarding the Board's authority to set audit standards and the funding of its operations.
(2) Promulgation of Audit Standards and Practices
Section 103(1) of the Act outlines the duties of the Board, in regards to auditing, quality control, and independence standards and rules -
"In general, the Board shall, by rule, establish, including, to the extent it determines appropriate, through adoption of standards proposed by 1 or more professional group of accountants designated pursuant to paragraph (3) (A) or advisory groups convened pursuant to paragraph (4), and amend or otherwise modify or alter, such auditing and related attestation standards, such quality control standards, and such ethics standards to be used by registered public accounting firms in the preparation and issuance of audit reports, as required by the Act or the rules of the Commission, or as may be necessary or appropriate in the public interest or for the protection of investors." [emphasis added]
A key role of the Board is to establish standards for conducting audits and auditor independence, with the SEC's oversight and approval. Therefore, we recommend that the Board conduct a thorough analysis of the current audit standards and practices used to conduct an audit. This analysis should consider previous assessments of the auditing process. For example, the O'Malley Report3 identified key elements for promoting quality audits - (1) definitive audit standards and (2) comprehensive and vigorous audit methods. The report also addressed the issues of earnings management, i.e., manipulation of reserves, nonrecurring charges, and recording immaterial errors to meet forecasted earning results, or outright fraud. The Panel recommended that audit firms should use auditors with forensic audit backgrounds to assist in the audits and for training audit staff in identifying cases of intentional accounting errors and irregularities. We supported strongly, and still do, this recommendation because the auditor should be able to identify earnings management or accounting irregularities, and thus, deter such activity in the future.
In addition, we recommend that the Board review the contents of the current auditor's opinion report. Today, the auditor's opinion has become a "boilerplate" statement because of legal concerns. We believe that the opinion should include statements about the auditor's relationship to the issuer (or audit client), including all services provided during the periods reported in the financial statements. AIMR has proposed a similar disclosure on the analyst's research report about conflicts of interests. Section 10 - Disclosure of the proposed Research Objectivity Standards (or ROS) specifies that -
"Firms must provide full and fair disclosure of all conflicts of interest to which the firm or its covered employees4 are subject. To be full and fair, disclosures should be comprehensive and complete, be presented prominently in the supporting documents or on the firm's web site, be written in plain language that is easily understood by the average reader, and be designed to inform rather than obscure the nature of the conflicts of interest faced by the covered employee or the firm."
Some users have indicated that the auditor's report should provide information about the assessment of risks, involving the issuer's business transactions and activities, and how the auditor considered those risks in performing the audit of the issuer's financial statements. Similar disclosure is noted in Section 103(a)(2)(A) -
"…each registered public accounting firm shall describe in each audit report the scope of the auditor's testing of the internal control structure and procedures of the issuer, required by section 404(b), and present (in such report or in a separate report) -
|(I)||The findings of the auditor from such testing;|
|(II)||An evaluation of whether such internal control structure and procedures -|
(aa) include maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of the asset of the issuer;
(bb) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the issuer are being made only in accordance with authorizations of management and directors of the issuer; and
|(III)||A description, at a minimum, of material weaknesses in such internal controls, and of any material noncompliance found on the basis of such testing."|
Under Section 103(a)(3), the Board is given the authority to adopt other standards, subject to Section 107 - Commission Oversight of the Board - any portion of any statement of auditing standards or other professional standards that the Board determines satisfy the requirements. We recommend that the Board consider in its analysis a comprehensive review of audit effectiveness on a global basis. With the convergence of accounting standards and practices on the horizon, propelled by the increase in cross-border financial activities, audits of financial statements must also converge into a common set of auditing standards and practices. A common approach to the audit, including oversight and enforcement, is needed to ensure that financial statements conform to a global set of financial reporting standards.
Funding of the Board
Under Section 101(f) and (g) of the Act, the Board is granted authority to conduct its operations and maintain offices, including the allocation, assessment and collection of accounting support fees and appointment of employees - accountants, attorneys, and other agents. To fund its operations, the Board is given the power to levy fees that include (1) accounting support fees from registered public companies and (2) registration fees and annual fees from registered accounting firms, which provide audit services to registered public companies.
The predecessor to the Board, or Public Oversight Board (POB), had substantial issues in regards to funding its operations because accounting firms and accounting professional organizations were the major underwriters of the POB. We believe that this dependency greatly impaired the POB's ability to operate effectively as a governing body and overseer of accounting firms. Therefore, we support strongly the compulsory funding of the Board by those companies that issue securities and the accounting firms that audit these companies.
However, the source of funding is not the only issue. The Act stipulates that the amount of fees levied will be based on the Board's annual operating budget, which the SEC must approve. Our primary concern is whether the Board will be given sufficient funding to operate properly as an effective overseer and enforcer of audit standards and financial reporting requirements. Therefore, we believe strongly that the need for investor protection and transparent financial reporting must override any political or other special interests in determining the annual operating budget and the fees assessed. As such, there must be adequate resources to operate the Board in order to provide for effective oversight and enforcement.
Public Access to Information About the Board's Activities
The Act outlines, in various sections, what information will be made available for public inspection. In particular, Section 102(e) stipulates that certain portions of the registered public accounting firms' registration applications and annual reports may be designated for public access, "…subject to the rules of the Board or the Commission, and to the applicable laws relating to the confidentiality of proprietary, personal, or other information…" We believe, at a minimum, that the contents of applications required under Section 102(2)(B) and (G) should be made available for public review.
Content required under (B) is information that a registered public company must provide in its annual proxy statement, relating to the fees paid to the auditor for audit services, non-audit services, and information technology (IT) services. Therefore, it would be useful to compare the two sources of information about similar activities provided by the registered public accounting firm as well as its audit client (or registered public company).
Item (G) requires "copies of any periodic or annual disclosure filed by an issuer with the Commission during the immediately preceding calendar year which discloses accounting disagreements between such issuer and the firm in connection with an audit report furnished or prepared by the firm for such issuer." We believe strongly that such information should be made available for public inspection because it is relevant to understand the accounting policies selected and applied by the issuer in preparing financial statements. Also, users of this information may decide to make adjustments to reported amounts on the financial statements in preparing their analysis and/or in assessing the risks and uncertainties of the issuer.
High quality information is the "lifeblood" of the capital markets in that it promotes efficient allocations and liquidity of capital within these markets. However, too often over the past several years, the quality of disclosures has eroded to the point that they are fraudulent and totally misleading. As a result, there have been significant adjustments to reported earnings in previously audited periods, and in turn, significant declines in companies' market capitalizations accompanied by investor large losses.
We believe the requirements of the Sarbanes-Oxley Act of 2002 establish the framework for improving the current financial reporting system. Now, the SEC and the Board must use this framework, and the means provided, to improve and ensure auditor independence and audit effectiveness.
We appreciate the opportunity to comment on these proposals. If you have any questions or seek elaboration of our views, please do not hesitate to contact Georgene Palacky at 1.434.951.5334 or firstname.lastname@example.org.
|/s/ DeWitt F. Bowman
DeWitt F. Bowman, CFA
Chair, Audit Subcommittee of USAC
|/s/ Georgene B. Palacky|
Georgene B. Palacky, CPA
U.S. Advocacy Committee (USAC)|
Patricia D. Walters, Ph.D., CFA - Sr. Vice President,
AIMR Professional Standards & Advocacy
Rebecca T. McEnally, Ph.D., CFA - Vice President, AIMR Advocacy
|1||The USAC is charged with responding to new regulatory, legislative, and other developments in the United States affecting the investment profession, the practice of investment analysis and management, and the efficiency of financial markets.|
|2||With headquarters in Charlottesville, VA, and regional offices in Hong Kong and London, the Association for Investment Management and Research® is a non-profit professional organization of over 59,000 financial analysts, portfolio managers, and other investment professionals in 107 countries of which 45,300 are holders of the Chartered Financial Analyst® (CFA®) designation. AIMR's membership also includes 117 affiliated societies and chapters in 29 countries. AIMR is internationally renowned for its rigorous CFA curriculum and examination program, which had more than 100,000 candidates from 143 nations enrolled for the June 2002 exam.|
|3||In 2000, a special panel of the Public Oversight Board issued a report on the effectiveness of audits, including finding and recommendations on how to improve the auditing process.|
|4||Firm employee who (1) conducts research, writes research reports, and/or makes investment recommendations; or who comes in contact with the research or recommendation prior to issuance; (2) takes investment action on behalf of clients or the firm, or who comes in contact with investment recommendations or decisions during the decision-making process; (3) may benefit, personally or professionally, from influencing research reports and recommendations.|