McGladrey & Pullen, LLP
400 Locust Street, Suite 640
Des Moines, Iowa 50309
O 515.284.8660 F 515.284.1545
January 9, 2003
Jonathan G. Katz, Secretary
U.S. Securities and Exchange Commission
450 Fifth Street, NW
Washington, D.C. 20549-0609
RE: File No. S7-49-02
Dear Mr. Katz:
McGladrey & Pullen, LLP is pleased to provide input to the Securities & Exchange Commission as it considers revisions to its auditor independence rules. We are one of the largest audit firms in the U.S., we are primarily focused on serving the needs of mid-sized organizations and their owners/stakeholders, and we have a long-standing commitment to audit quality. We are supportive of changes to independence standards that enhance auditors' ability to serve the public interest. Following are our general and specific comments regarding the Commission's Proposed Rule, Strengthening the Commission's Requirements Regarding Auditor Independence:
The Commission should carefully weigh the expected costs and benefits of each proposed change to the independence rules. We believe that changes to professional standards and SEC Practice Section rules made in recent years as a result of implementing the recommendations of the Panel on Audit Effectiveness and the Blue Ribbon Panel on Audit Committees made significant strides towards better protecting the public interest. However, many of these changes, as well as the Commission's most recent changes to its independence rules, have not been in effect long enough to fully assess their impact.
The U.S. capital markets have historically been a source of capital for small and mid-sized businesses that are, in turn, the creators of significant innovation and job opportunities. Except in very rare cases, we believe that the capital markets are no longer available to small and mid-sized businesses, and we are concerned that the proposed rule changes will create additional adverse consequences for small and mid-sized public companies, including the following:
- Certain aspects of the proposed rule changes may substantially increase audit costs for small and mid-sized public companies. In particular, the proposed changes to the partner rotation rules would lead to a significant increase in audit costs because the engagement team would constantly be required to re-acquire the knowledge of the issuer's business already possessed by their predecessors. We are also concerned that the loss of knowledge inherent in engagement team rotation will lead to an increased risk of audit failure.
- The proposed rule changes will limit the ability of small and mid-sized public companies to seek the advice and counsel of their CPA firm professionals. When an auditor provides advice and recommendations, the issuer obtains the benefit of the auditor's expertise and knowledge, but retains the responsibility to assess the advice received and determine whether to implement the recommendations. Small and mid-sized issuers have historically relied on the advice and counsel of their auditors, who have significant knowledge of their business. We encourage the SEC to closely evaluate the extent of the limitations on auditors' provision of non-audit services.
- We believe the proposed rules requiring audit committee approval of non-audit services will cause significant logistical problems for small and mid-sized public companies. Because of their limited resources, these companies tend to rely on the audit firm for a wide array of assistance, particularly in the tax area. As a result, the audit committee may find that it more focused on approving and monitoring these services than overseeing the financial reporting process.
We are concerned about the adverse effects of the proposed rule changes on small and mid-sized audit firms. The four largest audit firms already audit the vast majority of issuers. The proposed rule changes create additional logistical challenges that will make it difficult, if not impossible, for small and mid-sized firms to provide reasonable competition to the largest firms. This is especially troublesome in light of the substantial increase in professional liability insurance costs that the entire profession is experiencing because of the audit failures of the largest firms.
The proposed rules should clarify the types of non-audit services that can be provided to the issuer by the audit firm, particularly with respect to operational internal auditing and expert tax services. We believe very strongly that an auditor can assist an issuer with tax examinations, administrative appeals and private letter ruling requests without impairing independence. In addition, while we agree that an external auditor should not perform ongoing monitoring activities, we do not believe a workable definition of internal audit outsourcing currently exists.
We believe the independence rules need to provide an auditor the opportunity to cure unintended violations because the complexity of the rules makes absolute compliance extremely difficult and there is a significant cost to an issuer when an audit firm is determined to lack independence. We understand the need to have harsh penalties for intentional or reckless violations, but do not see that the public interest is served by having similar penalties for immaterial or unintended violations.
A. Conflicts of Interest Resulting from Employment Relationships
Consistent with Section 206 of the Sarbanes-Oxley Act ("the Act"), the positions to which this provision applies should be limited to those signing reports and certifications in the capacity of Chief Executive, Chief Financial and Chief Accounting Officer. The ability of other persons serving in a financial reporting oversight role to influence the selection and application of the issuer's critical accounting and financial reporting policies does not warrant audit firm rotation.
Similarly, audit firm rotation should only be required if the partner or professional employee leaving the audit firm to join the audit client participated on the audit engagement team during the same fiscal year in which he or she joins the client. Looking back beyond the beginning of the fiscal year is tantamount to questioning the audit firm's independence during the prior audit without addressing the consequences. The existing SECPS requirement for an independent review of the individual's work on the prior audit is an adequate safeguard over his or her participation in audit activities of prior years.
B. Services Outside the Scope of the Practice of Auditors
Financial Information System Design and Implementation Services
The proposed rule prohibits financial information system design and implementation, but provides no clear definition of "design" or "implementation". The existing rule implies that such services encompass the identification of systems to be evaluated and selected, the controls and system procedures to be implemented, the scope and timetable of system implementation, and the testing, training and conversion plans. It would be helpful to include definitions or other guidance within the final rule.
Internal Audit Services
The proposed rule prohibits internal audit services related to the internal accounting controls, financial systems, or financial statements. The proposing release states that such services do not include nonrecurring evaluations of discrete items or programs that are not in substance the outsourcing of the internal audit function, or operational internal audits unrelated to the internal accounting controls, financial systems, or financial statements. It would be helpful if this guidance, along with examples of each, were included within the final rule.
Human Resources Services
In the discussion of human resources services, the proposing release states, "Under the proposed rule, an auditor's independence also is impaired when the auditor advises an audit client about the design of its management or organizational structure." However, the proposed rule does not contain such a prohibition. If it is the intent of the Commission to prohibit those services (or other services such as advising an audit client about compensation arrangements with its executives), the prohibition should be expressly stated in the final rule.
Unregistered Broker-Dealer Services
The proposed rule prohibits acting as an unregistered broker-dealer on behalf of an audit client. If this is intended to encompass all of the activities referenced in footnote 48 of the proposing release, we believe a definition of an unregistered broker-dealer should be included in the final rule.
Expert Tax Services
In assessing the likelihood of an unfavorable outcome from legal proceedings involving an audit client, auditors routinely rely on the opinions of the same legal counsel that is representing the audit client. Accordingly, provided the auditor has the requisite expertise to assess the likelihood of an adverse outcome, his objectivity is no more impaired by the provision of expert services than that of any other expert upon whose opinion he must otherwise rely.
In the case of tax services, accountants have historically been recognized as experts and enjoy special privileges of client representation in most tax administrative and regulatory proceedings. Because the results of administrative and regulatory proceedings can be appealed by either party, providing expert or advocacy services to an audit client in those proceedings would not pose a threat to an auditor's objectivity. In those cases, the result of the proceedings would not be binding and an auditor would have to assess the likelihood that such results would be sustained or overturned on appeal, regardless of whether he relies on his own opinions or the opinions of others.
The final rules should not prohibit an auditor from providing expert tax services in administrative, regulatory or legal proceedings. However, if they do limit the provision of expert tax services, the final rules should clearly distinguish between permitted and prohibited tax services.
C. Partner Rotation
Consistent with Section 203 of the Act, the partner rotation requirements should be limited to the lead audit partner and the concurring partner. Further the "time out" period should be limited to two years. Finally, as the rule proposes, only time on the engagement as a partner should count in determining the rotation requirement.
The threat to objectivity does not justify either the cost to the audit firm and the audit client or the exposure to a decline in audit quality associated with the requirement to rotate partners other than the lead engagement partner and the concurring partner. The final responsibility for making judgments and forming opinions on significant audit findings or issues and critical accounting policies rests, subject to any consultation requirements of the Firm's quality control systems, with the lead engagement partner and requires the concurrence of the concurring partner. In forming their opinions and judgments, these two partners consider the opinions and judgments of other partners involved in specific aspects of the audit. Those other partners have typically not formed an opinion on the financial statements taken as a whole. Accordingly, the cost of a "fresh look" at the judgments reached by those partners would likely exceed the benefit, and there would be a real danger (especially in mid-sized and smaller firms) that the individuals performing the functions previously performed by those partners would have substantially less knowledge and experience. At a maximum, rotation requirements should not extend beyond partners responsible for the audit of significant components of the issuer.
A five-year "time out" period is unnecessary and places mid-sized and smaller issuers and firms at a significant disadvantage. A two-year period is more than adequate to provide for the "fresh look" necessary to assure objectivity and reassess audit effectiveness, especially when it applies to both the engagement and concurring partner. It is extremely unlikely that findings suggesting that the prior audit engagement partner lacked objectivity or that the audit approach used under his supervision was ineffective would surface in years three through five. In the case of mid-sized and smaller firms, the longer the rotation requirement the greater the likelihood that partners with insufficient knowledge and experience will be called upon to serve in capacities for which they are not fully qualified. As a result, issuers and audit firms would incur additional costs at the same time audit quality would suffer. As an example, in our firm we have limited the number of partners permitted to serve as the engagement or concurring partner for a financial institution audit engagement. More frequent rotation requirements combined with a longer "time out" period would likely force us to expand the pool of eligible partners, resulting a dilution of industry focus and expertise.
D. Audit Committee Administration of the Engagement
The final rule should provide more guidance regarding the pre-approval policies and procedures that may be established by the audit committee.
The proposed rule regarding the compensation of partners assigned to the audit engagement team is unrealistic, unworkable and unnecessary. To suggest that audit firms specifically allocate various elements of partnership income away from partners assigned to the audit engagement team runs contrary to the notion of a partnership. In addition, it would likely lead to experienced partners refusing to accept assignments to audit engagements, resulting in a decline in overall audit quality. Finally, it would not accomplish the objective intended by the Commission. If necessary, there are potentially better ways of protecting partners assigned to the audit engagement team from financial pressures associated with the overall audit client relationship.
G. Communications with Audit Committees
The final rule should incorporate the definitions of "critical accounting policies and practices" and "alternative accounting treatments" contained in the proposing release. The requirement to communicate alternative accounting treatments discussed with management should be limited to those discussions that occurred during the most recent fiscal year.
Thank you for considering our comments. Questions regarding these or other matters may be directed to Bill Travis, Managing Partner (952.921.7780) or Bruce Webb, National Director of Auditing and Independence (515.281.9240).
McGladrey & Pullen, LLP