January 13, 2003

Mr. Jonathan G. Katz, Secretary
U. S. Securities and Exchange Commission
450 Fifth Street, NW
Washington, DC 20549-0609

Re: File No. S7-49-02

    In Re: Proposed Rules on Strengthening the Commission's Requirements Regarding Auditor Independence

By Email:

Dear Mr. Secretary:

Grassi & Co., CPAs, P.C. is a regional CPA firm with its main offices located in Lake Success, New York and New York City. Our clients include both Securities and Exchange registrants as well as privately held entities.

As proud members of a profession that prides itself on high ethical standards and the highest integrity, we laud the passage of the Sarbanes-Oxley Act (the "Act") and the SEC's efforts to maintain the spirit of the Act in its proposed rules. We appreciate the opportunity to express our views.

While we support the Act, we are, however, of the belief that it is inherently impossible to adapt the auditor independence rules of the Act, and by extension the proposed SEC rules, to small and midsize CPA firms on an "as is" basis. Doing so poses unique and significant problems for smaller CPA firms and their invariably smaller registrants - at best, placing disproportionate demands with a myriad of impacts; at worst, many CPA firms will not even be able to survive.

We cannot ignore, nor do we think Congress, the SEC and the profession should ignore, that taken from a historical perspective, the Act's propulsion to the forefront has in reality been the result of issues relating to entities of very large size, both at the CPA firm level as well as the registrant level. Therefore, the firms that had the least to do with the current climate of issues relating to auditors are the very ones which will carry the largest burden relating to the resolution of these issues!

We acknowledge that there are potential abuses at smaller firms and that controls are necessary to control those potential abuses. With their strong commitment to high quality, we do however maintain that a smaller firm is less prone to abuses, and that from a practical standpoint it is much more likely that even one liability issue could put these smaller firms out of business.

We respectfully correlate our belief to the following areas of the Act and proposed rules:

Partner Rotation

Nowhere is the disproportionate nature of the Act and the proposed rules more evident than in the area of partner rotation. We agree that partner rotation continues to be a necessity; however, we feel the proposed rule requiring rotation of the lead and review partners after five consecutive years with a five-year cooling off period is unnecessarily burdensome and unnecessary, particularly for smaller firms. Smaller firms simply do not have the bandwidth and quantity of partners to enable such a rotation without severe impacts on the firm's financial condition and its audit and client service quality. In the area of audit quality particularly, in an ironic twist, the result will be the lessening not the enhancement of audit quality, as partners without the proper experience with the client, applicable regulations, and the industry may necessarily be rotated onto a client as the lead audit partner. In turn, the client will suffer, perhaps not receiving the proper service and/or most likely having to bear the additional cost as their new audit partner(s) get up to speed on the company's business operations and unique accounting and financial reporting matters.

Further, we believe the lead and review partners are the only partners the rotation need apply to, and in any event, that the rules relating to the lead partner should be different, ie, more stringent, than those for the review partner as the lead partner invariably has the client relationship.

Therefore, we propose that the SEC delay partner rotation requirements for small to midsize firms for three to five years so that perhaps Congress can readdress the Act as it relates to small and midsize firms. If this is not a possibility, we recommend at a minimum that the SEC proposed rules for small and midsize firms do not go beyond those mandated by the Act - a five year consecutive limit for the lead and review partners with a one-year cooling off period.

We ask you to also take into consideration in your decision the concern voiced by the AICPA on the "cascade effect" any legislation has on nonpublic entities through future Federal and state legislative action.

Nonaudit Services

In keeping with our premise that smaller and midsize firms and their registrants need a different set of rules, we believe there are nonaudit services that, from a cost-benefit standpoint, should be allowed for auditors of small and midsize companies. We wholeheartedly agree with the SEC and AICPA position that an auditor should never be put in a management type role for its audit client. We do, however, note many instances where an auditor might perform a necessary and valued service for the client while still maintaining his or her independence both in appearance and in fact.

These instances include, among others:

  • Internal Audit Consulting:

    The current SEC independence rules include an exception to internal audit restrictions for external auditors for businesses with assets totaling less than $200 million. The proposed rules, however, eliminate such exception maintaining that despite an entity's size, an external auditor in performing internal audit functions may be put in a position of auditing his or her own work.

    We submit that, with proper safeguards in place and a clear definition of allowed versus prohibited services, this exception should not be revoked.

    It is counter-productive and runs counterintuitive to deny a smaller company access to certain of the valued functions of internal audit. Companies which are not in an economic position to avail themselves of this important function or which are not of sufficient size to warrant a fulltime internal audit department should have the right to call upon experts who are most familiar with its policies, procedures, operations and goals. Invariably, for smaller businesses, these experts are their external auditors. Indeed, many aspects of the internal audit function are a natural extension of the external auditor's audit and as such, performing such services under the auspices of internal audit as opposed to external audit does not change the nature of such services.

    Specifically, the external auditor of a small business should be allowed to evaluate and make recommendations on the client's system of internal controls and financial systems. This definition should uphold the belief that the external auditor should not act in the place of management nor should the external auditor be placed in any type of decision-making capacity. The external auditor's recommendations should be submitted to management and the audit committee for consideration for action thereon.

    With a clear distinction and understanding that the external auditor is acting in an advisory capacity, making recommendations as opposed to writing policy, we do not believe it would be construed that the auditors would be auditing their own work. Clearly defined and detailed examples of services which may be construed as either advisory (allowed) or managerial (prohibited) would ensure that auditor independence is not impaired and at the same time, enable smaller businesses to take advantage of this otherwise prohibitively costly function, resulting in enhancement of an entity's system of controls regardless of size.

  • Tax Services:

    The same concepts as cited above apply to certain tax services which are considered prohibited services, namely, the provision of tax opinions and the formulation of tax strategies.

    We do not believe that the providing of opinions on the tax effects of transactions or contemplated transactions need be construed as the auditor auditing his own work. Nor do we believe, with proper safeguards in place, does the auditor become part of management. The study of transactions, similar to the study of internal controls, and the making of recommendations thereon, is a much different role than the decision-making process which is a function of management and/or audit committees. Furthermore, the cost-benefit of the company's auditor (who is most familiar with the company's financial information) providing such services would again make it prohibitively expensive for a smaller company to avail itself of seeking yet another firm to provide advice, a clear duplication in that the company would be forced to explain its operations and financial data to a second CPA or CPA firm. We do not believe the Commission's concerns, easily safeguarded against, justify this cost for smaller companies.

    As in the area of internal audit, there should be a clearly delineated list of allowed and prohibited services which would ensure that auditors are not auditing their own work nor placed in a position where they may be construed as being a member of management.

    Regarding the client advocacy argument, interpreting the effects of a transaction against applicable rules and regulations and opining thereon or alternatively, providing advice on the structuring of a transaction in relation to its tax minimizing effects should be looked upon as an interpretative role as opposed to an advocacy role, similar to a CPA firm interpreting an SEC regulation for a client and explaining its effects to them.

    We are also in agreement with 1 - the AICPA's taking exception to the interchangeable use of the concepts of tax strategies and tax shelters and 2 - the AICPA's position of using the concept of "business purpose" as a baseline against which to measure appropriate and inappropriate tax service provided to clients by their auditors.

In closing, as a template for sweeping accounting and audit reform, the SEC must "get it right" in ensuring that the final rules make sense and are reasonable for entities of all sizes by taking into account the inherent differences in firms and registrants, and by arriving at rules that make sense for everyone and not falling victim to a "one size fits all" approach which, for smaller companies, may very well ultimately have the exact opposite effect from that which was intended.


Louis C. Grassi, CPA, CFE
Managing Partner