Moss Adams LLP
VIA ELECTRONIC FILING (firstname.lastname@example.org)
January 10, 2003
Jonathan G. Katz, Secretary
Re: File No. S7-49-02 Proposed Rule: Strengthening the Commission's Requirements Regarding Auditor Independence
Dear Mr. Katz:
Moss Adams LLP is pleased to submit its comments on select portions of the SEC's proposed rules on auditor independence implementing Title II of the Sarbanes-Oxley Act of 2002 (the Act).
Moss Adams agrees with the basic principles of the new rules. Strengthening independence in both appearance and in fact is important to restore trust of the audit function by the users of financial statements.
After reviewing the proposed rules we believe additional clarification is needed in certain areas while in other areas we do not believe the benefits of the proposed rules outweigh the costs of application. Our comments focus on partner rotation, tax services and the prohibited non-audit services of bookkeeping, financial information system design and implementation, and internal audit outsourcing services.
Partner Rotation Requirements
Section 203 of the Act states "It shall be unlawful for a registered public accounting firm to provide audit services to an issuer if the lead (or coordinating) audit partner (having primary responsibility for the audit), or the audit partner responsible for reviewing the audit, has performed audit services for that issuer in each of the five previous fiscal years of that issuer.'' We understand the intent of this rule is to provide a "fresh look" at the audit and financial statements and to eliminate a partner from "growing up" with a client.
We agree that a "fresh look" at the financial statements enhances the audit process and that the rotation of certain partners helps provide a "fresh look". At the same time, we believe maintaining continuity of the engagement team results in the auditors having a better understanding of the client as well as the industry, leading to a higher quality audit. We therefore believe a balance in rotation is necessary.
We do not believe the proposed rule creates a proper balance between the benefits of rotation and maintaining a knowledgeable engagement team. While Section 203 of the Act focuses on the rotation of the "lead" or "coordinating" audit partner and the audit partner responsible for reviewing the audit, the rules proposed by the Commission extend to all partners who perform audit services for the issuer. We do not believe consistent application of the rotation period to all partners involved is appropriate. In addition, we believe the five-year cooling-off period is excessive.
Applying the rotation period to all involved partners removes the benefits that are obtained when a partner is provided with a period of time to become familiar with the specific risks and issues related to an engagement. We understand the concerns and issues raised when partners get "too close" to management. However, risk of a failed audit increases when the primary responsible partner does not have a thorough understanding of the client and related risk areas. The rotation requirements, as proposed, may force firms into putting less qualified partners into positions of primary responsibility in advance of them being ready for the role on a given engagement.
In addition to the issue of losing experience gained through auditing a client over time, firms other than the large international and national firms may encounter extreme difficulty in meeting the rotation requirement. If finalized as proposed, the rule on auditor rotation may force many qualified "local" and "regional" firms to decide to abandon audits of publicly held entities as a provided service. This will result in a shrinking in the pool of available audit firms for registrants to consider as their auditor. The talents of skilled auditors now working for local and regional firms may be lost as firms realign service offerings. In addition, many smaller registrants may be unable to afford the higher fees typically charged by larger CPA firms.
We believe partners involved in the audit should be classified into the categories of (1) partner primarily responsible for the audit, (2) concurring partner or (3) other partners involved in the audit. For the partner primarily responsible for the audit and the concurring partner we believe mandatory rotation is appropriate after five years in the respective role. For other involved partners, rotation would be appropriate after 10 years. If a partner involved on a limited basis assumes the role of the primarily responsible partner or concurring partner, rotation should be mandatory after the shorter of five years as primarily responsible or concurring partner or 10 years in total. In addition, in determining years of service, we believe only service as a partner should apply.
We do not believe rotation is necessary for tax or other non-audit partners. While tax partners are involved in the audit to the extent of their review of tax and related accounts, the overall responsibility remains with the primarily responsible partner. We believe a similar thought process applies to information technology and valuation partners who may be consulted with by the audit engagement team. While they may be providing critical expert input into the audit process, overall responsibility remains with the primarily responsible partner.
We believe a "cooling off" period of three years is more appropriate than the five years presently proposed. Even if a three year "cooling off" period is adopted, we believe many firms would chose not to rotate the primarily responsible partner off the engagement until the end of a five year term in order to maximize the advantages of knowledge gained and minimize disruption to the client. However, the shorter period of three years would provide flexibility for the unusual situation where the primarily responsible party did not complete their full five-year term. We believe this shorter "cooling off" period is particularly important to allow smaller firms to continue to practice as auditors of public companies.
We believe the partner rotation rules should be transitioned for fiscal years beginning after December 15, 2003. This transition period will allow firms to assess and plan for an effective allocation of partners to engagements. This is critical to ensure that all engagements are sufficiently staffed with the appropriate level of technical expertise. In the interim, the existing partner rotation rules established by the SEC Practice Section of the AICPA should remain in effect.
Based on our understanding of the Act, tax services, subject to advance approval of the audit committee, were not intended to be considered prohibited services. While the Commission's proposed rules do not define "tax services," the following statement is made:
We agree representation of a client in tax court or being an advocate for a client on "novel" tax issues may violate one or more of the three basic principles that an auditor cannot (1) audit his or her own work, (2) function as part of management, and (3) serve in an advocacy role for a client. However, the sentence which states "...formulation of tax strategies (e.g. tax shelters) designed to minimize a company's tax obligation..." is of concern to us. Interpreted broadly, this sentence could be read to prohibit virtually all tax services.
The primary function of the tax accountant in assisting a client in preparing a tax return is to minimize the tax obligation to the client within the limits of the applicable tax laws. If the goal is to minimize taxes, is the service prohibited? While we do not believe the intent of the proposed rules is to broadly prohibit tax services, we do believe additional clarification is needed. With respect to tax strategies, the materiality of the tax strategy on the financial statements should be addressed. In addition, a much more clear definition is needed as to
what represents a "tax strategy" versus good tax advice, with a valid business purpose, within the applicable tax rules.
Prohibited Non-Audit Services
The proposed rules discuss in some detail the nine prohibited non-audit services included in Section 201(a) of the Act. We agree with the basic premises of the prohibited services, however, we also believe additional clarification and or consideration is needed.
Bookkeeping or Other Services Related to the Audit Client's Accounting Records or Financial Statements of the Audit Client
We believe additional clarification is needed with respect to certain "bookkeeping" services. Specifically, clarification is needed with respect to assisting clients in the preparation of financial statements that are filed with the Commission. In practice, smaller registrants require assistance in drafting of the financial statements and related disclosures for final publication. The drafting is accomplished using the final trial balance and account groupings, as provided by the client, subject to audit adjustments and with the staff of the audit firm providing wordprocessing services. The auditors provide assistance in editing the financial statement in order to comply with GAAP, regulatory and SEC disclosure requirements. Is the intent of the proposed rules to prohibit this type of service?
We do not believe assisting clients in drafting financial statements that are to be filed with the Commission, represents a non-audit service, but rather a process that is simply part of the audit. Our belief takes into consideration the three basic principles in the Senate Report that accountants should not (1) audit their own work, (2) function as a part of management or as an employee of the audit client or (3) act as an advocate of the audit client. We do not believe the assistance in drafting financial statements violates these basic principles.
For smaller registrants there is a general expectation that the drafting process of the financial statements, from the information provided by the client, is controlled by the audit firm. We believe it would be an unnecessary hardship for smaller registrants to seek assistance from others in this process. It would result in an additional cost to the registrant without any real benefit.
Financial Information Systems Design and Implementation
We do not disagree with the prohibition of financial information system design and implementation services. However, we believe additional clarification is needed. Specifically, clarification is needed with respect to certain software, which may be used by the audit firm during the audit process, or on a periodic basis throughout the year.
In some situations, software is used by the auditors to extract data from the client's financial system. The extracted data is then used to generate reports for management and the Board.
The output can be generated and used as on-going management reports. Does use of this software represent the "design and implementation" of a software system that "aggregates
source data underlying the financial statements or generates information that is significant to the audit client's financial statements taken as a whole?" Does this data extraction and reporting service create an independence concern if performed on a periodic, but not regular basis?
Unless the reports generated are used as a basis for generating the company's financial statements, we do not believe use of such software tools by the audit firm with periodic reporting to the client's management should impair the auditor's independence. We believe additional clarification is needed regarding use of data extraction and other financial summarization tools.
Internal Audit Outsourcing
Proposed Rule 2-01 (c)(4)(v) states "an auditor is not independent when the auditor performs internal audit services related to the internal accounting controls, financial systems, or financial statements, for an audit client. This does not include nonrecurring evaluations of discrete items or programs that are not in substance the outsourcing of the internal audit function. It also does not include operational internal audits unrelated to the internal accounting controls, financial systems, or financial statements."
We believe additional clarification is needed with respect to what represents operational internal audits unrelated to the internal accounting controls, financial systems, or financial statements. For example, for a financial institution, we believe, operational internal audits many involve activities related to tellers, new accounts, loan processing and regulatory compliance with bank regulatory agency rules and regulations. We believe additional clarification is needed with respect to what represents a prohibited internal audit service versus outsourced services involving operational or regulatory compliance matters.
In addition, we believe clarification is needed with respect to the meaning of "nonrecurring evaluations of discrete items or programs".
We share your concern about the effect of the proposed rules on small businesses without internal audit functions. We believe an exception should be provided for small businesses. For example, we do not believe it is fair to compare a large publicly traded company to a publicly traded community bank with assets less than $500 million, or to Small Business filers. Smaller community banks and SB filers typically do not have internal audit departments. We believe the cost of prohibiting the involvement of external auditors in the internal audit function out weighs the benefits. In many cases, due to the cost, the registrant will omit the internal audit function from its control structure. In addition, we believe for the smaller entities, participation of the external auditors in the internal audit function can enhance the overall quality of the audit.
An example of a situation in which we believe the quality of the external audit is enhanced through an internal audit type function is loan file reviews for financial institutions. As discussed above, many community banks do not have internal audit departments. Use of the
external auditors to perform tests of the loan files throughout the year in essence reflects a continuous audit, resulting in more reliable quarterly as well as annual financial reporting. In this type of situation, we do not disagree that this service could be construed to be a part of the clients system of internal accounting control. However, we believe the benefit both to the quality of the audit and improved interim reporting out ways any costs related to the external auditors involvement.
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We appreciate the Commission's consideration of our comments in finalizing the rules on auditor independence.