Eide Bailly LLP
406 Main Avenue
Fargo, North Dakota
January 8, 2003
Jonathan G. Katz, Secretary
U.S. Securities and Exchange Commission
450 Fifth Street NW
Washington, D.C. 20549-0609
Re: SEC File No. S7-49-02
Members and Staff of the Commission:
Eide Bailly LLP respectfully submits the following written comments on the U.S. Securities and Exchange Commission's (the "SEC" or the "Commission") proposed rules regarding the Commission's requirements related to auditor independence. Eide Bailly LLP is a regional accounting and auditing firm with 70 partners and approximately 600 employees serving public and private company clients.
Our comments related to the proposed rules are presented in the form of responses to specific requests for comment in the rule proposal.
A. Conflicts of Interest Resulting from Employment Relationships
Should the Commission include exceptions subject to certain criteria? If so, what should these criteria be?
Because there exist a significant number of issuers in specialized industries, we believe that the Commission should include provisions for exceptions. However, rather than provide specific criteria for exceptions, we propose that the rules be adopted which would allow the Commission the authority to grant an exemption, on a case by case basis, similar to those included in Section 201(b) of the Sarbanes-Oxley Act of 2002 with respect to prohibited services. This would preserve the integrity of this provision of the proposed rules while allowing the flexibility for exception when this may well serve the best interests of the issuer and the investor.
B. Services Outside the Scope of the Practice of Auditors
Is the meaning of the general principles sufficiently clear?
The general principles detailed in the proposed rules, principally that an auditor should not audit its own work and that the auditor or firm should not function as a part of management or as an employee of the audit client, should provide an appropriate framework and guideline to identify prohibited services.
Financial Information Systems Design and Implementation
Is an auditor's independence impaired when the auditor helps select or test computer software and hardware systems that generate financial data used in or underlying the financial statements? Why or why not?
We acknowledge that the design and implementation of a financial information system may place the auditor in a position of functioning as a part of management and/or be later placed in a position of auditing its own work. However, we do not necessarily believe that an auditor impairs its independence by assisting a client in testing computer hardware and software systems.
We believe that an audit firm may provide services to an issuer in this area without functioning in a management role and without being later placed in a situation to audit its own work. By applying the concept of an engagement team, as is utilized in the proposed rules relating to Conflicts of Interest Resulting from Employment Relationships, or an even stricter definition of engagement team for purposes of rules related to services outside the scope of auditors, a firm could provide such services without impairing independence. We believe that effective rules can be adopted in which individuals not affiliated with the engagement team would be able to provide these services. We expect that such services would be subject to the audit committee pre-approval requirements set forth in the Act, and that the audit firm be required to inform the audit committee of the relationship within the Firm of the respective engagement teams.
Whether a system is used to generate information that is "significant" to the audit client's financial statements may depend upon the size of the engagement. Does the magnitude as a percentage of either audit fees or total fees of the fees for such services make a difference on whether performance of the service impairs independence?
We do not believe that such a "test" is the most indicative factor in determining whether or not independence has been impaired as a result of these types of services. Rather, we believe that a more appropriate evaluation of impairment can be made as a result of the audit committee applying the general principles noted when evaluating their approval of such services.
Do services related to designing or implementing internal accounting controls and risk management controls result in the auditor auditing his or her own work? Would such services impair an auditor's independence when the auditor is required to issue an opinion on the effectiveness of the control systems that he or she designed or implemented?
Do services related to assessing or recommending improvements to internal accounting controls and risk management controls result in the auditor auditing his or her own work? Would such services impair an auditor's independence when the auditor is required to issue an attestation report on the effectiveness of the control systems that he or she has assessed or evaluated for effectiveness?
We believe that the auditor's design and/or implementation of internal accounting controls would result in the auditor auditing his or her own work, and that providing these services would impair an auditor's independence when issuing an opinion and/or attestation report on the effectiveness of those controls.
However, we do not believe the assessment of controls, or recommendations related to improvements of those controls, results in an impairment of independence or the auditor auditing his or her own work. Rather, this is the responsibility of the auditor under current standards, and it should remain the responsibility of the auditor. A thorough and effective assessment of internal controls and the ability to recommend improvements to management should enhance audit quality and reporting, and thus better serve the public interest.
We request comment on whether providing tax opinions, including tax opinions on 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?
While we agree with the basic principles established for determining whether or not auditor independence has been impaired, we disagree that the application of these principles as discussed in the proposed rules, specifically as they are related to representation before a tax court as an advocate of a client or the formulation of tax strategies designed to minimize a company's tax obligations. We believe that in the vast majority of these types of situations, that those individuals providing these services are not affiliated with the individuals providing the audit services, and as a result, auditor independence is not impaired. Particularly when these services are subject to audit committee pre-approval, we do not believe that their prohibition best serves the public interest.
C. Partner Rotation
Should the Commission adopt rules requiring that issuers engage forensic auditors periodically to evaluate the work the financial statement auditors (and related requests for comment)?
We do not believe that the Commission should adopt such rules, either in general or as an alternative to partner rotation. We believe that a stringent and accountable peer review process will be as effective in monitoring the quality of audit work performed. The implementation of such rules would likely result in an entire additional set of standards to be followed by the forensic auditors and the adoption of a system to monitor the quality of their work as well.
While such provisions may provide an opportunity for other firms to enter the market to provide these services, we believe that they will result in significant increases in the audit-related fees, without a corresponding impact and improvement in audit quality.
In the event that such rules were adopted, we do not believe that engagement of forensic auditors to evaluate the work of the financial statement auditors should be an alternative to partner rotation. The concept of partner rotation is to achieve a different perspective, to have a "fresh set of eyes", on the audit engagement. As we note above, we believe that this alternative will not achieve this objective, but will instead increase costs without the benefit of a significant improvement in audit quality or providing better information to the investor.
Is the exclusion of certain "national office partner" personnel from the rotation requirements appropriate?
We agree with the proposed rules related to the services provided by "national office partners", and that as long as these individuals are providing a service as a technical resource that they should not be subject to the partner rotation requirements. However, we do believe that some guidance may be warranted as to what constitutes a partner in this position. While this is fairly easily identifiable in the national firms and larger regional firms, it may become much less clear in a smaller regional firms or a large local firm. Additionally, the proposed rules make reference that such an individual may "consult on client matters regularly". Do these rules allow direct consultation between such a partner and an issuer, or must such consultation "pass through" the engagement team? If direct consultation is allowed, at what level of contact with an issuer does this individual become more than a technical resource? As a result of these types of questions, we believe more guidance may be needed in this area.
Should additional personnel (such as senior managers) be included within the mandatory rotation requirements?
While acknowledging that one of the goals of the partner rotation requirements is to ensure that audit engagement team members do not "grow up" on an engagement, we do not believe that audit quality will be improved by extending the partner rotation requirements beyond the partner level, rather that audit quality may well suffer as a result of extending the demands of rotating personnel on an engagement, particularly in specialized industries or where significant audit and accounting issues may exist.
Is the five-year "time out" period necessary or appropriate? Would some shorter time period be sufficient, such as two, three or four years? Should there be different "time out" periods based on a partner's role in the audit process?
While we recognize and support the value of partner rotation, we also believe that audit quality will be higher as a result of consistency of personnel on an engagement. Accordingly, we believe that there are benefits to providing for different "time out" periods depending upon the engagement and concurring partners' roles in the engagement, as follows.
A significant issue in the determination of individual partner independence is that of "client dependency", and the resulting pressures that client dependency may have on an engagement and on individual engagement partners. We believe that absent a situation of client dependency, a shorter "time out" period would be appropriate, and that the most appropriate measure of this dependency is a percentage of engagement revenue to total partner revenue. We suggest that a shorter "time out" period be provided for engagement partners in situations in which the engagement revenue is not significant in relation to that of the office or the firm.
Additionally, there are a number of entities that meet the definition of an issuer whose securities are not listed or traded on a national or regional exchange. The goal to achieve better audit quality to better serve the "public interest" does not have the same priority for these entities. Since these companies often operate in specialized industries, we believe that audit quality can be improved with consistency of personnel, therefore recommend that a shorter "time out" period also be applied in these cases.
Lastly, because a concurring review partner fulfills a different role and has a different responsibility of that of the engagement partner, we believe that a partner serving in a concurring reviewer capacity does not need to be subject to a five-year "time out" period, but that a shorter period would be sufficient. Additionally, we believe that a shorter period would be appropriate for a former engagement partner returning to an engagement as a concurring review partner. Accordingly, we recommend that concurring partners, and former engagement partners returning to an engagement as a concurring partner, be subject to a "time out" period of two years rather than five years. A different "time out" period for concurring review partners should still result in achieving the objectives of partner rotation without compromising audit quality, in fact, we believe that this may well enhance audit quality.
If a partner rotates off of an engagement after fewer than five years, should the "time out" period also be reduced?
We do believe that there should be provisions for the "time out" period to be reduced if a partner rotates off of an engagement after fewer than five years. We also recognize that with such rules there exists the possibility of compromising the objectives of partner rotation, and therefore recommend that specific rules be implemented.
We do not believe that the objectives of partner rotation are achieved by allowing a partner to serve for one year, rotate off for a year, and then return to an engagement. We propose that rules be adopted wherein a partner serving for two or more years would be subject to a "time out" period equal to the time served.
This type of rule would ease the effects of the proposed rules on smaller firms and those issuers in specialized industries.
The proposed rules would not require all partners on the audit engagement team to rotate at the same time. Should it? Why or why not?
We do not believe that a complete turnover of personnel every five years will result in improved audit quality, rather, we believe that this will diminish audit quality as the new partners will need time to familiarize themselves with the industry and audit and accounting issues involved.
Is it appropriate to provide transitional relief where the proposed rules are more restrictive than the provisions of the Sarbanes-Oxley Act?
We believe that it is imperative, and in the issuers' and public's best interest, that transitional rules are provided. We do not believe that audit quality will be improved, and, in fact, believe that audit quality will be compromised by implementing the proposed partner rotation rules without transitional provisions. A transition period will allow smaller firms time to plan for the rotation and for firms working in specialized industries the time to appropriately train those partners who will need to become a part of the engagement team.
We propose a framework for transitional rules, as follows. First, a one-year transitional period would be available for all engagement and concurring review partners. This will be of particular benefit to the smaller firms impacted by the provisions and allow these firms and their clients to more appropriately plan for the future.
Second, engagement and concurring partners would be subject to a mandatory rotation after serving a period of the higher of seven years of service or five years from the effective date of the final rules, including the one-year transitional period provided for above. For example, if an individual has currently served as the engagement or concurring partner for a period of four years, he or she would have three years remaining prior to rotating off of the engagement. If an individual were in his or her first year as an engagement or concurring partner, he or she would be subject to rotation after five years.
Again, we believe that a transition period is critical to these provisions so as to prevent the unintended consequence of diminishing audit quality by not having the most qualified individuals serving in the engagement and concurring partner roles.
D. Audit Committee Administration of the Engagement
Is allowing the audit committee to engage an auditor to perform non-audit services by policies and procedures, rather than a separate vote for each service, appropriate? If so, how do we ensure that audit committees have rigorous, detailed procedures and do not, in essence, delegate that authority to management?
The proposed rules provide for the audit committee to have the ability to "...establish policies and procedures provided they are detailed as to the particular service ...", and that the audit committee be informed on a timely basis of each service. We believe that audit committees will generally readily accept their role in this process and assume the appropriate level of responsibility. If audit committees perform their role as defined in the proposed rules, the fact that they do not have a separate vote for each service would not seem to increase the possibility that they would delegate such authority to management.
Would the proposed rule change be difficult to put into practice?
While the goal of removing the possibility of impairment of independence by placing rules and restrictions on audit partner compensation may seem appropriate, we question how these rules will be written so as they can be applied to the diversity of firms providing these services, and given this diversity, question how the rules, if reasonably written, would be enforced.
G. Communications with Audit Committees
In light of the requirements for the CEO and CFO to certify information in the company's periodic filings, should the auditor be required to communicate information on critical accounting policies and practices and alternative accounting treatments to management as well as the audit committee?
Since the CEO and CFO will ultimately assume responsibility for the financial statements and the related accounting policies and practices, we believe that it is appropriate to provide this communication to management, as well as to the audit committee.
Critical Accounting Policies and Procedures
Should the auditor be required to provide the communication in writing?
We believe it would be appropriate to require this communication to be in writing to reduce the possibility of misunderstandings related to this communication.
Timing of Communications
Should the timing of these communications be required to occur before any audit report is filed with the Commission or at some other time? Should these communications regarding critical accounting policies be required to be in writing?
We believe that these communications (management representation letters, reports on observations and recommendations on internal controls, and schedule of material adjustments and reclassifications proposed and a listing of adjustments and reclassifications not recorded) should also be in writing, principally to provide that management and the audit committee receive a consistent communication. Additionally, we believe that these communications should be required to be provided prior to the audit report being filed with the Commission, as the possibility exists that these communications could provide information critical to the CEO and CFO certifications that will accompany the filing of these financial statements and related audit report.
Should the list of recommended other communications be required to be communicated to the audit committee? Why or why not?
We believe that any additional communications to management that may be required to be provided to management should also be required to be provided to the audit committee. Given the additional responsibilities that audit committees will assume under the provisions of the Act, it is appropriate that they also be provided with this information.
H. Expanded Disclosures
Principal Accountants' Fees
Is the proxy statement the appropriate location for this disclosure? If not, why?
While we do not disagree with this information being disclosed in the proxy statement, we believe that consideration should be given to this information also being disclosed in the annual report (Form 10-K and Form 10-KSB).
I. Transition Period
Would a period of time beyond the adoption date of the final rules be necessary or appropriate for compliance with the final rules by smaller companies or companies with whose securities are not listed or quoted? If so, which rules should we consider a delayed effective date?
As we have noted in our response, we believe it would be appropriate for a transition period related to the adopted partner rotation rules. The rules, as proposed, pose significant challenges not only for smaller firms and issuers, but for larger firms and issuers, as well, and accordingly, a transition period will serve not only the interests of these parties, but also of investors.
Eide Bailly LLP
Darold Rath, CPA
Chief Executive Officer, Managing Partner