January 19, 2003
Mr. Jonathan G. Katz
Re: File No. S7-49-02; Strengthening the Commission's Requirements Regarding Auditor Independence.
Dear Mr. Katz:
This comment letter serves to supplement the comment letter I sent the Securities and Exchange Commission ("SEC" or "Commission") dated January 13, 2003. This letter provides additional comments to the Commission regarding its proposal on the impact compensation to audit partners and advocacy of an auditing firm has on a firm's independence.
Audit Partner Compensation
In the auditing firm in which I was previously an audit partner, as well as in other audit firms, the partners' compensation is affected by a number of factors. These factors may include the number of ownership units a partner holds in the accounting firm, the overall profits of the firm which are divided among the units, and the evaluation process for assigning the units. Firms may also award selected partners bonus payments or participation in a bonus pool based on a number of criteria, including the ability to generate billings for non-audit services.
The partners in an auditing firm, regardless of the discipline or division they practice in (e.g., taxes, audit, consulting, national office, etc.), are sometimes paid from the combined pool of firm profits. They are not paid just from the profits of the division they work in. As the SEC Chief Accountant, I learned from some of the Big Five firms, that even when a separate legal entity was established for a separate product line such as information technology consulting, there were profit sharing arrangements between the legally separate entities. These profit sharing arrangements could and did impact the compensation audit partners received. From recent discussions with people in the profession, I understand that some believe that because a partner may be paid from a firm-wide pool of profits, the proposed amendments to Regulation S-X, Article 210.2-01, in particular item (8) Compensation would not preclude partners from sharing in, and being paid based on the profits generated by the consulting practice, to the extent they contribute to the overall firm pool of profits.
This is a significant issue as during periods of a robust economy in the United States, such as existed during the 1990's, consulting and other non-audit services grow to become a very significant portion of firm's profits. In turn, the profits generated by these non-audit divisions of a firm will likely have a significant impact on the total compensation a partner receives. The potential independence conflicts affecting the audit partner and personnel assigned to an audit engagement are increased when the compensation is calculated by dividing a firm-wide pool of profits by the number of partner units. You might recall, during the SEC's 2000 auditor independence rule-making initiative former Commissioner Issac Hunt requested information on just how large a portion of the Big Five accounting firms' revenues and profits were generated by non-audit fees. As the adopting release notes, the firms refused to provide the data to the Commissioner.
So as not to mislead investors and consumers as to how the final SEC rule does impact an audit partner's compensation, I urge the Commission to clarify its rule in the circumstance where partners do receive compensation based on either a firm-wide pool of profits or a profit-sharing arrangements between different parts of the firms' practice, including where separate legal entities have been established. I believe the rule as proposed and written would cause an auditor to lack independence, if their compensation was based on a firm-wide pool of profits that included the revenues and profits from non-audit services. I believe this is an appropriate answer to protect investors. However, as some in the accounting profession may not agree with this interpretation of the rule, and to ensure investors are not misled into believing that as a result of a final SEC rule that audit partners compensation was not impacted by revenues and profits from non-audit services, if in fact they are, the rule should be clarified or clarifying language should be included in the adopting release.
I believe that an important part of the partner compensation process is the annual evaluation process. That process is often used to establish the number of partnership or ownership units the partner will own. If the audit partner evaluation process includes, explicitly or implicitly, an evaluation of the sales of non-audit services, and that evaluation is used to determine the number of partner units awarded, the partner's compensation is being directly impacted by compensation for non-audit services. Accordingly, the proposed rule should be modified to state that an auditor's independence is impaired if the partner's evaluation is based on selling of non-audit services (or the lack thereof) and that evaluation is used to determine the award of partner units.
Another issue arises in the case of an auditing firm that has sold its non-audit services to a financial services firm, when the partners of the ongoing audit firm are compensated by the financial services firm for services of the financial service firm the audit partners sell. For example, an audit firm may sell its tax practice and information systems consulting practice to a third party who is a financial services firm. The audit partners may receive stock in the financial services firm as part of the sale, and may receive or be eligible to receive, stock options in the financial services firm. The value of the stock will be impacted by the ability of the financial services firm to continue to sell tax and consulting services to the companies the audit firm continues to audit. The audit partners may also receive other forms of compensation from the financial services firm as well. Because the selling of non-audit services in such situations gives rise to the concerns expressed by the Commission regarding the impact of auditors' compensation on auditor independence, the final rule should be clarified to encompass compensation regardless as to who pays it, so long as it is for selling non-audit services to the audit client.
Finally, it is important to focus on the compensation of the executive partners or shareholders in an audit firm. These partners are elected or selected for these roles, in part because the partners in the firm believe they can run the business successfully, maximize the profits of the firm, and in turn maximize the compensation of the partners. The senior leadership can only be successful, however, if the partners in the practice offices are able to maximize the profits of the firm. If partners in the practice offices fail to achieve the goals set by the executive partners, then the executive partners will be unable to achieve their goals and their positions may become tenuous. As a result, the compensation scheme in a firm is often set up with achieving profit goals having greater importance than the interests of the investing public. While performing high quality audits and thereby reducing the number of restatements or other financial statement errors and litigation is also consistent with profit maximization, it is often overshadowed by the need to meet budgetary and profit goals. I believe the most effective way for the Commission to address this conflict, is to adopt its proposal, with language that makes it clear, that partners who are performing the audits cannot be evaluated by those "up the ladder" based on the success in selling non-audit services.
Advocacy By An Accounting Firm
Some in the accounting profession have proposed that advocacy is merely an issue with respect to the independence of an accounting firm if such actions are taken in a public forum. The Commission should reject any such absurd reasoning. It smacks of a midnight bank robber who believes he is innocent if not caught.
Advocacy can impact an auditor's independence regardless of whether an investor is aware of such actions or not. For example, my former accounting firm, would provide expert witness support to a company on such issues as contract disputes and costs for clean up at environmental contamination sites. If an auditor is engaged to argue before an arbiter, as often happens, that a contractor's costs and the resulting billings should be deemed acceptable pursuant to a contract change order, then that auditor would be placed in an extremely difficult situation if during the ensuing audit it was determined a different result should have been calculated. Likewise if an auditor argued before a court that a company should not be named a responsible party at a superfund site, and then had to audit the liability for environmental costs, an auditor would be conflicted between arguing for perhaps the lowest possible exposure for the company in court and during the audit having to consider if such a position had a reasonable basis. It would make no difference as to whether an investor was or was not aware of these conflicts. Reasonable people would conclude that such situations cause a lack of independence "in fact," as well as from an "appearance" perspective.
The same is true of an accounting firm that has rendered a tax opinion to a company the firm audits. I have observed a situation where a firm's tax department issued a tax opinion letter that the audit engagement team disagreed with. That opinion took a position that was different than the company wanted to use with respect to the income tax accrual and disclosures. This results in the audit partner having to decide between signing off on numbers reported in the financial statements for income taxes that are consistent with the tax opinion, or requesting a change in those numbers in which case the firm may be subjected to litigation regarding its own opinion letter. This is not just an "appearance" issue, but it is also a serious question of independence of the auditor "in fact."
The dictionary defines an advocate as "a person who pleads for or in behalf of another; intercessor...a person who pleads for or in behalf of another in a court of law..." It goes on to define advocacy as "an act of pleading for or giving verbal support to a cause..."1 Accordingly, consistent with the intent and language of the Sarbanes-Oxley Act of 2002, the final rule adopted by the Commission should prohibit an auditor from providing expert services, including legal or tax services, when an auditor is engaged in an activity that involves promoting to a third party the interests of the company they are auditing. This should be the rule regardless of whether such a service is publicly observable or not. As noted above, such an activity is in fact advocacy and is therefore violates an auditor's independence both in fact and appearance and is a violation of the Act.
However, a firm should be permitted to act as a fact witness. For example, if a company requested an auditor to discuss with the SEC the facts surrounding a transaction, how the accounting literature applied to that transaction, and how and why the accounting firm reached its decision regarding the transaction, it would be acting solely as a fact witness. Likewise if an accounting firm was asked to provide similar information to a court, explaining its audit and the work it performed with respect to a companies financial statements, then it should be permitted to do so. These situations involving simply discussions of facts are different I believe from those where a firm is promoting the interests of the company they are auditing.
I would be pleased to discuss this matter with the staff should they have any questions.