HSBC Holdings plc
Mr Jonathan G Katz
Ref: File number 57-49-02
10 January 2003
I refer to your proposed strengthening of the auditor independence rules published for comment on 2 December 2002.
I welcome the efforts to strengthen the role of audits. As both a registrant and a major user of financial statements HSBC believes that a robust, independent audit is essential to the proper functioning of the capital markets and banking sector in the US and elsewhere.
In my view the key ingredients for such a robust audit are a strong understanding of the business value drivers, the cost structures and the risk factors within the business model. In assessing the results of the business model and the judgements made by management the auditors then need to apply, a high level of integrity, independence of mind and soundness of judgement, particularly from the key partners involved. It is important that balance is achieved in setting standards for those personal attributes such that in striving for pure independence the auditor is not so restricted in his access to the company and its management and his grasp of the business model is weakened. Unfortunately it is difficult to legislate for this and hence the temptation is to legislate to deal with public perception of these issues. Whilst the latter is not unimportant it needs to be kept in context and we should not damage reality by over zealous regulation of perceived problems.
For the most part I believe that the Commission's proposals are sensible and achieve the balance alluded to above. However whilst the Commission has clearly articulated principles which should underly independence, I am concerned that the proposals adopt a "rules based" approach which endeavours but necessarily fails to cover all areas.
In addition, there are three areas where, in my opinion, the proposals would potentially damage the audit and/or are unworkable in practice. These are as follows:
Partner rotation rules
As a major global organisation we operate in over 80 countries worldwide and in nearly all of these our operations are subject to an external audit, principally due to our desire to ensure that all, bar our most insignificant businesses, are subject to this discipline and partly due to local law and regulation. As a consequence, our auditors estimate that over 250 partners worldwide would be subject to the proposed rotation rules.
From my perspective the key factor in a sound audit is deep understanding of our business and its inherent risks. Given the global nature of our business and the ease with which financial transactions can span the globe HSBC needs an effective team of partners who communicate well and freely across geographical and cultural divides. If we are to achieve this we require a high degree of continuity in engagement staff as well as controls to ensure that inappropriate judgements by individuals are not perpetuated. In my experience most financial reporting failures derive from failings at the top, both of companies and audit teams. Hence the proposals to prevent the audit engagement partner and concurring partner from acting in those capacities for more than five years are, in my view, reasonable. However, in order to manage adequate succession and maintain the quality of the audit in an organisation as complex and diverse as ours I seriously question whether extension of the same rules to all other partners who provide audit services is beneficial.
As a multinational we are also desirous of achieving harmonisation of rules if possible lest we find ourselves caught between conflicting demands. In this connection I would ask the Commission to consider if the rules recommended by the European Union, and recently adopted in the UK might not provide an acceptable basis. As you are aware this provides for key audit partners to be rotated after seven years on the client. This has, in my opinion, the following benefits:
(1) It recognises that partners other than the lead audit engagement partner may play key roles on the audit and as such should be subject to mandatory rotation, but allows more flexible arrangements to balance continuity and "new blood" in those countries where both we and our external auditors have limited operations.
(2) It recognises that other key partners have less influence than the lead audit partner or concurring partner and hence allows for an extended period and a shorter "cooling-off" period which I believe strikes a more appropriate balance between desirable continuity and the perception of over familiarity.
(3) It allows a future lead partner to serve on a client in a more junior capacity to facilitate a sensible "hand-over" period. It would be unusual and undesirable in a major company such as ourselves for the lead audit partner to come in "cold". If therefore the hand-over period counts towards the five year rotation period then we will have three or at most four years service only from any individual as lead audit partner. It would not be uncommon in HSBC for our lead audit engagement partner on the Group to have served as audit partner on at least one of the major subsidiaries. Frankly I do not see how they can adequately discharge their responsibilities without such experience.
Investment company audit committees
It is wholly appropriate that as an investment adviser we do not seek to influence an investment company regarding its choice of auditor. As the Commission notes this is at present the responsibility of a majority of directors who are not interested persons and the proposed rules will further strengthen the role of the investment company's audit committee. Equally, however, it is not appropriate that the investment company's audit committee should determine the extent to which HSBC in aggregate can use that accounting firm in areas which may have no connection with the investment company's business simply because we have an investment advisory relationship. We are under no obligation to, nor would wish to, discuss all the engagements in which we might wish to use the accounting firm concerned. Neither can the accounting firm disclose such information for client confidentiality reasons. And with only four global auditing firms there is virtual certainty of having a relationship with all these firms.
We believe the proposition should be withdrawn as drafted. If the concern is that the accounting firm may work, for example, on systems of the investment adviser which may underly the accounting records of the investment company then this can surely be tackled more directly by prohibiting the relevant services.
I fully appreciate and endorse the Commission's views that there may be occasions on which the supply of tax services by an audit firm may breach one of the fundamental principles. In practice this is, in my opinion, only likely in a limited number of circumstances and I believe this area is best left to principles rather than seek to establish a rule which may not be appropriate in all situations. In a number of countries it would be very difficult to ensure the auditors do not supply the services as local Revenue authorities habitually route queries to the company seeking corroboration from the company's auditors.
In addition to the above concerns I have noted in the attached Appendix responses to certain of the Commission's questions and other points.
I hope that you find these comments helpful.
Appraisal and valuation services
In a number of countries, including the UK, contribution in kind certificates are required as a measure of shareholder protection to prevent directors overstating the value of assets subscribed to the company. In many respects therefore the opinion is more in the nature of an attest function (ie is the director's valuation appropriate?) rather than a valuation per se. Since this is in effect the same function as would be undertaken in the audit itself (if the amount concerned is significant) it does not seem to present the conflict the Commission is concerned about.
This area is one which demonstrates the difficulty in a rules based approach to the simple principle that an auditor should not be an advocate for the client. By framing the rule in a way that works in a US context the Commission does not take account of the impact in foreign jurisdictions nor that not all provision of legal services results in acting as an advocate. In my view it would be better to adopt the principle, certainly as applied to foreign jurisdictions.
As you will be aware regulation of the auditing profession varies across the world although in general most major countries are moving towards some independent assessment process. For example, in the UK all registered auditors are reviewed by the Joint Monitoring Unit. I would prefer that any proposals in this regard took account of such efforts through a process of mutual recognition. I believe that independent oversight by a government sponsored body in this way provides a better solution than yet another layer of potentially unaccountable private sector firms.
Additionally given the scope of our international operations and the fact that we engage the other global accounting firms to perform tasks which our auditors cannot perform it is a real issue as to whether any forensic auditor is "independent" to perform this forensic role.