Larrowe & Company, CPA's

January 13, 2003

Jonathan G. Katz
U. S. Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549-0609

File No. S7-49-02 Proposed Rule: Strengthening the Commission's Requirements Regarding Auditor Independence

Members and Staff of the Commission:

We respectfully submit the following comments on the proposed rules of the Securities and Exchange Commission (the "SEC" or the "Commission") to enhance the independence of accountants that audit and review financial statements and prepare attestation reports filed with the Commission (the "Proposed Rule").

We are a ten-year old, one-office firm specializing in the community banking industry. The industry group represents over one-half of our annual revenue. Our firm is the auditor of record for 16 community-based Bank Holding Companies and Banks that are public companies as defined under the Securities Act of 1934.

We understand the concerns of the Congress and support the Commission's efforts to strengthen the profession's independence rules as they relate to financial statement audits of public companies. However, as a four-partner firm, we are concerned about the transition provisions and partner rotation requirements in the Proposed Rule that extend beyond the requirements of the statute.

Our comments are limited to those issues, and reflect our belief that the Commission should limit its current rulemaking efforts to implementation of the provisions of the Act without creating requirements that go beyond it. While a number of our comments mirror those of the AICPA, we have attempted to identify and respond to those items most directly affecting our practice.

Our concern centers around the likely impact of this proposed rule on small publicly traded businesses and the accounting firms that audit them. We believe that the Commission should take special care to address the rule's impact on the complexities and costs of operating small publicly traded businesses, and on the ability of smaller audit firms to serve them. It is our belief that the Commission has both the authority and discretion to provide appropriate relief to small businesses through regulatory exemptions that will allow it to implement the Act in a manner consistent with the public interest and protection of investors, and at a time of great concern about the vitality of our economy.

We realize that the partner rotation requirements as proposed will impact small audit firms by operationally compelling many of them to merge with larger firms. It seems counter-intuitive to create this environment when the failures creating the Act itself involved the world's largest audit firms.

Partner Rotation

We support the Commission's objectives underpinning the partner rotation requirement for auditors of publicly-held companies and the requirements of the Act in this regard. We are concerned, however, with the breadth of the Commission's proposal both with respect to the number of partners it covers and the length of the "time out" period. We believe that the Proposed Rule will reduce audit quality and that the public would be best served if the Commission adopted what is stated explicitly in the Act.

The Final Rule should provide for an exemption for small publicly traded businesses and smaller public accounting firms that audit the financial statements of publicly-held companies, because partner rotation, for these firms, is tantamount to firm rotation, a concept that Congress contemplated but rejected pending further study.

We fully support the importance of a "fresh set of eyes;" yet this benefit must be appropriately balanced with the cost of loss of continuity and institutional knowledge that a recurring partner brings to an audit engagement. We believe that it is crucial to the health and welfare of the U.S. financial markets that partners assigned to audit engagements are the most competent, knowledgeable and experienced individuals, and that any rule or requirement that would discourage this, without any compelling reason or overriding benefit, would be detrimental to the well-being of the economy. When experience, knowledge and skill are not appropriately matched to an audit engagement, audit quality and investor confidence suffer. A decrease in audit quality is a mistake that we cannot afford to make.

The disadvantages of a rule that unduly restricts the continued availability of partners utilized on specialized engagements should not be overlooked. To rotate partners who are not responsible for signing off on an audit engagement, who understand a registrant's business environment and who can facilitate and enhance the audit would be detrimental to the financial markets and serve little purpose. If a firm does not have the depth of experience and knowledge in its partner ranks, inappropriate over-reliance will likely be placed on lower level staff and inexperienced partners.


The Commission should recognize that while audit decisions are made every day by all members of the engagement team, the final audit decisions are made by the lead partner and significant decisions made by the lead partner are considered by the review partner. Accordingly, the rotation requirements should be limited to those individuals. This adequately protects the public, while assuring audit quality will not suffer. Furthermore, we believe the five-year "time out" period is unnecessarily long, and places an undue burden on both registrants and firms. The Commission will be able to achieve its objective of a fresh set of eyes with a "time out" period of significantly less than five years.

The legislative history of the Act indicates that the Congress gave significant consideration to testimony given by numerous witnesses as to whether an issuer should be required to rotate its audit firm after a number of consecutive years, and seriously weighed the costs of audit firm rotation (e.g., reduced audit quality and effectiveness, increased audit costs) against the benefits (e.g., a fresh and skeptical set of eyes). While Congress agreed that there were strong benefits to having a fresh set of eyes evaluate the issuer periodically, it did not conclude that audit firm rotation was necessary.

This history is an important factor to consider in evaluating the appropriateness of an exemption from the partner rotation rules for smaller public accounting firms. Because smaller public accounting firms are not large enough to have a substantial number of partners available to rotate, as noted above, a partner rotation requirement is tantamount to firm rotation for these firms. And, audit firm rotation has significant costs that far outweigh the potential benefits, as government agencies (including the SEC and GAO), private organizations and members of academia previously have concluded. Those costs include:

  • Increase in audit failures. Studies by the POB, Commission on Auditor's Responsibilities, and the National Commission on Fraudulent Financial Reporting found that audit failures are three times more likely in the first two years of an audit. Thus, there is a positive correlation between auditor tenure and auditor competence.

  • Increased start-up costs. Changing auditors results in more frequent start-up costs, both for the auditor and the company.

  • Increased difficulties in timely reporting. Mandatory rotation makes timely reporting more difficult because audit firms need to meet a very short "learning curve" to perform a rigorous audit.

  • Loss of "institutional knowledge." Over successive audits, audit firms increase institutional knowledge, including, for example, their knowledge of the client's accounting and internal control systems and greater familiarity within the industry in which the client operates. These benefits would be greatly diminished by mandatory rotation.

  • Opportunity to disguise voluntary rotations. Companies may use mandatory rotation as a means to disguise problems in the relationship between the company and its auditor, thus avoiding the negative marketplace reaction that often accompanies a voluntary change in auditors.

  • Reduced incentives to improve efficiency and audit quality. Mandatory rotations fail to fully reward firms that achieve greater efficiency and audit quality, because rotation reduces potential demand. Auditors that are less efficient and provide lesser quality services are nevertheless likely to survive because there will constantly be companies looking for new auditors. Conversely, the incentive for each firm to increase its market share and profits would be reduced by the loss of clients after the maximum allowed duration.

  • Sharp increase in time and resources dedicated to proposal process. With more than 16,000 public company audits, a mandatory rotation would create a significant annual "proposal frenzy" for thousands of audits, potentially distracting firms from the delivery of quality audits.

The AICPA's SEC Practice Section has successfully exempted firms that have fewer than ten partners and five SEC clients from its partner rotation requirements. This exemption was provided for a number of reasons:

  • First, to eliminate the costs that outweigh the benefits associated with audit firm rotation, as described above;

  • Second, to avoid the hardship that would otherwise be experienced by small businesses that are considering public funding or are at a stage where they do not need the services of a large, multi-national or regional public accounting firm; and

  • Third, to preserve the quality of financial reporting for businesses that cannot afford to hire a multi-national or regional public accounting firm or that are located in remote locations.

Our country has always prided itself on the opportunities it offers to its citizens. We believe that opportunities should be afforded to small businesses and that, by providing such businesses with access to a resource they can afford, the economy benefits.

Other Comments

We believe the Commission needs to be absolutely clear that the rule only applies to partners in their capacity as partners, and does not reach back to audit services provided in a non-partner position (such as manager). While we believe the language in the rule clearly reflects this position, the Proposing Release indicates that the proposed rules are designed to ensure that professionals (versus partners) do not "grow up" or spend their entire career on one engagement.

In our audit firm, the issue of "growing-up" on an engagement is not relevant. The audit clients we represent are not large enough for any person to be continuously assigned to a single engagement. Our professionals routinely work on five to eight public companies annually, rather than have a staff of five to eight professionals working on a single audit. This concern seems more applicable to the largest audit firms and companies rather than smaller ones.

Should the rotation requirements apply to all partners on the audit engagement team? If not, which partners should be subject to the requirements?

No, for the reasons set forth above.

Should additional personnel (such as senior managers) be included within the mandatory rotation requirements?

We do not believe this was the intent of Congress and accordingly do not believe it is either appropriate or in the public interest to include additional personnel. We also believe that the Commission should clarify its intent that the rotation period does not include time spent on the audit, review or attest engagement in a position other than as a partner, principal or shareholder.

Is it appropriate to provide transitional relief where the proposed rules are more restrictive than the provisions of the Sarbanes-Oxley Act?

Yes. We believe it is appropriate to provide transitional relief where the proposed rules are more restrictive that those currently required by the AICPA's SEC Practice Section. Transitional relief should provide for an orderly transition, take into consideration experience and expertise of auditors, allow for a firm to stagger rotation terms, and not harm the registrant in any way, particularly if an audit is in process.

Should the rotation requirements be different for small firms? What changes would be appropriate and why? If so, how should small firms be defined?

We believe smaller firms should be exempted from the rotation requirements. We would suggest the Commission consider defining a smaller firm in one of several ways. SEC Practice Section requirements currently define a smaller firm as one having fewer than ten partners and auditing fewer than five SEC clients. Another measure could be a combination of audit firm annual revenues (e.g., $10 million) and issuer market capitalization (e.g., $100 million).

Would the proposed rules impose a cost on smaller firms that is disproportionate to the benefits that would be achieved?

As more fully described in discussion above, the audit firm rotation likely to occur in smaller firms increases the risk of audit failures, increases audit costs, presents difficulties for timely financial reporting and results in a loss of institutional knowledge that is essential to audit quality.

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?

Particularly for smaller audit firms, we believe that the five-year "time out" period is unnecessary and places an undue burden on both registrants and firms. The Commission could achieve its objective of ensuring a "fresh set of eyes" with a "time out" period of no more than one year.

The Proposing Release suggests that a five-year "time out" period is necessary because any shorter "time out" period would fail to satisfy investors that rotated partners were not being placed in a secondary role on the engagement for a year or two only to resume the same role that they had previously occupied and return to the prior engagement team's approach to accounting and auditing issues. We believe the SEC Practice Section's current two-year "time out" period has been effective and that there is no evidence that firms subject to the requirement place the rotated partner in a secondary role only to return as lead partner. We believe that a one-year "time out" period contemplated in the Act appropriately balances the fresh look at accounting and auditing issues confronted by the company with continuity and audit quality costs associated with any rotation.

If the Commission has a concern that firms will not abide by the spirit of the rotation requirements and will not assign the rotated partner to an unrelated audit engagement, the Commission should simply prohibit the rotated partner from being assigned to the audit of the client in any secondary role.

If a partner rotates off an engagement after fewer than five years, should the "time out" period also be reduced? Why or why not? If so, how much should the reduction in the time out period be?

In the event a partner rotates off an engagement after fewer than five years, we believe the appropriate "time out" period is one year. Anything more would complicate an already complex requirement and would serve no other purpose than to penalize the public accounting firm.

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?

In addition to the views expressed in our discussion above, we believe it would be harmful to the investing public if all partners were rotated at the same time, since the loss of institutional knowledge would decrease audit quality.

Transition Period - Partner Rotation

Proposed Rule 2-01(6) of Regulation S-X would require the rotation of certain audit partners who have performed audit services for an audit client for five consecutive years, and preclude the partner from providing audit services for five additional years following the mandatory rotation. As proposed, the partner rotation provisions would take effect upon the rule's adoption, requiring firms to implement changes immediately in order to comply with these provisions.

As the Commission has noted, these rotation provisions exceed the current requirements of the accounting profession and the Act. Without an adequate transition period for issuers and accounting firms, the implementation of the rule would entail significant disruption. Auditors will have to reorganize audit teams, train partners in new industries and, in many instances, resign from engagements. In addition, it is not feasible to expect firms immediately to identify and reassign partners with expertise sufficient to ensure continuity in providing quality service to clients, as partners will be required to develop general expertise in order to serve a broader range of industries. Firms (and, in particular, smaller firms) will need time to plan for and implement these changes. For example, a partner currently in the fifth or sixth year of a seven-year rotation cycle under existing rules (or a partner exempted due to firm size) will need to immediately rotate off the engagement the day the rule becomes effective to prevent an impairment of his or her firm's independence.

Similarly, a partner who complied with the current standards and rotated off the engagement three years ago and has now returned to the engagement team will be required to immediately rotate off the engagement to avoid an impairment of independence. Without adequate time to prepare for such changes in the composition of audit teams and the transfer of knowledge regarding current engagements, audit quality will suffer. This is hardly the desired result of the Act. These effects would be exacerbated for firms with several public clients, firms with few partners and engagements with multiple partners.

We recommend that the Commission provide a two-year transition period before the partner rotation rules become effective. This is consistent with the approach adopted by the AICPA when it implemented partner rotation in the late 1970's. This approach would allow for a smooth transition by permitting issuers and accounting firms to mitigate the effect of the disruptions caused by the rule changes and facilitate the staggering of audit partner rotation cycles on large audits, as recommended by the Commission in the Proposing Release.

Thank you for the opportunity to comment on this Proposed Rule.

Respectfully submitted,

Nikki E. Larrowe, CPA
Administrative Partner
Larrowe & Company, CPA's