RADIN, GLASS & CO.
Certified Public Accountants
360 Lexington Avenue
New York, NY 10017
December 31, 2002
Mr. Jonathon G. Katz, Secretary
U.S. Securities and Exchange Commission
450 Fifth Street, NW
Washington, DC 20549-0609
File No. S7-49-02
Strengthening the Commissions Requirements Regarding Auditor Independence
I am the managing partner of a small accounting firm which audits approximately 15 public companies. We have revenues under $ 6 million. I have been practicing before the Securities and Exchange Commission as an employee or partner of a number of firms for over 40 years. I have served on both the AICPA SEC Regulations Committee and the New York State Society of CPA's SEC committee. While I believe much of the Sarbanes-Oxley Act of 2002 (the "Act") is counterproductive to audit performance, I do believe that I could continue to perform audits of SEC Registrants under the Act. However, the Proposed Regulations could result in my firm discontinuing the audits of our public clients.
I disagree with the Act's underlying tenet that independence is more important than knowledge and experience. As an investor I would be pleased to know that the audit partner "grew up on the account" as that would assure me that he or she had an appropriate level of familiarity and knew how to audit the relevant potential errors and the issues relating to the audit. In my experience, frauds are not found by exotic procedures; rather they are found by knowledgeable auditors believing that something does not look right. That belief is dependent on experience both with the client and with other audits. (The most recent example of the importance of knowledge is the discovery of the fraud at Worldcom. It was discovered by a non-independent knowlegible auditor.)
As I discuss below, the Proposed Regulations require a "five-year cooling off period" before an auditor or reviewer returns to the client in an audit or review capacity. This amount of "time off" would insure a lack of knowledge. I believe five years is excessive for a new partner to have a "fresh look." Congress felt that one year was enough. The Commission has not made a case for why five years is necessary. I believe that two years under the SEC Practice Section was sufficient time for a new partner to become familiar with the audit and to bring a fresh look. There is now a legal mandate for one year cooling off. I see no reason to go further than the Act. Five years is certainly excessive.
From an auditing firm's point of view, the possibility of an inadvertent independence violation is very frightening. As the rules are drafted there could easily be a slip which would have the firm lose its independence for possibly up to five years. Such an error would make the financial statements unaudited for a number of years, creating liability to the Registrant through no fault of its own. Such inadvertent slips could include: performing non-audit service without prior audit committee approval; having a partner perform part of an attest function in the absence of the normal assignee; having a partner compensated for non-audit work; a casual call to a partner which later is determined to be part of the attest function, etc. Adding to the exposure, several years after the incident a look back could make the incident a major litigation issue.
Small public companies do not have the access to many advisors. They depend on their auditors for advice and counsel in many areas. We are proud of our efforts in this area, helping the capital formation process by not burdening new companies with excessive professional fees. I believe that the Proposed Regulations would eliminate a single place for advice, where the Registrant and auditor know and trust each other. Rather, they would create walls of where advice or counsel could be given, who could talk to the client, and who from the firm could work on the client. I do not believe that the Act requires the approach taken by the Commission.
A general issue with small firms relates to Initial Public Offerings. To facilitate IPO's and reduce the need for reaudit of previously audited potential registrants, I recommend waiving some of the rules where another firm has audited the final year as is common in IPO's, providing the originally issued financial statements are not significantly modified.
Because of the size of the Proposed Regulations and the Commission's questions, I am responding only to certain specific issues.
A. (4) (i)(A) and (C) Maintaining or preparing the audit client's accounting records - The following have been routinely prepared by the auditor: depreciation schedules, unusual computations such as Black-Scholes computations, valuation of beneficial conversion features, blank templates for projections, complex dilution computations, etc. It is not clear as to which of these would make the auditor not independent. The term "source data" is also unclear. For example, for a Black-Scholes computation, the auditor may have the formula reside in his or her computer, the auditor may look up the market price of the stock at the time of an option grant on a Website, the auditor would then input the exercise price, the market price and the terms supplied by the client using a volatility based on a formula from market prices and from that determine the option value. Would those procedures, involving no subjective decisions, result in the auditor losing its independence? In addition, would the maintaining or preparing of income tax accounting records, such as depreciation, render the auditor not independent?
Unless it is believed necessary to define records, I believe that A should be dropped and C remain as the appropriate rule.
For an example of independence rules relating to small companies please see the General Accounting Office publication on Government Auditing Standards - Answers to Independence Standard Questions (GAO-02-870G) questions 46 to 57. Auditors have found those rules to be workable and protective of independence.
B. (4) (i) (B) Preparing financial statements - Many of our small clients do not have the financial expertise to mechanically prepare the Form 10-K and 10-Q. Their staff prepares a rough financial statement which the auditor converts to the format required by the Regulations. Is this "preparing" the financial statements? The proposed Regulation uses a term that is not defined by GAAS.
I recommend that this proposed rule be dropped.
C. (4) (ii)(B) designing or implementing a hardware or software system - Does opening a shrink wrapped standard accounting package, installing it on to a client's computer, and explaining how it works constitute "designing or implementing a hardware or software system..."? For example, we recommend to our small clients that they use Quickbooks, an inexpensive proprietary system which is easy to learn and produces a first draft of financial statements. I believe that under the Proposed Regulations when a new client comes in, asks what they should use, and we say "Quickbooks", we are not independent for all years in which Quickbooks is used.
I believe that the restriction should be drafted to exclude "standard packages costing under $10,000..." or a similar limitation to prohibit only the installations that the Sarbanes Oxley Act appears to intend to prohibit. As these packages are common to almost all small companies and require no special expertise, I do not believe that an auditor's independence is compromised by recommending, installing and training personnel on their use.
D. (4) (x) acting as an advocate - We routinely represent our clients in connection with audits by Federal, state and local tax authorities. We advocate our client's position as the taxing authorities expect. It appears that inspite of the Act's allowance for auditors to perform tax services, the Proposed Regulation would prohibit us from performing tax services other than routine compliance.
Further, does this Proposed Regulation relate to oral or formal written opinions? The terms are so general that they could include a large number of routine meetings with governmental and industry people.
I believe that the easiest way to solve this issue is to allow representation at tax proceedings, where the compensation to the auditor is not dependent on the results of the examination.
E. (6) Partner rotation - The Act required a one year cooling off period after five consecutive years as an audit or review partner. The Proposed Regulations require a five year cooling off period. We have three partners qualified to perform SEC audits. Theoretically we can continue following the Act's rules but not the Proposed Regulations. Under the Proposed Regulation it would appear to be necessary to have a minimum of four SEC qualified partners. In view of normal turnover, the risk would require five partners. Therefore assuming the normal distribution of talent to perform audits a firm would have to have a minimum of ten partners. Such a firm would most likely have approximately 100 staff. Using these parameters, SEC work would be limited to the 50 largest firms, some of which, I have been informed, are discontinuing working on SEC audits.
Alternatively, a firm could decide to have SEC clients for five years and then resign. While Congress seems to like this idea, all professionals have been trained to work effectively with their clients in order to maintain a long relationship. I do not believe that the development of a short term model of audit relationship is satisfying either to industry or to a profession that I would want to participate in.
The Proposed Regulations require any partner in a decision making position to also rotate off for five years. Many small or even medium sized accounting firms have an "SEC Partner" who consults on all SEC matters and frequently reviews all significant filings. Would such a firm be required to have two SEC Partners, so that each could rotate off for five years?
Because of the small size of my firm, any significant issue relating to an SEC Registrant is discussed among all three SEC partners. I therefore assume that after five years all of us could not work on the audit. It is possible that we would have to keep track of decisions and determine whether the involvement was sufficient to disqualify one of us. Of course then a court or the Commission could disagree and invalidate a number of years of audits. It is not a risk that I would choose to run.
As the Proposed Regulations are drafted would it be appropriate to switch off for one year after four years as this schedule would not appear to violate the words of the Proposed Regulations, only the intent?
I recommend not going beyond the basis of the law by imposing more than a one year cooling off period or extending the five year restriction beyond the audit partner and the review partner as required by the Act. Further, the definition of "audit" should be limited strictly to the services involved in connection with "expressing an opinion on such statements" to clarify that the accountant can perform other services as long as there is a different audit and review partner. As I read the Act, the definition could be limited to the audit partner and review partner which would eliminate much conflict.
F. (7) Audit Committee administration of the engagement - I believe that the "de minimus exception" will not be useful as it requires non-knowledge of the Act. As a CFO is normally the person who contacts the auditor, non-knowledge is highly unlikely. Further the auditor would normally ask if there has been audit committee approval when accepting an assignment thereby disqualifying the exception.
I believe that the final Regulation should have language authorizing the audit committee to approve in advance types of services, such as tax return preparation, assistance at tax audits, income tax planning, acquisition reviews, non-audit accounting consultations, providing that the audit committee sets a maximum fee limit on each type of service. After such charges for each type of service reaches the amounts approved, it will be necessary for management to obtain additional authorization. This procedure of course is common in both industry and government.
G. (8) Compensation - This Proposed Regulation appears to be totally unworkable in a small accounting firm. Compensation arrangements for partners commonly include provisions such as fixed percentages of the firm's earnings, amounts proportionate to their billings, amounts proportionate to the earnings on their clients, amounts dependent on their chargeable hours, and amounts subjectively decided by the managing partner or a managing committee. Assuming that the accounting firm performs more than audit services, any of the above provisions could create an independence issue that is totally unresolvable. For example, if the firm does tax work and a partner receives 10% of the earnings, which would include the tax work, does that make him not independent. If the partner is partly compensated on chargeable hours and he or she spent a few hours reviewing the tax return, would that make him or her not independent? If the compensation is subjectively decided, does the managing partner or the committee have to document why the tax work was not considered? The Proposed Regulation would prohibit any audit partner from working on the income tax return. As the audit partner is likely to be very knowledgeable as to certain information relating to the tax return, his or her exclusion could reduce the quality of tax reporting.
I recommend dropping this section from the final Regulations as it is not required by any definition of auditor independence.
I appreciate that the Commission has requested responses as to the costs of the Proposed Regulation. I do not believe that it is practicable to determine amounts such as: the cost of two accounting firms replacing the benefits of one auditor with broad knowledge; the cost of finding another accounting firm when a time sensitive issue arises and there is insufficient time to convene an audit committee meeting; the cost of asking another accounting firm to learn the company in order to recommend an appropriate accounting software package, etc.
If it is the intent of the Commission to limit the audit of SEC Registrants to fairly large firms, the Proposed Regulations would be effective. I do not believe that they will add to audit efficacy.
Arthur J. Radin