January 13, 2003
The Honorable Jonathan G. Katz, Secretary
Re: Comments on Proposed Regulations Regarding Auditor Independence
Dear Mr. Katz:
Aon Consulting is pleased to submit the following comments on the Commission's proposed amendment to rules dealing with auditor independence as required by Title II of the Sarbanes-Oxley Act (the Act). Under provisions of that title of the Act, certain non-audit services will be prohibited, conflict of interest standards will be strengthened, and the relationship between the independent auditor and the audit committee will be clarified and enhanced. Aon Consulting is supportive of the SEC's efforts and generally agrees with the approach taken. We do, however, have several suggestions for strengthening or clarifying the proposed rules.
Aon Consulting provides actuarial, human resource and benefit plan design consulting services to thousands of employers of all sizes and in a diverse array of industries. The issue of auditor independence is critically important to all of these clients as well as to their shareholders and employees. Any actual or potential compromise in the credibility of publicly disclosed reports related to the financial status of the companies or their employee benefit plans puts at risk both the actual well-being and status of the companies and their plans and increases the risk that the investors and employees will be misinformed or misled. This risk is amply demonstrated by the adverse consequences to investors and employees of several recent well-publicized examples of improper auditing allegedly due, in part, to loss of independence and objectivity.
Both actual independence and the appearance of independence are critical to the credibility accorded the financial reports of companies and of their employee benefit plans. The independence of auditors is the foundation upon which investor and employee protections rest. Without the assurance that company financial statements have been reviewed by a party free of any conflict of interest, measures to safeguard those who rely on the statements could be jeopardized, leaving vulnerable the employment, retirement, and health security of thousands of working and retired Americans. Opening the door even slightly could whittle away at the ability of audit committees to maintain real auditor independence and could well undermine the ability of the Act to achieve fundamental reform in this area. We therefore urge the Commission not to dilute these important standards by creating any exceptions to the nine listed categories of services and to assure that, if final rules do allow for any exceptions, they will be very narrow and subject to rigorous review and restriction.
Actuarial Services for Employee Benefit Plans and Their Sponsors
The proposed rules strictly limit the actuarial work an auditing firm can perform on behalf of an audit client. We strongly support such limitations.
Employee benefit plans are very significant corporate obligations. For a publicly held company with traditional pension plan arrangements, the value of its pension and postretirement benefit promises is typically of the same order of magnitude as the company's market capitalization. There are numerous instances of public companies that report expense (or income) due to these plans, which represents over 25% of reported earnings per share. These plans, like all employee benefit arrangements, are governed by a complex, interlocking web of tax, employment law, and other legal considerations which continually changes - and there are significant penalties for failure to fully comply with rules governing these plans.
Appraisals of these programs require actuarial skill and judgment in the application of accounting standards and other regulatory requirements. Benefit programs and their governing rules are constantly changing. Determination of the appropriate accounting or regulatory treatment for these programs is rarely, if ever, a mechanical process; instead it represents choices and judgments on a variety of issues. These include such issues as the selection of appropriate data to evaluate the costs of these programs and the quality of such data; the choice and application of appropriate demographic assumptions; the attribution of benefits earned to periods of service under plans with multiple and/or hybrid benefit formulas; and the appropriate interrelationship of economic assumptions. These and other choices represent judgments, which generate material differences in the measurements of liabilities, contributions and expense for these programs.
Prior guidance from the Commission allowed accounting firms to provide actuarial services with respect to pension and postretirement benefit plans sponsored by audit clients, on the basis that the actuarial functions were not "basic to the operation and management of the company" sponsoring the plans. Given the materiality and magnitude of these programs, we would question that underlying premise.
Other commenters have suggested that management makes all judgments involved in the valuation of these programs without reliance on its actuarial advisors and that the actuarial firm follows a purely mechanical process to generate the resulting calculations. This is not our experience. Instead, management generally delegates certain functions to the actuarial firm and solicits actuarial advice on a number of other issues regarding its potential alternatives.
We believe that the Commission's proposed rules appropriately recognize the risk that allowing auditors to perform actuarial and related services would violate basic principles espoused in the legislative history of the Act. Performing actuarial services that calculate the employer's expense for employee benefit programs represents the assumption of a key management task. Auditing the employer's books would require the auditor to opine on the results of its own work. In addition, performance of actuarial services, such as the calculation of minimum required or tax deductible contributions to these plans, routinely involves the actuary as an advocate for client positions before regulatory agencies. Avoidance of both actual and perceived conflict between the accounting firm's role as auditor and any role as consultant is imperative to honor the principles of the Act.
The proposed rules would allow an audit firm to use its actuaries to assist in conducting the audit, provided the audit client uses its own actuaries or third-party actuaries to provide management with the primary actuarial capabilities. We believe that the Commission intended this "exception" to be very narrow, and we suggest that the preamble and final regulations clearly indicate such. Final rules should clarify this restriction to provide that the auditing firm is not independent if the auditing firm prepares actuarial calculations to determine reported expense under the FASB requirements or calculates required or deductible contribution amounts under tax and ERISA requirements where either the plan or its sponsor is an audit client. The underlying basis for the development of tax numbers is determined by the basis used for the ERISA numbers, and the tax figures become an integral part of the ultimate financial report. The audit firm thus should not be in the position of developing the tax figures, which are then subject to their audit. While the proposed rule clearly bars preparation of FASB numbers for the employer/audit client (e.g., FAS 87), the bar on tax and ERISA services for both the employer and plan and the preparation of FASB numbers for the plan as a separate audit client may not be as clear. Failure to bar these conflicts could diminish the integrity of the disclosures and threaten the safeguards meant to protect employees and investors.
It should be noted that the general prohibition on providing valuation services and the waivable prohibition on providing tax services can overlap with the prohibition on providing actuarial services. For example, the reevaluation and redesign of a pension plan can involve actuarial calculations to estimate the cost of various options in light of tax rules that apply to qualified retirement plans. The final rule should assure that prohibitions in these areas cannot be circumvented by characterizing them as tax compliance services that are permitted to be provided if approved by the audit committee.
Not all actuarial work done in connection with a plan is done for the plan or its sponsor. For example, a plan participant may need to determine the value of the plan benefit for marital asset distribution purposes. The SEC should address whether or not the audit firm is prohibited from offering services to third parties in this and similar situations where the work would not have any bearing on the audit of the employer or plan financials.
Human Resource Functions
The Commission's proposal would prohibit the audit firm from providing hiring and management functions that include the following:
Input on the range of other services in the employee benefit area that should be banned is requested. In our view, to preserve independence, the audit firm should be barred from a full range of employee benefit services, including the design, compliance and administration of employee benefit plans, placement or evaluation of group insurance products, the outsourcing of the benefits administration function and general benefit, compensation and human resource activities and services. These functions are similar to those prohibited and can directly result in conflicts for the auditor or impair the auditor's objectivity and independence. As previously discussed, all employee benefit plan operations are governed by complex, interlocking tax and employment law provisions, which contain significant penalties for failure to fully comply with legal restrictions. The auditor may well need to opine on the materiality of any liability arising due to these programs. Allowing the auditor to provide such services puts the auditor in the position of opining on its own work product. Both auditor independence and the appearance of independence are critical.
Legal Advocacy and Expert Services
The Commission's proposal states that an auditor may not provide expert, consulting, or other services to the audit client's attorney in connection with litigation, administrative, or regulatory proceedings. The objective of the prohibition is to assure that the auditor not take the role of an advocate for the audit client or be put in a position of auditing his or her own work. We fully support the Commission's interpretation of the Act as barring the provision of services that would compromise the ability of auditors to fairly, objectively and independently perform their audit evaluations without concern for undermining the expert advice provided by colleagues.
The Commission's proposal would allow an audit firm to provide tax services if the audit client's audit committee approved the service in advance. While the term "tax services" is not specifically defined, it is understood to include a range of activities including the preparation of tax returns, tax compliance, tax planning, tax recovery, and other tax-related services. However, the proposal provides that an auditor may not formulate tax strategies designed to minimize a company's tax obligations because providing these services may require the accountant to audit his or her own work, to become an advocate for the client's position on novel tax issues, or to assume a management function. The proposal also expresses concern that providing a tax opinion about a proposed transaction between the audit client and a third party to induce the third party to participate might be impermissible because the audit firm would be acting as an advocate for the audit client by actively promoting the client's interests.
We would encourage the Commission to caution audit committees further beyond the strong admonition concerning tax strategies and tax opinions for audit clients. Many of the other services described may initially seem somewhat benign but could easily develop into significant conflict-of-interest situations resulting in far-reaching adverse consequences. It is important to preclude auditors from being put in a position where they have divided loyalties to the audit client, the investing public, and their own company's profitability. Again, auditor independence and the appearance of independence are critical.
Recent history and some prominent business failures have underscored the critical nature of auditor independence. The passage of the Act highlighted Congressional concerns regarding this issue. The Commission's proposed regulations are a positive step in assuring that the operations and financial status of companies and employee benefit plans are thoroughly, objectively and independently evaluated and disclosed. We support the steps proposed by the Commission, but, as suggested herein, we recommend that several areas of possible auditor conflict be furthered restricted or clarified by eliminating or narrowing proposed exceptions or reinforcing the underlying prohibitions.
We very much appreciate the opportunity to submit these comments. If we can provide further assistance, please contact me at 732-302-2124.