Comments of BDO Seidman, LLP on S7-49-02

BDO Seidman, LLP
Accountants and Consultants
330 Madison Avenue
New York, NY 10017
(212) 885-8000

January 13, 2003

Mr. Jonathan G. Katz, Secretary
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, DC 20549-0609

Re: Release No. 33-8154
Strengthening the Commission's Requirements Regarding Auditor Independence
File No. S7-49-02

Dear Mr. Katz:

This letter is the response of BDO Seidman, LLP to your request for comments regarding the above-captioned proposal.

We strongly support the need to strengthen the public's recently tarnished perception of auditor independence. In that regard, we agree with certain aspects of the Commission's proposals, particularly those that would enhance the audit committee's role in the audit process. We believe that enhancing the audit committee's role in the administration of an engagement is a constructive step toward improving audit quality. We also believe that mandating the types of communications with audit committees called for by proposed Rule 2-07 of Regulation S-X is appropriate. While we support these types of constructive changes to enhance auditor independence, we believe that many of the Commission's proposals, particularly those that go beyond the requirements of the Sarbanes-Oxley Act (the "Act"), will not benefit investors or serve the public interest. Therefore, we believe that major changes need to be made before adopting final rules.

Summary of Our Major Concerns

Given the number, breadth, and complexity of the Commission's recent proposals, we are concerned that issuers, auditors, and others have not had sufficient time to fully consider and comment on them. We know that we have not had sufficient time to do so. Given the Congressionally mandated final rule adoption date of January 26, we are also concerned that the Commission and its staff will not have sufficient time to consider thoughtfully the comments on the proposals and craft the appropriate changes. We are especially concerned about the lack of time for the Commission to fully consider and react to comments on this particular proposal, given the 13-day period available to do so, the complexity of the issues it addresses, the major changes we believe are necessary, and the profound adverse effects many of these rules (particularly those dealing with partner rotation) will likely have on accounting firms, issuers, and the public interest if the Commission adopts certain of them in their current form. These adverse effects include reducing the quality and increasing the cost of audits and the disproportionate impact on smaller issuers and accounting firms. Accordingly, we urge the Commission to adopt only the rules that are unequivocally mandated by the Act at this time and to consider the other proposals over a more appropriate period. We also urge the Commission to provide ample transition periods so there will be time to modify these rules before they take effect in order to avoid unintended or inappropriate consequences.

We have the following additional reasons for believing the Commission should limit the auditor independence rules it adopts to those that are unequivocally mandated by the Act:

The Act and the many rules the Commission is in the process of adopting make sweeping changes to improve the reliability of corporate reporting. These changes are designed to:

Focus management on its responsibility and hold it accountable for such reporting;
Focus greater attention on and improve the quality of internal accounting and disclosure controls and procedures;
Address important reporting and disclosure issues;
Improve the composition of audit committees and enhance their involvement in the process;
Ensure that attorneys work for the benefit of stockholders;
Improve the objectivity of analysts' research and provide investors with more useful and reliable information; and
Improve the oversight of the auditing profession. In this regard, the Public Company Accounting Oversight Board will (1) have the authority to set auditing standards, (2) perform annual inspections of accounting firms that audit more than 100 issuers (and at least triennially for other accounting firms that audit issuers), and (3) investigate and discipline accounting firms and individual auditors.

Given the nature and magnitude of these changes, we expect them to make significant progress toward their intended objectives. Therefore, we believe the Commission's appropriate response is to adopt only the Congressionally mandated rules, observe their effects for a suitable time, and then consider additional measures such as those proposed only if there is persuasive evidence they are needed. We also believe that doing more at this time could be interpreted as the Commission usurping the responsibilities of the PCAOB and audit committees, thereby undermining investor confidence in them.

In addition, we believe the Commission needs to make a number of changes to the proposed rules to:

Permit audit committees greater latitude in using their judgment to represent the interests of investors;
Avoid imposing unduly harsh effects;
Clarify the rules;
Make the rules consistent with the Act and the Commission's intent as discussed in the Release;
Communicate how they would apply to issuers in initial registrations; and
Provide for appropriate transition.

In considering these changes, we urge the Commission to use its exemptive authority under Section 36(a) of the Exchange Act¹ to the extent necessary to ensure that the final rules best serve the public interest and protect investors. In that regard, we believe it is important to recognize that Section 3(c)(2) of the Act preserves the Commission's exemptive authority, as follows:

Nothing in this Act or the rules of the Board shall be construed to impair or limit ... the authority of the Commission to set standards for accounting or auditing practices or auditor independence, derived from other provisions of the securities laws or the rules or regulations thereunder, for purposes of the preparation and issuance of any audit report, or otherwise under applicable law.

Our more specific comments on the proposed rules and our recommendations for alternative approaches are set forth below.

Partner Rotation

We believe the proposed partner rotation requirements are by far the most troublesome aspect of this proposal in that they can pose the most harm to the very investors the Commission and Congress are obligated to protect. As such, they require the greatest Commission attention as it considers the revisions to reflect in the final rules. The proposal appears to presume that all accounting firms have an unlimited array of interchangeable partners possessing similar skills and industry expertise. This is a fallacious assumption and, as such, provides an unsuitable foundation for the proposed rules.

Our most significant concerns regarding the partner rotation requirements are:

The categories and resulting number of partners to be rotated and the 5-year "time-out" period are excessive and inappropriate. In many instances, they would be tantamount to accounting firm rotation, an idea Congress specifically considered and rejected.²
The proposal to have the rotation requirements take effect upon adoption of the final rules would cause unreasonable levels of disruption.

We are concerned about these aspects of the partner rotation requirements because we believe they would have effects that would run counter to the public interest by:

Reducing the quality of audits;
Increasing the cost of audits;
Being particularly detrimental to smaller accounting firms; and
Being detrimental to issuers, especially those audited by smaller accounting firms (which comprise the smaller companies registered with the Commission).

More specifically, adopting the rules as proposed is not appropriate for the following reasons:

It would be tantamount to and result in all the drawbacks of mandatory accounting firm rotation.
The level of partner turnover reflected in the proposed rules will cause a significant reduction of engagement team continuity. Depending on the circumstances, the resulting disruption may be substantially similar to that which occurs when companies change accounting firms. In addition, we expect the level of disruption to prompt some companies to change accounting firms when it becomes necessary to rotate partners. The benefits of broad rotation for the purpose of meeting the Commission's stated goal of providing a "periodic fresh look" do not outweigh the risks and the costs. In that regard:
1. Adopting the proposal would increase the risk of undetected fraud and would actually provide less, not more, protection for stakeholders.
  The disruption caused by the excessive rotation of partners and time-out period would serve to erode the audit team's base of knowledge and experience with the client's business, operations, systems, controls, and accounting policies. This would require the audit team to expend more effort on learning or teaching others about the client and distract the team from auditing the client's financial statements. We believe the proposed partner rotation and time-out requirements would increase the incidence of frauds that go undetected by auditors. Past studies support our belief. They show that undetected fraud correlates with changes in accounting firms. For example:
  - The Quality Control Inquiry Committee of the SEC Practice Section, which reviews litigation and other indications of audit deficiencies involving member firms to determine if quality control improvements are warranted, analyzed 406 cases of alleged audit failure that were considered between 1979 and 1991. This analysis showed that allegations of audit failure occur almost three times as often when the accounting firm is performing its first or second audit of the company's financial statements.³
  - In its 1987 report, the National Commission on Fraudulent Financial Reporting stated that "the Commission's review of fraud-related cases revealed that a significant number involved companies that had recently changed their independent public accountants ...."
  - The independent Commission on Auditors' Responsibilities (1974 - 1978), chaired by former SEC Chairman Manual Cohen, found that several of the cases of substandard performance by auditors examined by the group were first- or second-year audits.
  - In Italy, where firm rotation is required, a study funded by the European Contact Group and conducted by SDA Bocconi showed that mandatory firm rotation had a negative effect on the quality of audit work carried out by accounting firms during the first year of an appointment. The study noted that audit partner suspensions imposed by the Consob (the Italian national commission for listed companies), which generally arise in situations in which material misstatements were not identified by the auditor, occurred most frequently in the first year after appointment. The study also found that start-up costs associated with the rotation were significant for both the auditor and the client. In that regard, the study found that audit hours increased by up to 40% in the year of the change.
2. Adopting the proposal would detract from partners' focus on auditing and increase their focus on selling.
  The SDA Bocconi study of the effects of firm rotation in Italy referred to above showed that rotation caused fierce competition among the largest firms to replace the business lost due to rotation. In addition, if partners rotate off engagements more frequently and have the extensive time-out periods proposed, they will feel more pressure to sell other work to secure their positions after rotation. For example, consider a partner who spends most of his time on one major client and, based on age and family considerations, strongly desires to not have to relocate after he or she rotates off that client. This partner could be much more motivated to focus on building a book of business to justify his/her place in the office after rotation than on auditing his/her current or new client. Such an environment is inconsistent with the Commission's stated goal of having "accountants at the partner level ... viewed as skilled professionals and not as conduits for the sale of ... services."
3. Adopting the proposal would dilute auditors' existing industry expertise.
  Auditors would need to learn about new industries in preparation for auditing new clients, rather than proactively planning assignments to make the best use of the skills they have on continuing audit clients. This will be particularly true at smaller accounting firms. This diminution of industry expertise will reduce auditors' understanding of their clients' businesses and thus could lead to more instances of undetected fraud.
4. Adopting the proposal would make accelerated/timely filing more difficult.
  The process improvements that enable a company to accelerate its financial reporting typically come from years of practice and continuous small improvements - not brilliant ideas that come from someone new taking a fresh look. Repeatedly changing auditors eliminates the institutional knowledge needed to sustain continuous improvement. This is particularly true on multinational engagements, where the limited quantity of experts in U.S. GAAP and GAAS resident in foreign countries means that the new members of the foreign engagement team typically need to learn about U.S. professional standards as well as about a new client.
5. Companies and the capital markets do not have the range of options needed to make this a viable approach.
  The number of firms with the size and scope to service medium- and large-sized and multinational companies has decreased steadily over the last two decades. What was once the Big Eight is now the Big Four. With the more restrictive scope of service rules, these companies will increasingly find that one or more potential firms will lack the independence needed to perform the audit.
  If adopted, we expect the rotation requirements to drive many regional and local firms from auditing public companies. We also expect the remaining firms to be less willing to serve the smallest registrants a result of the increased regulatory impediments and risks of doing so.
  The capital markets will come to depend on a small handful of firms capable of meeting their requirements. If any of these remaining firms were to fail, or exit the public company audit practice for any other reason, the disruption to the markets would be greater and longer lasting than was the case after Arthur Andersen's demise.
It would unfairly hurt the smaller accounting firms.
Smaller accounting firms typically have fewer partners in each office who are appropriately suited to serving the needs of the SEC registrant clients of that office. Thus, when partners rotate, a smaller firm is more likely to need to ask one or more of the rotating partners to move or to ask a partner who is not located close to a client to serve that client. Both of these situations significantly disadvantage those firms. They put them at a cost disadvantage, they disrupt the personal lives of the partners involved and their families (discouraging some of the best and brightest young people from pursuing careers in which they specialize in serving SEC registrants) and, in cases where the partner serves a client from a different location, it is more difficult to compete by providing responsive service to the client.
Although these problems are most severe for smaller accounting firms, we believe they are significant issues for all firms. For example, we understand that the audits of certain major corporations include the active participation of hundreds of partners around the world. Requiring most or all of them to rotate would cause similar problems.
These problems are present any time an office serves SEC registrants and has a limited number of partners who are appropriately suited to serving those clients. They are more severe in small firms and small offices of large firms. They are probably most severe in non-U.S. offices (regardless of size) that audit a limited number of foreign registrants or subsidiaries of domestic registrants.
It would unfairly hurt smaller registrants.
If the proposal causes larger companies to rotate accounting firms more frequently, it will increase the pressure on auditors to sell audits to those companies at the expense of providing auditing services to their current clients, particularly their smaller clients. We have witnessed this many times over the past year as Arthur Andersen's clients "rotated" to new accounting firms.
Rotating auditors requires a great deal of incremental time from company personnel as well as auditors. In smaller companies, a greater portion of that time is spent at the upper management level. Smaller companies tend to be more thinly staffed at that level. This makes changing auditors more burdensome for smaller companies.
Rotating more partners than mandated by the Act⁴ would add significant costs to audits without providing any significant benefits.
The key decisions on audits are made by the lead engagement partner. The audit approach developed and key decisions made by other line partners (including partners who audit foreign subsidiaries) are reviewed and approved by the lead engagement partner. Our firm has policies requiring lead engagement partners to periodically visit significant subsidiaries and review the work performed by the local engagement teams. We also require local engagement teams to communicate proposed audit adjustments and significant issues addressed in the audit to the lead engagement partner. Given the degree of direction and decision-making by the lead engagement partner, we believe requiring other partners who perform portions of the audit to rotate will provide marginal benefits and not justify the costs.
In the Release, the Commission states, "Partners assigned to `national office' duties (which can include both technical accounting and centralized quality control functions) who may be consulted on specific accounting issues related to a client are not considered members of the audit engagement team even though they may consult on client matters regularly. While these partners play an important role in the audit process, they serve, primarily, as a technical resource for members of the audit team. Because these partners are not involved in the audit per se and do not routinely interact or develop relationships with the audit client, we do not believe that it is necessary to rotate the involvement of these personnel." We believe that excluding these partners from the rotation requirement is not only appropriate but absolutely necessary. We believe that other partners who play similar technical consultation roles should also be excluded from the rotation requirement. Examples of such partners include (1) local office partners with whom the engagement team consults on accounting and auditing issues, (2) information systems audit specialists, and (3) tax partners.
- Local office partners with whom the engagement team consults perform a function similar to the national office function discussed in the Release but reside in the local office. The fact that engagement team members work to resolve issues locally before consulting the national office should not expand the number of partners subject to the rotation requirement. These partners are not involved in the audit per se and do not routinely interact or develop relationships with the audit client.
- Information systems audit specialists are people whose participation in the audit is limited to assisting the engagements teams with understanding and recommending approaches for auditing complex information systems. They serve primarily as technical resources for members of the audit team and do not routinely interact or develop relationships with the audit client at the senior management level.
- Tax partners perform two roles. They provide tax services to clients and they provide technical assistance to the audit engagement team. Auditing the tax accounts and disclosures is the responsibility of the audit engagement team. The auditors are the experts in GAAP and the financial statement disclosure requirements, and only they have the expertise to conclude on financial accounting and reporting matters. In some circumstances they require technical assistance, and in those cases they receive assistance from the team that provides tax services to the client. When performing that technical assistance role, the role of the tax person involved is similar to that of a national office person - serving as a technical resource and not involved in the audit per se.
5. The proposed five-year time-out period is inappropriate.
The supposed need for this lengthy time-out period does not seem to be supported by any sound evidence. Rather, it seems to be based solely on the Commission's assumptions about investors' perceptions.
We believe the Commission is focusing on this issue from the wrong perspective. The Commission seems to be focusing on this issue from the perspective of investor perception, rather than the perspective of whether insufficient time-out periods have been a cause of audit failures. (The Commission states, "If a shorter time-out provision is used, investors might believe that partners merely would be placed in [a] secondary role for a year or two, only to resume the same roles that they previously occupied and to return to the prior engagement team's approach to the accounting and auditing issues.") However, we are not aware of any evidence suggesting that investors perceive time-out periods to be too short or that insufficient time-out periods have caused audit failures. Moreover, it is not economically feasible for firms to hold partners in unproductive roles for two years until they can rotate back on engagements.
The Commission states in the Release that the five-year time-out period is to ensure that there will be a periodic fresh look at the accounting and auditing issues related to a company, suggesting that if the time-out period is shorter, this will not occur. We think this line of thinking is unfounded because:
1. We believe the current two-year time-out period provides sufficient time for the newly assigned partner to identify any significant problems that might have been overlooked by the previous partner.
2. It ignores the facts that other members of the engagement team change frequently, and engagement team members consult with a variety of other people. Each of these individuals is expected to and is held responsible to exercise professional care and judgment and perform with integrity. There are several safeguards to ensure that they do this, which are listed below. We do not understand the basis for thinking they would behave "better" under a five-year time-out rule than they currently do under a two-year time-out rule.
  The Commission fails to demonstrate any Congressional intent for such a sweeping change in the time-out period. A literal reading of the Section 203 of the Act could lead one to conclude that it requires only a one-year time-out period.
The proposal to have the rotation requirements take effect upon adoption of the final rules would cause unreasonable levels of disruption.
Many audits where a partner is in his or her sixth or seventh year and would therefore be subject to the rotation requirement will be substantially complete when the rules are adopted later this month. Given the cost, delay and risk of mistakes it would cause, it is not reasonable to require firms to change partners late in the process of completing an audit. In addition, where multiple partners on an engagement are in or about to start their sixth or seventh year, immediately applying the rule would require large scale partner changes on engagements and not permit the staggered changes the Commission seems to agree are appropriate.
It fails to appropriately recognize the safeguards in place to assure that audit partners maintain the objectivity and independence required for an effective audit.
These safeguards include:
- The partner rotation requirements in the Act;
- The annual (or tri-annual for firms that audit less than 100 issuers) inspections of audit firms to be conducted by the PCAOB;
- Oversight of auditors' independence by audit committees;
- The major accounting firms' policies requiring consultations on important issues with national office technical partners who have no responsibility for revenues or client billing;
- The normal turnover of key individuals involved in the audit process;
- The proscriptions on providing certain non-audit services to audit clients, which prohibit auditors from acting as advocates for their clients;
- The firms' internal review and disciplinary processes; and
- The fact that the compensation of partners other than the lead engagement partner generally is not influenced significantly by retention of the client.
We believe that these safeguards are sufficient and warrant the Commission adopting only those rotation and time-out requirements required by the Act.

We do not believe the alternative of relying on forensic audits in lieu of rotation is viable. It is not clear to us what the scope of such audits would be, whether accounting firms would be willing to perform them, how much they would charge to accept the related risk, or when they would need to be performed. If they were performed after a filing was made, the consequences to issuers if the forensic auditor arrived at a different conclusion would be onerous. Accordingly, we believe issuers would insist that they be completed before a filing was made. We believe this would unduly delay filings and is inconsistent with the Commission's goal of providing investors with more timely information. It is also not clear to us how this would interrelate with the inspections to be performed by the PCAOB. It appears to us that this would add a significant layer of cost in exchange for uncertain value.

Recommendations

For the reasons discussed above, we recommend the following:

The Commission should limit the rotation requirement to the lead engagement partner and concurring partner, as specified in the Act. In addition, only the time spent in those roles should "count" toward the five-year limit. The Commission should leave it to audit committees to decide when additional rotation is warranted.
The Commission should leave the current two-year time-out period for the engagement partner unchanged. We see no reason for a longer time-out period for the concurring partner. Instead, we recommend that the Commission adopt a one-year time-out period for concurring partners and anyone else that may become subject to rotation.
Because we believe a considerable transition period will be required:
- The Commission should consider the fact that firms often start training replacement engagement partners for a year before they assume responsibility for an audit. In order to allow time to train replacements, the rule should first apply to audits for years beginning after December 15, 2003. Sometimes firms train people to serve as lead engagement partners by assigning them to other roles on engagements. If the Commission decides to require the rotation of additional partners, then it should structure the transition rules so firms can retain the benefits of these training efforts. In that regard, time spent in other roles prior to the effective date of the new rules should not "count" toward the five-year limit.
- Full transition should be further delayed on engagements where a firm would be required to rotate both the engagement partner and the concurring partner in the year the rules take effect. In that situation, only one of those partners should be required to rotate. Audit committees should be permitted the choice as to which partner to rotate. If the Commission decides to require the rotation of additional partners, then it should provide additional deferrals to facilitate staggered changes.
- Since smaller companies present less of a risk to investors and transition is likely to be a greater burden for them, the Commission should provide them with an additional year to make the transition and require them to first comply in audits for years beginning after December 15, 2004. The Commission should provide this additional year to issuers that do not meet the definition of "accelerated filer" in the Commission's recently adopted amendments to Exchange Act Rule 12b-2.
- The burden may be greatest for foreign auditors. The Commission should require foreign registrants to first comply in audits for years beginning after December 15, 2005. Since foreign operations of domestic registrants ordinarily present less of a risk to investors, the requirements should first apply to audits of those entities for years beginning after December 15, 2006.
The Commission should modify the text of the rule to make it clear and consistent with the Commission's intent discussed in the Release, as follows:
1. The Release states that national office technical specialists are not to be subject to the rotation requirements. However, the text of the rule states that it applies to an "audit engagement team" partner. Since the definition of "audit engagement team" in Rule 2-01(f)(7) includes "persons who consult with others on the audit engagement team," the Commission needs to modify the rule for it to have the effect intended by the text of the Release.
2. Footnote 72 to the Release states that the rotation requirement applies to partners "who are involved on a continuous basis in the audit of material balances in the financial statements." The rule makes no reference to a "continuous basis." It is not clear whether this phrase is simply referring to consecutive years or has some other meaning. If it has some other meaning, the Commission should convey this in the rule. If not, the Commission should clarify this in the adopting Release.
  In addition, footnote 72 indicates that the rotation requirements apply only to partners involved in the "audit of material balances." However, the text of the rule provides no materiality exception for partners working on the audit of the parent or a significant subsidiary. Read literally, the rule indicates that if a partner performs any audit services on an immaterial parent company account balance (e.g., very limited inventory work at an insignificant plant or an immaterial balance at a significant subsidiary), the partner is subject to the rotation requirement. We believe that including a materiality exception such as that described in footnote 72 is appropriate and that the Commission should make such modifications in drafting the final rule.
3. The Commission should expand the rule to cover fact patterns that will arise frequently in practice that it does not address. Examples are:
  - How long the time-out period needs to be if a partner rotates off an engagement after less than five years - We recommend that the Commission require a time-out period of one year in these situations.
  - How the rule will apply in an IPO situation when a partner has worked on the engagement for more than five years - We recommend that the Commission allow the partner to continue to serve for two years.
  - How the rule will apply in an IPO situation when a partner audits multiple years concurrently - We recommend that the Commission count these as one audit.
  - How the rule will apply if the registrant changes its fiscal year-end - We recommend that the Commission count the transition period as a year if it is six months or longer, consistent with the conditions that require an issuer to file a transition report on Form 10-K, rather than Form 10-Q.

Auditors' Scope of Practice

The following section of this letter contains our comments on proposed Rule 2-01(c)(4) of Regulation S-X covering prohibited non-audit services. Our most significant concerns are as follows:

Given the significant adverse consequences to companies and accounting firms of violating these rules, we believe it is critical that they clearly define the line of demarcation between permitted and prohibited services. In many cases, we do not think the rules as proposed are sufficiently clear, specifically in the areas of bookkeeping, financial information systems design and installation, internal audit outsourcing, and tax services.
Given (1) the difficulty of defining the line of demarcation referred to above, (2) the significant changes in practice some of these rules might require, and (3) the significant differences between what some of these rules might require and local practice in many foreign countries, we think the risk of inadvertently violating some of these rules will be significant, particularly in the early years after they are enacted. We expect that in many cases the harm to companies and their investors that would result if the company is required to change auditors because of inadvertent violations would be far greater than the harm resulting from the potential diminution of auditor independence resulting from the violation. Therefore, we encourage the Commission to add exceptions, where appropriate, and give audit committees discretion to decide whether the auditor's independence has been impaired in those cases.

Bookkeeping Services

Rule 2-01(c)(4) currently contains exceptions to the general rule prohibiting auditors from providing bookkeeping services to their clients. These services are permitted (1) in emergency situations and (2) in extremely limited situations in which de minimis services can be provided to a client's foreign operations. The emergency situation exception has apparently served the public interest. We believe it was appropriate for it to be available in response to the crisis that followed the events of September 11, 2001. We are not aware of situations where providing services in accordance with the limited exception for foreign operations has impaired an auditor's independence in appearance or in fact. Accordingly, we recommend that the Commission retain these exceptions when it modifies Rule 2-01(c)(4).

We believe the Commission's rules should recognize the fact that, despite the best efforts of issuers and accounting firms to establish, communicate and enforce clear policies prohibiting foreign operations from engaging auditors to provide bookkeeping services, compliance with these policies is not flawless. Inadvertent exceptions have occurred in the past and can be expected to occur in the future. If inadvertent exceptions involve accounts that are immaterial to the financial statements the issuer files with the Commission, we believe it is unfair to an issuer, its investors, and its auditors to deem the auditor not independent and require the issuer to engage a new auditor. After all, immaterial components of an issuer do not have to be audited at all. Why should a more stringent standard apply to those same components if foreign auditors have performed bookkeeping services relating to them?

Consider the following hypothetical example:

A huge multinational company operates in over 100 countries throughout the world. Its worldwide annual audit fee is $15 million. The company's operations in country B, a remote foreign location, constitute less than .01% of its assets and revenues. Due to the extreme immateriality of the operations in country B, the local office of the issuer's auditors has never visited those operations or contacted any of its employees. Among its many written policies, the issuer has a worldwide policy prohibiting its employees from engaging its auditors to perform bookkeeping services. A newly hired employee in country B is unaware of the policy and engages the local office of the auditor to provide $12,000 of bookkeeping services. The accounting firm has written policies prohibiting it from providing bookkeeping services to U.S. SEC registrant audit clients. The local auditor checks the firm's client list before accepting the bookkeeping engagement. Because the issuer's business in country B operates under a different name than the issuer, the auditor fails to realize that providing the services would violate the Commission's rules, and the auditor provides the bookkeeping services. When the issuer and the auditor learn of this, they discuss the matter with the audit committee. The audit committee, management, and the auditor all agree that this does not impair the auditor's independence.

In such a situation, we do not believe it is in the interest of the issuer or its investors to require the issuer to incur the cost and suffer the adverse capital markets consequences that would result from requiring the company to engage another accounting firm to audit its financial statements. Therefore, we believe the rules should permit exceptions that (1) are inadvertent, (2) involve subsidiaries, divisions, or accounts that are immaterial to the financial statements the issuer files with the Commission, and (3) are approved after-the-fact by the issuer's audit committee. This would be consistent with the interests of investors and would generally conform with the approach the Commission proposes to take in Rule (c)(7) in situations where an issuer fails to receive audit committee pre-approval of a permitted non-audit service.

Incorporating financial statement materiality in the bookkeeping services rule would also be consistent with proposed Rule 2-01(c)(4)(ii), which permits design or implementation of systems that generate information that is insignificant to the financial statements and proposed Rules 2-01(c)(4)(iii) and (iv), which prohibit valuation and actuarial services only "where it is reasonably likely that the results of these services will be subject to audit procedures."

Proposed Rule 2-01(c)(4), as written, seems to provide the type of exception we recommend. That rule states that it applies only to services "where it is reasonably likely that the results of these services will be subject to audit procedures during an audit of the audit client's financial statements." However, it is not clear to us whether we are reading this provision correctly. The commentary in the Release states that the proposal "continues the prohibition on bookkeeping, but ... propose[s] to eliminate the limited situations where bookkeeping services may be provided under the current rules." We recommend that the Commission be clear on this point in the adopting Release and the final rule.

In addition, we recommend that the Commission define the term "bookkeeping." A narrow interpretation of this term could lead one to question whether an auditor (1) proposing an adjustment that the client then records, (2) providing significant assistance with drafting financial statement footnotes dealing with complex disclosures, or (3) providing significant assistance to foreign registrants or subsidiaries (e.g., in converting from local GAAP to U.S. GAAP or in preparing statutory accounts after the audited financial statements are filed) could be viewed as providing bookkeeping services. We believe these services do not cause independence issues, since the auditor either reviews the issuer's work, provides technical accounting advice, or performs services which do not form the basis of the audited financial statements and, in all cases, the auditor's involvement improves the quality of the issuer's financial reporting.

Financial Information Systems Design and Installation

Given the consequences of violating the proposed ban on financial information systems design and installation services, we believe the Commission needs to more clearly define what constitutes "designing or implementing" a financial information system. It is not clear how one would distinguish (1) evaluating systems and recommending improvements, which would be allowed, from (2) designing and implementing a system, which would be prohibited.

With respect to transition, the Commission should recognize that companies might currently be subject to system design and installation contracts that may contain termination penalties. We suggest that the Commission permit companies with such contracts to complete them.

With respect to companies filing initial registration statements, we suggest that the rules permit these companies to complete contracts entered into before the initial filing of the registration statement. Since the largest accounting firms have all taken actions to exit the systems design and installation business, we do not expect that a liberal rule applicable to initial registrations would lead to widespread abuse.

Appraisal or Valuation Services

We believe the Commission's proposed approach of permitting limited appraisal and valuation services (i.e., in situations where the results of that work are not likely to be subject to audit procedures) is appropriate. However, we are concerned that the description of the prohibited services in the proposed rule is written so broadly that it might be construed to apply to discussions between an auditor and a client that are aimed at ensuring compliance with GAAP that occur before a valuation is performed by the client (e.g., an auditor advising a client on the appropriate approach to use and factors to consider). We believe the purpose of such discussions is to assure high quality financial reporting and note that an auditor would need to have such a discussion with a client after a valuation had been performed if the valuation had been performed inappropriately. We believe the Commission should modify the rule to clearly permit services involving advice provided to ensure compliance with GAAP.

The Commission should also provide an exception for valuations where (1) the client provides all the assumptions, takes responsibility for the assumptions, and is capable of making informed decisions regarding the assumptions and (2) the auditor merely operates a standardized model to produce the valuation (e.g., Black-Scholes valuations of stock options). Since no professional judgment is involved, in these circumstances we believe producing valuations would not impair independence.

Internal Audit Outsourcing

We have a number of concerns regarding the proposed rules that would ban internal audit outsourcing services.

We do not think the rule as drafted is operational because it is not clear to us what activities are prohibited. We think the goal of defining the term "internal audit outsourcing services" is one that has never been achieved. Companies and auditors have been able to operate in spite of this problem because the restrictions that recently became effective provide exceptions for smaller companies and for large issuers that perform a major portion of their internal audit work. If the Commission totally bans these services, it must clearly define them. If it does not clearly define them, companies and auditors will likely avoid performing any service that could possibly be construed as internal audit services. We believe that this result would run counter to the public interest.

In our opinion, performing extended audit services (i.e., performing substantive audit work on specific account balances or evaluation and testing of internal controls beyond what is necessary to complete the audit of the financial statements or attest to management's assertion regarding the adequacy of internal controls and procedures for financial reporting) does not impair an auditor's independence, and it is in the public interest for companies to engage their auditors to perform such services. Based on the Commission's comments in the section of the Release discussing management functions, it appears to us that the Commission agrees. We also believe it is in the public interest to permit issuers to turn periodically to qualified professionals who know their business, i.e., their auditors, for assistance with discrete non-recurring projects that could be construed as "internal audit" activities if they were performed on a continuing basis. Such projects are often performed in response to a suspected problem and need to be completed in a short time.

To avoid these problems, we believe the Commission needs to clearly communicate the nature and characteristics of "internal audit" activities. In addition, since performing "discrete" internal audit projects would apparently be permitted and it is only "outsourcing" arrangements that would be banned, the Commission also needs to define the characteristics that distinguish discrete projects from outsourcing arrangements. However, if the proposed total ban is adopted, we believe many small businesses would not be able to afford such a function or engage others who are unfamiliar with their operations to perform it. We believe that professional internal audit functions improve management's control over and the effectiveness of a company's operations and the quality of its financial reporting. Accordingly, we believe it is in the public interest to encourage companies to develop and operate internal audit functions. This is consistent with a recent proposed change to the listing standards of the New York Stock Exchange. Given the benefits of an internal audit function and the potential adverse effect on the reliability of financial reporting if smaller issuers are unable to maintain such a function, we encourage the Commission to exempt small companies from the ban. We believe that an appropriate measure of the size and sophistication of a company that should be exempt from the ban is the definition of "accelerated filer" in the Commission's recently adopted amendments to Exchange Act Rule 12b-2. We believe that any company that does not meet this definition should be permitted to engage its auditor to perform internal audit services, subject to the safeguards in the current rules.

With respect to transition, the Commission should recognize that companies with outsourcing arrangements will need time to transition to new arrangements or develop in-house capabilities. We suggest that the Commission take an approach similar to the one it took when it revised the internal audit outsourcing rules in 2000 and require issuers to comply with the new rules 18 months after they are adopted.

We also suggest that the rules apply only to companies in fiscal years beginning after they become Exchange Act registrants, in order to avoid unduly restricting the ability of companies considering an initial registration to receive the benefits of an internal audit function during the period before they complete the registration process.

Management Functions

We do not believe that evaluating or recommending improvements to internal accounting, disclosure, or risk management controls results in an auditor auditing his or her own work. We also believe it does not impair his or her independence with respect to the financial statement audit or the engagement to attest to management's report on internal controls. In our view, these services are consistent with the auditor's requirement under Section 404 of the Act to report on internal controls. The fact that the auditor reports that assessment in a less formal manner (i.e., in the form of comments and recommendations) does not change the nature of the function the auditor is performing. We believe this is a valuable service and that it is in the public interest for auditors to provide it.

The services discussed above involve existing controls. We believe the nature of the service is key - not when the auditor performs the service. Therefore we believe an auditor should also be permitted to perform similar services regarding the design of proposed control structures.

Human Resources

Proposed Rule 2-01(c)(4)(vii)(E) would permit an auditor to advise a client on the competence of candidates for accounting, administrative, or control positions. We believe it is in investors' interests for an auditor to be able to comment on other aspects of a candidate's skills and to provide advice when a candidate is being considered for other positions. This is particularly true when the candidate is a current or former employee of the accounting firm, and the firm knows the candidate well. Assuming the requirements of the cooling off period, if applicable, have been met, when a client calls an auditor to discuss one of the firm's current or former employee's qualifications, it is in investors' interests for the auditor to answer questions about the person's interpersonal skills and work ethic, as well as the person's competence. As long as the client makes the hiring decision, we believe that performing this service does not put the auditor in a position of performing a management function. This service also does not result in an auditor auditing his or her own work or serving as an advocate. The fact that an auditor has a degree of "interest" in the advice proving to be correct should not cause the Commission to prohibit the auditor from providing it. Auditors provide companies with advice on a wide variety of matters with widely varying degrees of formality. Anytime an auditor expresses a view on anything, he or she runs the risk of losing credibility if that view proves to be incorrect. The rules should not put a damper on communications between auditors and management.

The commentary in the Release states, "[A]n auditor's independence also is impaired when the auditor advises an audit client about the design of its management or organizational structure." We do not find anything in the text of the proposed rule that communicates this prohibition. In addition, we do not think providing advice on these matters should be prohibited for the reasons discussed above. Further, we think such a prohibition would be too broad. For example, we think an auditor recommending to a client that it create or strengthen an internal audit department is a form of providing advice about organizational structure that is consistent with an auditor's role and in the public interest.

In the Release, the Commission asks whether it impairs an auditor's independence if he or she provides consultation with respect to the compensation arrangements of the company's executives. We do not believe that providing advice on these matters impairs independence, because we do not believe it violates any of the three principles. We think it is important to note that such advice most often relates to the accounting and tax aspects of compensation arrangements. We think providing such accounting and tax advice is clearly permitted.

Legal Services

As noted in the Release, in some jurisdictions it is mandatory that someone licensed to practice law perform tax work. Therefore, under the proposed rule an accounting firm providing such services would be deemed to be providing legal services. In some jurisdictions, for example Germany, tax work is defined as legal work, and accounting firms hold a limited license to perform this legal/tax work. We believe that a foreign accounting firm should be permitted to provide, either itself or through an affiliated law firm, the same tax or other services that a U.S. accounting firm could provide. The nature of the service is important - not the form of the entity that delivers it. In this case, the nature of the services is such that providing them does not violate any of the three independence principles.

Tax Services

The provisions of the Act and its legislative history clearly indicate that auditors may perform tax services without exception provided they are pre-approved by the audit committee. Therefore, we fundamentally disagree with the Commission's view stated in the Release that accounting firms may not provide certain tax services to their clients without impairing their independence. Moreover, in an apparent attempt to address the highly publicized issue of abusive tax shelters, the Release provides conflicting and vague guidance, resulting in an unworkable model for auditors and issuers.

We agree with much of the following statement in the Release relating to Congressional intent to limit the proscribed services:

We note that the terms used by Congress could be construed very broadly. We nevertheless believe that Congress did not intend to ban any service that could conceivably fall within one of the prohibited categories of services. Both the language in the Act and the legislative history argue against such a broad construction. Each service as properly interpreted would be banned; however, proper interpretation must be made in light of the three basic principles. For example, the statute prohibits `expert' services. A broad interpretation of this prohibition could lead one to conclude that almost all services provided by a certified public accountant (CPA) could be considered to be `expert' services. For example, tax services would seem to be among the services that are provided by an `expert.' However, it is clear that Congress did not wish to ban all expert services because the Act specifically provided for an auditor to be able to perform certain services, including tax services, if the audit committee approves them in advance.

However, in the case of tax services, we believe it is inappropriate for the Commission to attempt to make the "proper interpretation ... in light of the three basic principles." In that regard, the Senate Report quoted in the Release states:

The intention of this provision is to draw a clear line around a limited list of non-audit services that accounting firms may not provide to public company audit clients because their doing so creates a fundamental conflict of interest for the accounting firms. The list is based on simple principles. An accounting firm, in order to be independent of its audit client, should not audit its own work, which would be involved in providing bookkeeping services, financial information systems design, appraisal or valuation services, actuarial services, and internal audit outsourcing services to an audit client. The accounting firm should not function as part of management or as an employee of the audit client, which would be required if the accounting firm provides human resources services such as recruiting, hiring, and designing compensation packages for the officers, directors, and managers of an audit client. The accounting firm should not act as an advocate of the audit client, which would be involved in providing legal and expert services to an audit client in legal, administrative, or regulatory proceedings, or serving as a broker-dealer, investment adviser, or investment banker to an audit client, which places the auditor in the role of promoting a client's stock or other interests.

The July 25, 2002 statements by Senator Sarbanes quoted in the Release repeat these points.

To use the basic principles as criteria for determining whether certain tax services should not be permitted does not necessarily have a logical basis. For example, while tax return preparation is clearly permitted and has not raised independence issues, the previous tax returns and related tax compliance work may impact or even form the basis for the tax accrual in the financial statements. Does that mean that providing these permissible tax services could be viewed as auditing one's own work?

We believe that the Senate report communicates Congress' intent to not limit the tax services auditors can provide to their clients. The report states Congress' intent "to draw a clear line around a limited list of non-audit services" (emphasis added). The list in the Act does not include tax services, which are expressly permitted under Section 201. The report then goes on to explain how the "simple principles" apply. Nowhere in this explanation does it state that these principles lead to the prohibition of providing tax services.

The following is an analysis of how tax services may be viewed in the context of the three broad principles:

Functioning as management - When an accounting firm suggests a tax saving idea to a client, the firm is providing professional advice, similar to when it suggests improvements in internal controls or other cost saving ideas. It is not acting as management. The decisions regarding whether to enter into or structure transactions or take positions on tax returns to reduce taxes are decisions that management makes based on comparing the tax savings to the costs and risks involved.
Auditing one's own work - The Release indicates that providing some types of tax advice is permitted ("tax consultation and tax planning encompass a diverse range of services, including ... tax advice related to mergers and acquisitions, employee benefits plans ..."). Presumably, the Commission believes (and we agree) that providing this tax advice does not require one to audit one's own work. Yet somehow the Commission seems to believe that providing other types of tax saving advice will result in auditing one's own work. There is no clear guidance, however, as to how to distinguish these two types of services.
Serving as an advocate - The Release acknowledges that accountants may provide a factual account of how tax returns were prepared and the judgments he or she made. The Release also acknowledges that "assistance and representation in connection with tax audits and appeals ... and requests for rulings or technical advice from taxing authorities" constitute permitted services. We expect these would typically be the functions accountants would perform after providing tax advice to clients. Of course, given the judgments the accountant previously made, it is likely that the account or assistance he or she provides will support the client's position. We do not believe that this makes the accountant an advocate for the client's position. The accountant is providing or assisting the client with providing information - not serving as a "hired gun."

The Release indicates that independence problems may arise when the services involve formulation of tax strategies, an example of which is a "tax shelter," according to the Release.

The incredible complexity of the Internal Revenue Code results in circumstances where the more complex areas are more likely to trigger novel approaches for dealing with them. We do not think that the nature of the accounting firm's role changes dramatically simply because an idea might be novel. After all, all ideas were novel the first time someone thought of them, management still makes the decisions on the approaches the company will take, and there is a body of rules against which all can evaluate the validity of an idea. As stated in the Release, "tax services are unique, not only because there are detailed tax laws that must be consistently applied, but also because the Internal Revenue Service has discretion to audit any tax return." These factors provide significant independence safeguards.
We do not think there is anything inherently sinister about formulating tax strategies designed to minimize taxes. Unfortunately however, the Release equates such advice with "tax shelters," a term that has developed negative connotations. In that regard, the only tax shelters that should be avoided are those that are illegal. As long as there is a reasonable basis for believing a tax saving idea is legal, we do not see why suggesting the idea to a client runs afoul of the three principles (or why some ideas would but others would not).

If the Commission ultimately decides to prohibit certain tax services, we believe it needs to communicate clearly in the final rule the types of services prohibited and the reasons why they are prohibited. In that regard, the Release discusses the nature of tax services in a number of sections. We suggest that it would significantly aid in understanding the Commission's views if all of the discussion were presented in one place.

We believe that drawing the line between permitted and prohibited tax services in a clear and reasonable manner is critically important. If that line is not clear, issuers are likely to avoid risk of not complying with the rule by assigning the more complex tax projects to firms (either law firms or other accounting firms) other than the firm that performs their audit. This could disadvantage the issuers, because the firms to which they assign the work may not be familiar with the issuers' businesses and, therefore, may not be in a position to provide the highest quality tax services. This could also result in issuers incurring additional internal and external costs for the time it may take the other firms to learn about the issuers' businesses. In addition, if a substantial amount of this work moves from accounting firms to law firms, this could reduce the desirability of a tax career in public accounting. Over time, this could reduce the pool of qualified tax resources available to serve as technical resources for audit engagement teams. The audit of the tax accrual requires extensive knowledge about both the tax law and regulations and the client's business. Such a reduction in the pool of qualified tax resources at accounting firms would also disproportionately disadvantage smaller issuers, who rely more heavily on their accounting firms for tax services.

The Commission requested comment on whether "providing tax opinions, including tax opinions for tax shelters, to an audit client or an affiliate of an audit client under the circumstances described above would impair, or would appear to reasonable investors to impair, an auditor's independence." The "circumstances described above" to which the Commission appears to be referring are "when the auditor provides a tax opinion for the use of a third party in connection with a business transaction between the audit client and the third party."

A properly issued tax opinion, including a tax opinion that may be relied upon by an individual or entity other than the client ("third party tax opinion") sets forth the facts and circumstances of a transaction, supplemented by representations of the client, and provides, based upon relevant tax authorities applied to the facts, circumstances, and client representations, in a neutral, impartial manner an opinion with respect to the tax consequences of the transaction. Generally, issuers of tax opinions, whether law or accounting firms, will not issue a third party tax opinion unless the facts, circumstances, and applicable law allow them to reach an opinion as to which they believe a court would conclude that the standard set forth in the opinion (i.e., "will," "should," "more likely than not," or otherwise) is clearly satisfied.

Accordingly, we do not believe the tax department of a public accounting firm providing a third party tax opinion impairs or appears to reasonable investors to impair an auditor's independence. Further, since there is a body of standards upon which to base the opinion, we do not see any difference between providing tax opinions and providing reports on the application of accounting principles, which are permitted under the Commission's rules and Statement on Auditing Standards No. 50.

Employment Relationships

We suggest that the Commission make a number of modifications to the proposed rule.

We do not think the Commission should extend the rule to cover management positions beyond those specified in 206 of the Act. The restrictions on employment reflected in the Act are limited to the chief executive officer, controller, chief financial officer, or any person serving in an equivalent position. Generally, these are the positions likely to be filled by persons on the engagement team with the potential to influence the results of the audit - i.e., the engagement partner or concurring review partner. We believe that limiting the management positions to those specified in the Act will provide reasonable safeguards. We think further restrictions will unnecessarily and unfairly limit (1) the ability of issuers to hire the right people for their accounting functions and (2) the career opportunities for young people in the accounting profession. We do, however, suggest that the Commission consider future rulemaking to expand the positions covered by the rule to include members of the audit committee because of the potential for these persons to influence the audit.

We recommend that the Commission narrow the group of accounting firm personnel it covers. The proposed rule would cover all members of the "audit engagement team." We think the rule should not apply to the following those people:

As discussed above in our comments on partner rotation, we believe that a number of the members of the "audit engagement team" serve as technical resources to the audit team and are not involved in the audit per se. Because of the limited nature of their role, we believe they should not be subject to the rotation requirements. Similarly, we believe that people who perform these roles, whether they are partners or staff, should be excluded from the employment limitations.
We believe there are other members of the "audit engagement team" who should be excluded from the employment limitations because of the limited nature of their role. Certain members of an audit team may perform only very limited amounts of work on an audit and not have any significant interaction with client personnel. For example, a person may spend one or two days observing a physical inventory at a remote plant location. We do not believe it is appropriate to limit such a person's ability to accept a job at the corporate office. As a practical measurement tool, we suggest that the restrictions apply only to people who spent more than 40 hours on the audit engagement.

We also suggest that the Commission change the manner in which the proposed rule calculates the cooling off period. The rule prohibits hiring a person if he or she was a member of the audit engagement team "during the one year period preceding the date that audit procedures commenced." Therefore:

The rule requires the client and the prospective employee (who must no longer be a member of the audit engagement team) to determine the date the current audit commenced, which may be difficult. It also generally strikes us as unnecessarily complicated.
The rule is based on the time period in which a person was a member of the audit engagement team, rather than the time period when the person actually performed services. Based on this language and the example in the Release, it appears to us that a cooling off period cannot begin until the audit report related to the audit on which a person worked is filed, regardless of when the person last performed services. In the case of an engagement partner, concurring partner, or the lead manager on an audit, we believe this is appropriate. However, others on the engagement may not have performed any services for the client for a significant period of time prior to the filing of the audit report. For example, a manager may have been involved in preliminary internal control testing and reviews of interim financial statements but not have spent time on the engagement for six months prior to the date the audit report was filed. In these circumstances we believe the proposed rule results in a cooling off period that is unnecessarily long.

We suggest that the Commission address these concerns and simplify the measurement of the cooling off period by simply prohibiting an issuer from employing a person who last performed audit or review services for the client within one year of their employment date.

We share the Commission's concerns that this rule could inappropriately restrict the ability of certain companies to hire qualified personnel. We believe this rule would have a particularly adverse effect on smaller companies. Therefore, we suggest that the Commission exempt a company from this requirement if (1) it does not meet the definition of an "accelerated filer" in the Commission's recently adopted amendments to Exchange Act Rule 12b-2 and (2) the person being employed was not a partner with the accounting firm. By limiting the exemption to auditors who were not partners, we believe the Commission would satisfactorily minimize the risk that the person could adversely influence the quality of the audit.

We believe that companies filing initial registration statements also warrant special consideration. We suggest that the rules apply only to companies in fiscal years beginning after they become Exchange Act registrants, in order to avoid unduly restricting the ability of companies considering an initial registration to upgrade their management team if necessary before offering securities to the public.

With respect to transition, we believe the Commission should grandfather all employment arrangements where employment had been offered, been accepted, or commenced before the final rules appear in the Federal Register.

Partner Compensation

Given the significant reduction in the non-audit services auditors would be able to provide to their publicly held audit clients, we do not believe it is necessary for the Commission to adopt the proposed rule prohibiting partner compensation for performing or selling non-audit services. Moreover, we believe that the changes in the professional environment brought about by audit failures, the demise of Arthur Andersen, and legislative and regulatory actions have had the effect of forcefully reminding auditors that the most important thing they can do to protect or enhance their compensation is to perform high quality audit work. We also note that this rule is not required by the Act. We think the Act and the other rules the Commission proposes to adopt provide sufficient safeguards. For these reasons, we see no need for the Commission to adopt this rule at this time.

If the Commission nevertheless decides to adopt this rule, we believe it should modify it in the following ways:

The proposed rule should not apply to all members of the "audit engagement team" as defined in Rule 2-01(f)(7) of Regulation S-X. We believe it should not apply to people who are not part of the "line" audit team, such as technical specialists (e.g., tax partners and information systems specialists). Consider the example of a tax partner who is a member of the audit engagement team. The rule would prohibit an accounting firm from compensating that tax partner for selling or even performing tax services for the client. We believe this would be an inappropriate result. It is important for a tax partner to develop the highly specialized skills that are used for a variety of purposes, including review of complex tax accruals and provision of tax advice. Therefore, it seems unnatural to prohibit such partners from receiving compensation for performing or selling services in areas that are a natural outgrowth of their skills. Doing so could have a detrimental effect on audit quality if it acts as a disincentive to having the most highly qualified tax partners participate in the audits of issuers. Moreover, a literal reading of the rule could lead some audit committees to require one tax partner to perform the tax work and another to consult with the audit team on matters related to the income tax accounts. We believe that requiring the audit team to consult with a tax partner who is less involved in and knowledgeable about the issues could reduce the quality of the advice the tax partner is able to provide. Involving two tax partners in the same issue would clearly increase costs. And when a local office does not have two partners with the appropriate expertise and needs to involve a tax partner from another location, the cost would increase further. We believe the Commission should modify the rule so that it applies only to "line" audit partners.
Since "audit-related fees" relate to "assurance and related services that are traditionally performed by the independent accountant," we believe that the rule should permit accounting firms to compensate audit partners for performing or selling audit-related services to audit clients. The proposed rule appears to prohibit this in some cases, because some audit-related services might not be considered "audit, review or attest services." An example of such an audit-related service would be "due diligence related to mergers and acquisitions." Furthermore, companies often need specific industry/company expertise in the individuals who are to perform special projects, which the engagement partner and concurring partner are likely to possess. Without access to this expertise, the company is at a disadvantage in terms of obtaining the resources it needs to complete the project in an effective and timely manner. Therefore, we believe the Commission should modify the rule to prohibit firms from compensating audit partners for performing or selling "... services other than audit or audit-related services or other services permissible under the rules that utilize the particular expertise of the audit partners."
The rule should prohibit only directly compensating audit partners for performing or selling such services. The rule should permit a partner to receive his normal share of whatever increase in earnings per unit might result from the firm providing those services. The increase in earnings per unit from providing one service to one client should not be significant enough to affect a partner's behavior or the public's perception. Prohibiting partners from being compensated indirectly would create a substantial administrative burden for accounting firms and would produce little benefit.
With respect to initial registrations, consistent with our recommendations above, we suggest that the rules apply only to companies in fiscal years beginning after they become Exchange Act registrants.

Audit Committee Administration of the Engagement

We believe that enhancing the audit committee's role in the administration of an engagement is a constructive step toward improving audit quality. However, we have two principal concerns with proposed Rule 2-01(c)(7) of Regulation S-X:

The rule is not specific in describing the level of detail into which individual services must be itemized when they are considered by the audit committee; and
The provisions allowing audit committees to approve services after-the-fact when inadvertent mistakes occur are not sufficiently flexible.

Neither the Release nor the proposed rule provides guidance regarding the level of detail in which services must be itemized when the audit committee considers them. For example, there is no guidance as to whether it would be sufficient for an audit committee to pre-approve "statutory audits in XX countries and state tax return preparation services for fiscal 200X" or whether the audit committee must pre-approve each of the statutory audits and tax return preparation services individually. We believe the final rule should provide the audit committee the discretion to determine the level of itemization needed to effectively consider the services to be provided by the auditor.

The provisions regarding audit committee approval of services after-the-fact when inadvertent mistakes occur are rigid in that they impose a quantified limit (5% of the total fees paid to the accounting firm) and they must be approved before the completion of the audit. The consequences of a significant failure to comply with the pre-approval rules are severe to both the accounting firm and the issuer. Therefore, we believe the best means of determining whether a failure is significant enough to warrant these consequences is to leave that decision up to the judgment of the representative of the investors - the audit committee, and the Commission should revise the rule to provide for this.

Our other concerns are as follows:

In defining which services should be categorized as audit services, the commentary in the Release indicates that the audit services should be categorized in the same manner as they are categorized for purposes of reporting fees in the proxy statement disclosure. Thus, audit services would include services such as providing comfort letters. However, the text of proposed Rule 2-01(c)(7) defines audit services as providing "reports required under the securities laws." Comfort letters are not required under the securities laws. Thus the commentary and the rule text appear to be inconsistent. We suggest that the Commission clarify this in the adopting release.
With respect to initial registrations, since most companies do not have audit committees before they complete their initial registration, we presume that these requirements would not apply to services arranged during this period. However, it is not clear to us how a literal reading of the rules would lead one to that conclusion. We suggest that the Commission modify the rules as necessary to make this clear.

Communications with Audit Committees

We believe that mandating the types of communications with audit committees called for by proposed Rule 2-07 of Regulation S-X is appropriate.

We are concerned, however, about the consequences if the auditor fails to comply with this rule in some respect. While we do not see any consequences stated in Article 2 of Regulation S-X, proposed Exchange Act Rule 10A-2 states, "It shall be unlawful for an auditor not to be independent under ... [Rule] 2-07." From this we infer that an auditor would not be considered independent and would be considered in violation of the Exchange Act if the firm failed to comply with Rule 2-07 in some respect. The requirements of Rule 2-07 are very general and require significant judgment to apply. We do not believe that it is reasonable to impose such harsh consequences if an auditor's compliance with the Rule 2-07 is less than flawless. We believe a higher level of misconduct (e.g., intentional or reckless disregard for the rule) should be required before this occurs. In addition, we do not understand why or think it is appropriate for a violation of this rule to cause an auditor's independence to be impaired. We do not believe such a violation runs afoul of any of the three principles upon which independence is based: functioning as management, auditing one's own work, or serving as an advocate.

The proposed rule would not require that the communications be made in writing. We support this approach. We believe that the key here is to encourage an open and frank discussion of the topics covered by the rule. We believe that requiring these communications to be made in writing would cause auditors to be more cautious about what they communicate, thereby reducing their effectiveness and producing a result which is inconsistent with the intent of the proposed rule.

It appears to us that Exchange Act Rule 10A-2 quoted above is meant to communicate that issuers must comply with Rule 2-07 after they complete their initial registration and become required to report under the Exchange Act. We suggest that the Commission communicate its views on whether Rule 2-07 applies in periods prior to filing an initial registration statement in the adopting release and consider modifying the rules to make them more clear on this point.

Expanded Disclosures

We believe the changes the Commission has proposed to the fees disclosure will result in more meaningful information for investors. However, we doubt that investors will find the extensive disclosures of the details of the audit committee's operating policies and actions useful, and we suggest that the Commission require disclosure only if the pre-approval requirements of Rule 2-01(c)(7) are not met.

We have a few technical suggestions regarding these proposed rules:

We believe that the discussion of which fees should be categorized as audit and audit-related included in the commentary in the Release points one toward different conclusions than one comes to when reading the text of Item 9 of Schedule 14A. For example, the commentary in the Release states that audit fees would include fees for comfort letters, statutory audits, and consents. The text of Item 9 states that audit fees should include only fees paid for the audit and review of the registrant's financial statements. Without the commentary in the Release, we would interpret Item 9 to say that fees for the services listed previously are not audit fees. We suggest that the Commission revise the text of Item 9 to include the principle stated in the commentary and make it consistent with the approach described in the commentary.
The commentary in the Release states that the following services should be reported as audit-related: "internal control reviews" and "consultation concerning financial accounting and reporting standards." It is not clear to us what was envisioned by the phrase "internal control reviews." However, we note that the attestation to internal controls accountants will be required to provide pursuant to Section 404 of the Act must be performed by the auditor of the financial statements and is not supposed to be part of a separate engagement. Therefore, it appears to us that the fee for this service should be reported as audit fees. Similarly, we believe that consulting with a client regarding the application of accounting standards to a pending or completed transaction is a service an auditor performs as part of the audit, and the fee for this service should also be reported as audit fees. We suggest that the Commission clarify this in the adopting release.
The commentary in the Release states, "The `Tax Fees' category would capture all services performed by professional staff in the independent accountant's tax division." We disagree. In our view, the fees for the audit services provided by those people (e.g., time spent assisting the audit team with the audit of the income tax accounts) should be reported as audit fees. The text of Item 9 seems to be consistent with our view, as it states that tax fees include only fees for "tax compliance, tax consulting, and tax planning." Accordingly, we recommend that the Commission retain the language in the text of the rule and provide commentary in the adopting release to clarify this point.
The proposed rule would require registrants to disclose each subcategory of services comprising the fees disclosed under the audit-related and other categories. We suggest that the disclosure would be more meaningful if the subcategories listed were limited to those for which significant fees were paid. We suggest that only subcategories where the fee exceeded 10% of the category total be required to be listed.

Other Matters

The Commission stated that it is considering relocating the rules covering auditor independence from Regulation S-X to the Exchange Act rules. We recommend that the Commission not do this. The independence rules apply to filings under the Securities Act as well as the Exchange Act, and we believe this is better conveyed by placing the rules somewhere other than in the Exchange Act rules. In addition, auditors are accustomed to finding the independence rules in Regulation S-X. We believe that moving the rules would simply further complicate the task of complying with the myriad of new rules.

In addition, we do not believe it is appropriate to hold an auditor in violation of the law in all instances where a violation of the independence rules occurs. The requirements of the independence rules are very general and require significant judgment to apply. Good faith reasonable efforts by auditors are unlikely to prevent all violations. We believe a higher level of misconduct (e.g., intentional or reckless disregard for the rule) should be required before an auditor is considered to have violated the law.

Finally we do not believe an auditor should be held responsible for matters beyond their control, such as failures by issuers or their audit committees to comply with the rules.

* * * * * * * *

We appreciate this opportunity to express our views to the Commission. We would be pleased to answer any questions the Commission or its staff might have about our comments. Please contact Wayne Kolins (at (212) 885-8595 or via electronic mail at wkolins@bdo.com), Lee Graul (at (312) 616-4667 or via electronic mail at lgraul@bdo.com), or Larry Shapiro (at (212) 885-8560 or via electronic mail at lshapiro@bdo.com).

Very truly yours,
/s/ BDO Seidman, LLP

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¹ Section 36(a) states, "... the Commission, by rule, regulation, or order, may conditionally or unconditionally exempt any person, security, or transaction, or any class or classes of persons, securities, or transactions, from any provision or provisions of this title or of any rule or regulation thereunder, to the extent that such exemption is necessary or appropriate in the public interest, and is consistent with the protection of investors."
² Rather than mandating accounting firm rotation, in Section 207 of the Act, Congress directed the Comptroller General to complete a study and review of the potential effects of mandatory rotation of accounting firms by July 30, 2003.
³ SEC Practice Section, Statement of Position Regarding Mandatory Rotation of Audit Firms of Publicly Held Companies, American Institute of Certified Public Accountants, 1992.
⁴ The Act mandates rotation only for "the lead (or coordinating) audit partner (having primary responsibility for the audit)" and "the audit partner responsible for reviewing the audit."