January 8, 2003
Mr. Jonathan G. Katz, Secretary
U.S. Securities and Exchange Commission
450 Fifth Street N.W.
Washington, D.C. 20549-0609
Re: File Number S7-49-02
Dear Mr. Katz:
PricewaterhouseCoopers appreciates the opportunity to comment on the Commission's Proposed Rule: Strengthening the Commission's Requirements Regarding Auditor Independence.1 We share and support the recent efforts by Congress and the Commission to restore investor confidence. Clear and unambiguous rules for audit committees, companies, and audit firms are needed to accomplish this. We have carefully reviewed the Commission's proposal and made a number of suggestions that we believe will help foster this clarity and that will help the Commission craft a final rule that strictly adheres to the letter and spirit of the Sarbanes-Oxley Act (the "Act).
We are a multinational organization that serves as independent auditors for many of the world's largest companies. We operate and serve clients with shareholders in every part of the world. We can best meet our responsibilities to investors in our increasingly global capital markets when standards that apply to auditors (and our policies and methodologies for implementing them) are relatively uniform around the world. We support an approach to auditor independence requirements based on principles, such as the revision of the International Federation of Accountants (IFAC) Code of Ethics that was endorsed by the International Organization of Securities Commissions (IOSCO). While we acknowledge that the Commission must develop regulations (including auditor independence requirements) that implement the letter and spirit of the Act, we encourage it to do so in a manner that is as consistent as possible with the approach used to develop the international principles.
We will be pleased to discuss any of our comments or answer any questions that you may have. Please do not hesitate to contact Hilary Krane at 415-498-7601 regarding our submission.
Very truly yours,
cc. Chairman Harvey L. Pitt
Commissioner Paul S. Atkins
Commissioner Roel C. Campos
Commissioner Cynthia A. Glassman
Commissioner Harvey J. Goldschmid
Giovanni P. Prezioso, General Counsel
Jackson M. Day, Acting Chief Accountant
TABLE OF CONTENTS
PricewaterhouseCoopers Comment Letter Dated January 8, 2003
Strengthening the Commission's Requirements Regarding Auditor Independence
I. General Comments
II. Discussion of Proposed Rules
II.A Conflicts of Interest Resulting from Employment Relationships
II.B. Services Outside the Scope of the Practice of Auditors
- Bookkeeping or Other Services Related to the Audit Client's Accounting
Records or Financial Statements of the Audit Client
- Financial Information Systems Design and Implementation
- Appraisal or Valuation Services, Fairness Opinions, or
- Actuarial Services
- Internal Audit Outsourcing
- Management Functions
- Human Resources
- Broker-Dealer, Investment Adviser or Investment Banking Services
- Legal Services
- Expert Services
- Tax Services
II.C. Partner Rotation
II.D. Audit Committee Administration of Engagement
II.G. Communication with Audit Committee
- Critical Accounting Policies and Practices
- Alternative Accounting Treatments
- Other Material Written Communications
II.H. Expanded Disclosure
II.I. Transition Period
III. General Request for Comments
I. GENERAL COMMENTS
The Commission should limit this rule-making to meet the specific requirements of the Act and should reserve consideration of additional amendments to its independence rule that go beyond the statutory mandate for a later date.
We appreciate the efforts made by the Commission and its staff to respond to the recent crisis in investor confidence and to meet aggressive legislative deadlines for rule-making in a wide variety of areas. However, multiple deadlines for important rule-makings have resulted in an unduly compressed time frame for public comments on this proposal and an even shorter period for the Commission to digest the comments and revise the rule where it deems appropriate. This creates a considerable risk of unintended adverse consequences that would be inconsistent with the objective of this rule-making: to promote high-quality, independent audits. For example, extending the partner rotation requirements beyond the lead and concurring review partners and introducing new rules on partner compensation will have a significant impact, particularly on non-U.S. firms and issuers, and deserve more time for analysis and consultation.
Recognizing the time constraints, we respectfully request the Commission consider restricting this rule-making to that which is necessary to meet the requirements of the Act. The Commission and the Public Company Accounting Oversight Board ("PCAOB") have continuing jurisdiction in the area of auditor independence and can impose additional requirements if, after full consideration of the implications and potential benefits, either deems it appropriate. Accordingly, we urge the Commission to focus its current efforts on perfecting the rules in order to meet the stated Congressional intent, leaving any requirements above and beyond those required by the Act for consideration in a reasonable timeframe appropriate to the magnitude of the issues presented.
The Commission should limit the reach of the rule generally to issuers and consolidated subsidiaries in order to simplify the rule and achieve consistency in its application, particularly in foreign countries.
The proposed rule will have very significant extra-territorial impact. This is exacerbated by the application of many aspects of the proposed rule to "audit clients," currently defined in SEC Regulation S-X to include affiliates (including non-controlled affiliates), despite the general usage in the Act of the term "issuer," which indicates a more limited coverage. We urge the Commission to revisit the breadth of the application of the final rule, particularly the extent to which the rule would apply to all affiliates of the audit client. The application of the current non-audit service rules to affiliates, particularly affiliates under common control with the audit client (e.g., sister companies and non-controlled affiliates), has led to confusion in the auditor and registrant community. Furthermore, there is no evidence that there are any corresponding benefits in relation to the appearance or fact of independence to justify this confusion. Extending the proposed rule to audit clients for the purpose of applying the cooling-off requirements and the compensation restrictions will add to this confusion.
A good example of the confusion and implementation burdens of extending the requirement is in the context of investment companies. Recognizing this, the Commission requested comment in the proposing release on whether aspects of the proposed rule should be applied to entities other than an investment company issuer itself. The rule should apply to the investment company issuer, not to other entities in the investment company complex. The Act does not require application beyond the issuer, and the legislative history does not evidence any intent to do so.2 Further, the existing regulatory framework governing registered investment companies has contributed to an environment in which there are few of the misstatements and other issues that the Act is intended to address. Substantially all registered investment companies report net asset values daily or weekly with a level of precision that few, if any, other issuers could maintain. Accordingly, there is no public policy reason to justify extending the proposed rules to all companies in an investment company complex.
The Commission's existing auditor independence rule has already had an adverse impact on the number of choices available to investment company audit committees when selecting auditors. First, the lack of any materiality standard in the investment company complex definition means that the auditor of an individual fund or small group of funds must often be independent of a significant portion of the related financial services organization, even if fees attributable to the fund are de minimis to the organization. Second, the fund auditor is subject to scope of service restrictions with respect to the entire investment company complex, even when the subject matter of the non-audit service has no relation to the operations, controls, or financial statements of the investment company issuer. In these situations, it is often difficult to identify any accounting firm other than the auditor of the adviser's parent (or possibly an auditor of a larger group of funds within the complex) that is willing to take on the audit of one fund or a small group of funds in the complex, because many audit firms choose not to put themselves in a position where they would be subject to these overly extensive independence requirements for the complex as a whole. Thus, investment company audit committees have significantly fewer large or internationally networked audit firms to choose from when selecting auditors and, in fact, may have only one firm available to them in these circumstances. An overly broad application of the proposed rule to entities other than the investment company registrant itself could exacerbate this situation.
The auditor independence rules should remain in Regulation S-X.
The Commission has requested comment as to whether its auditor independence rules should be retained in Regulation S-X, or, alternatively, moved into rules under Section 10A of the Exchange Act. We have serious concerns if the preliminary note to Rule 2-01(b) of Regulation S-X, including the general principles of analysis, is used to set independence standards, a violation of which may result in both civil and criminal prosecution by the government. Some of the independence standards are highly subjective, and will be used by the Commission and the PCAOB to judge accounting firm activities in hindsight. Given the serious criminal sanctions under Section 32 of the Exchange Act and the SEC's administrative remedies, we urge the Commission to limit the application of Rule 10A-2 and Section 208 of the Act solely to those activities that are clearly and specifically prohibited by statute or regulation, and exclude from the final rule any activity not subject to specific statutory prohibitions but potentially subject to question under the general principles.
The Commission should delete issuer specific compliance matters from the scope of proposed Rule 10A-2.
We have serious concerns about holding an accounting firm potentially liable for the failure of an issuer and its audit committee (or board of directors) to comply with the issuer focused mandates of Exchange Act Section 10A, including Section 10A(h), Preapproval Required for Non-Audit Services, Section 10A(i), Preapproval Requirements (which includes an investor disclosure requirement) and Section 10A(l), Conflicts of Interest (which makes unlawful the hiring of audit team members to serve as specified executives of an issuer prior to the running of a one-year cooling-off period). An accounting firm's potential liability stems from both proposed Rule 10A-2 and from Section 208 of the Act.
Accounting firms (and associated persons) should not be liable for compliance failures by issuers (including audit committees and/or boards of directors). Accordingly, we strongly recommend that the Commission (1) revise the language of proposed Rule 10A-2 to delete the reference to § 210.2-01(c)(7), Audit committee administration of the engagement, and (2) use its general rule-making authority to make clear that Section 208 of the Act only applies to violations of Section 10A(g), Prohibited Activities, and Section 10A(j), Audit Partner Rotation. We also ask the Commission to make clear that Section 208 of the Act does not apply to Section 10A(l), Conflicts of Interest. The issuer is in the best position to monitor and ensure compliance with Section 10A(l), particularly after a professional leaves his or her accounting firm, and can no longer be compelled by the firm to comply with the requirements of the proposal.
The Commission should consider setting out guidance on a safe harbor policy.
Accounting firms generally are held harmless when they discover an inadvertent violation of the rules and act in good faith to rectify the matter promptly. For example, the current rules provide that a firm's independence will not be impaired solely because a covered person in the firm is not independent of an audit client provided a number of conditions are met, including that the lack of independence is corrected as promptly as possible after the person or firm becomes aware of it. As a practical matter, firms apply such good faith measures to isolated inadvertent de minimis violations involving all aspects of the rules when it is appropriate to do so. We expect that firms will not be precluded from dealing with such violations in reasonable and practical ways in the future. Moreover, when a firm's compliance is dependent upon actions required of an issuer and/or its audit committee, we believe it is appropriate for the issuer and or its audit committee to be held harmless for their good-faith judgments, for example, in connection with the pre-approval of services with which the Commission later disagrees.
The Commission should make clear that the Act's definition of "person associated with a public accounting firm" is co-extensive with the term "associated entity" as used in the proposed rule.
The Commission's current independence rule and proposed rule use the term "associated entity" without defining it. Now that Congress has defined "associated with a public accounting firm," the Commission should make it clear that the statutory definition governs.
II. DISCUSSION OF PROPOSED RULES
II.A. Conflicts of Interest Resulting from Employment Relationships
Section 206 of the Act requires a one-year cooling-off period before professionals on an audit engagement team can join an audit client issuer as its chief executive officer, controller, chief financial officer, or chief accounting officer, or in any position for the issuer that is equivalent to those four positions. Accordingly, the Act identifies those positions at the audit client issuer level (i.e., the parent company but not its subsidiaries) that are closest to the financial reporting and audit process. The Commission's proposed rule applies the one-year cooling-off period to a broader list of positions (i.e., those meeting the definition of a financial reporting oversight role) at a broader group of entities (i.e., "audit clients" instead of "issuers"). We believe it is unnecessary to go beyond the requirements of the Act. Extending the cooling-off period requirement to the proposed broader list of positions and entities will also significantly increase the difficulty that audit committees and audit firms will face in trying to comply with the requirement once the professional has left the audit firm and is no longer under the "control" of the firm.
The four positions identified in the Act are those that would typically have the greatest level of regular interaction with the audit engagement team, as well as ultimate decision-making power in preparing the issuer's financial statements. Accordingly, these are the positions within the client's senior management where an individual could adversely influence the quality or effectiveness of the day-to-day audit if he or she had an incentive (and chose) to do so.3 Other positions included in the definition of financial reporting oversight role generally have varying degrees of interaction with the audit team and decision-making ability with respect to the preparation of the issuer's financial statements. They do not, however, have the regularity of interaction coupled with the overall financial reporting decision making powers that are possessed by those in the four key management positions. Thus, they do not present a threat equivalent to that posed by those positions. The Act appropriately focuses on the most meaningful management positions in a client organization, and the Commission should not require that additional positions be subject to the requirement.
Extending the cooling-off requirement to positions with an "audit client" (i.e., the issuer, its subsidiaries, and entities that are affiliated with the issuer because the issuer has significant influence over the entity) goes beyond what the Act contemplates as necessary to safeguard the independence of the auditor. In our view, the farther away the position is from the issuer, the less significant the threat. For example, in a typical issuer organization, if a member of the audit team becomes the controller of the issuer's subsidiary, that individual generally will not be in a position to adversely affect the quality or effectiveness of the audit of the issuer itself, because he or she does not have the ultimate decision-making power in the preparation of the issuer's financial statements. Extending the requirement to a position with an entity that is significantly influenced by the issuer, or to an entity that is part of an investment company complex solely because it is one of the service providers described in the definition of an investment company complex makes even less sense. Accordingly, we recommend that the Commission direct the cooling-off requirement in the final rule to positions directly with the issuer.
Re-directing the cooling-off requirement in the final rule to conform to the Act will also provide important compliance benefits to audit firms and audit committees. Once a professional leaves, typically the firm will be unable to monitor that individual's whereabouts for the next twelve months or, more importantly, to compel that individual (other than perhaps a partner who is eligible to receive a pension benefit from the firm) to comply with the one-year cooling-off period if the individual later decided to join a client. Thus, if an individual left the firm to join a non-client, or to pursue other interests, and, while still within the one-year cooling-off period, decided to join a former audit client, say, at a non-U.S. subsidiary as a director of internal audit, it would be up to the client to identify that situation as one subject to the cooling-off requirement. If the client failed to do so, the firm would be disqualified from continuing as auditor once the individual joined the client, and the company would be forced to find a new auditor. This would be an unduly harsh result for a situation that does not, in our view, have nearly the significance of one of the four key management positions with the issuer.
The dilemma described above is magnified in a situation where the individuals themselves have taken no action on their own to become employed by the audit client. For example, a member of the audit team may join a non-client that is acquired by their former audit client within the one-year cooling-off period. Under the proposal, this situation would presumably disqualify the audit firm from continuing as the auditor notwithstanding the fact that the Act focuses on the individuals seeking employment with the issuer. Accordingly, we recommend that the rule provide an exemption from the cooling-off requirement when the employment relationship arises through a merger or an acquisition. Providing such an exemption also ensures that the rule itself does not serve as an impediment to companies conducting corporate acquisitions that they have concluded are in the best interest of investors.
- Is the one-year cooling off period sufficiently long to achieve an appearance of independence by the accounting firm? If not, what period would be appropriate? The period should not be extended beyond one year. A longer period would be disruptive for clients, who already stand to incur potential lost opportunity costs by having to postpone the hiring of the right person for the job for one year.
- Is the term "audit engagement team" sufficiently clear? If not, what changes would improve the description to describe the group of accountants who would be covered? The term should be clarified so that national office consultants are not considered part of the "audit engagement team" for this purpose, similar to the exemption for national office consultants from the partner rotation provisions of the proposal. National office consultants generally do not have significant, regular interactions with the audit team. Further, they are not actually members of the audit team and typically will not understand all of the unique personalities of audit team members and their individual strengths and weaknesses. Thus, as a member of the client's management, they would not have the same ability to adversely influence the quality or effectiveness of the day-to-day audit.
- Is the phrase "commencement of the audit" sufficiently clear? If not, what changes would improve the description? Is that the appropriate time to mark the commencement of the period? Is there a better mark? We recognize that the Commission is attempting to provide clarity on what the Act refers to as "the initiation of the audit." The date when audit planning occurs can in many cases be an appropriate point at which to mark the start of the audit. However, the example in the commentary does not appear to do that. In that example, it appears that the client is a calendar year filer, because it has filed (presumably in its annual Form 10-K) the auditor's audit report with the Commission on 2/19/02. The example then notes that review procedures commenced on 2/20/03. If this were a calendar year company, it is unclear what is being reviewed, as a first quarter review would typically not occur that soon. To avoid confusion, we recommend that the example refer to 2/20/03 as the start of audit planning for the 2003 calendar year audit. However, where an audit is continuous, the point at which it is initiated can be difficult to identify. In such cases, the Commission may need to opt for a bright line test. We recommend that the bright line be the day after the date on which the company files it annual report with the Commission or the required due date of the filing, whichever occurs first.
- Are the appropriate officers covered by the proposed rule? If not, which additional individuals should be subject to the cooling off period provision? For example, should national office personnel who would be excluded under the proposal be included? As noted above, the appropriate officers are covered. There should be consistency in the treatment of national office consultants between this provision and the provisions on partner rotation, and national office consultants should be exempt from the cooling-off requirements.
Please refer to the II.F. Definitions section for our comments on the proposed definition of "accounting role."
- The cooling off period applies to all entities in the investment company complex. Is this too broad? Why or why not? As discussed above, this is overly broad. For example, the cooling-off period should not apply if the partner joins an entity that is in the investment company complex solely because it is one of the service providers described in the definition of an investment company complex. When the auditor does not audit that service provider, it is even more compelling that the cooling-off requirement not apply.
- Should the proposed rules apply equally to large firms/companies as small firms/companies? Would the proposed rules impose a cost on smaller issuers that is disproportionate to the benefits that would be achieved? Why or why not? Should there be an exemption to this requirement for smaller businesses? Assuming that the threat to independence that the Act suggests arises when a partner joins an issuer in one of the four key management positions, that threat would exist regardless of the size of the firm from which the partner comes, or the size of the company he or she joins. Accordingly, the same restrictions should apply regardless of the size of the company or the firm.
- Should the Commission include exceptions subject to certain criteria? If so, what should these criteria be? Yes. Please refer to our broader discussion above about the need to exempt situations where the individual joins the client as a result of business activities conducted by their new employer that occurred after the individual left the firm. Our broader discussion also describes a situation in which the individual no longer "controlled by the audit firm" decides to join the audit client after leaving the firm to pursue other interests, such as working for a non-client. If the cooling-off requirement is not re-directed to only the four key management positions at the issuer, then refer to the comments above regarding deleting issuer specific compliance matters from the scope of proposed Rule 10A-2.
Further, we suggest a de minimis test whereby if someone were considered to be on the audit team under the normal covered person rules, but worked for less than a prescribed number of hours such as ten hours or less,4 they could be exempted. An example is a partner, who may or may not be a national office partner, who advised the audit team on a matter as part of the conduct of the audit. Under the covered person rules, charging even one hour to the audit is enough to define that person as part of the engagement team for personal independence purposes. We urge the Commission to adopt an exemption for such situations.
We also recommend that the final rule note that former firm professionals who are already employed as of the effective date of the rule (discussed below) are grandfathered, even if they are promoted to a position covered by the final rule after the effective date.
Transition Issues Relating to The Cooling-Off Requirement:
To enable firms to set-up appropriate processes and procedures to ensure compliance, we recommend that the cooling-off requirement become effective 90 days after the final rule is published in the Federal Register for employment with an issuer that occurs after that date.
II.B. Services Outside the Scope of the Practice of Auditors
The Commission should ensure that the rule draws a clear line around prohibited services without casting doubt on a broad range of non-audit services.
The release states that the Commission relied on the three principles enunciated in the Act's legislative history to guide its efforts in crafting the proposed scope of service rule - namely, that an auditor should not (1) audit his or her own work, (2) perform management functions, or (3) act as an advocate for the client.
To be meaningful and stand the test of time, principles must be general and simply stated. However, those very characteristics present challenges in application. Principles are useful in producing a cohesive regulatory framework when applied systematically by people familiar with the relevant subject matter and who have spent significant time reflecting on the issues. However, efforts to apply those same principles by people without that background and/or sustained focus creates the potential for inconsistent outcomes. The proposal threatens to create just such a problem by suggesting that audit committees must apply the three broad principles when addressing matters involving auditor independence without clear lines being drawn in the rules themselves.
Audit committee members need to understand the concept of independence and be active participants in monitoring the independence of the auditors engaged by them. The objective of the Act is to give those committees clear guidance to aid them in discharging that obligation. Congress emphasized that its goal was to "draw a clear line around a limited list of non-audit services that accounting firms may not provide to public company audit clients." (S. Rep. No. 107-205, 107th Cong., 2d Sess., at 18 (2002)). Congress was direct in its call for clarity in the rules, stating "that it is appropriate to continue dealing with non-audit services by having the Commission proscribe specific services rather than casting doubt on a broad range of non-audit services." (H. Rep. No. 107-414, 107th Cong., 2d Sess., at 2 (2002), emphasis added).
The proposal taken a as whole does not provide the clear lines Congress sought. In the areas of tax, legal and expert services, in particular, the language of the rule is too ambiguous to apply consistently in practice. In addition, language in the commentary casts doubt on services that, we believe, Congress did not intend to be prohibited.
We urge the Commission to state unambiguously in the rule what is prohibited, and to refrain from using the commentary to suggest that services other than those described in the plain language of the rule would nonetheless be captured by separate application of the stated principles. This will give audit committees the best guidance with which to monitor and ensure ongoing independence, to the ultimate benefit of investors.5
The release accompanying the final rule should provide more guidance relating to the basic principles.
The Commission should clarify that providing general accounting and financial reporting and tax advice to clients is permissible and is not "auditing one's own work."
Read as a whole, the proposal and the release make it clear that the traditional function of providing accounting advice in a wide variety of settings remains consistent with auditor independence. The commentary accompanying the proposal relating to Expanded Disclosure for Proxy Statements characterizes "accounting assistance...in connection with proposed or consummated acquisitions" and "consultation concerning financial accounting and reporting standards" as "services that are traditionally performed by the independent accountant" and proposes that the associated fees should be disclosed as "audit related fees." (67 Fed. Reg. at 76798). Likewise, "tax consultation" including "advice related to mergers and acquisitions" is "viewed as closely related to audit services and as not being in conflict with auditor independence" and the proposal directs that associated fees should be disclosed in the "tax fees" category. (Id. at 67698-99).
Without a clear statement that purely advisory services are permitted, an audit committee could wrongly conclude that obtaining advice on accounting or tax treatments and interpretations could contravene the principle of auditing one's own work. Accordingly, the Commission should state that the principle that an auditor should not audit his or her own work does prohibit an auditor from providing advice on the application of accounting or tax principles generally, even when such advice is connected to a specific transaction. The Commission should affirm that such advice is a core function of the auditor and one that improves the quality of overall financial reporting to the benefit of issuers, investors and the capital markets generally.
The Commission should clarify that the principle that an auditor should not perform management functions has the same meaning as it is given in the specific rule prohibiting these activities.
Management functions has a unique role in the proposal: it is one of the principles discussed in the Act's legislative history, and it is a separate service category. Clearly management functions are intended to cover managerial tasks but not advisory functions, such as providing assistance to a company in its design and implementation of internal accounting controls and risk management controls. To avoid any confusion, the Commission should make it clear that application of the principle should be guided by the specific definition of management functions included in the text of the rule and current practices, which the commentary acknowledged the Act did not change.
The Commission should clarify that "acting as an advocate" involves advancing the client's cause in a public forum.
The commentary in the proposing release includes statements that suggest that general advisory and support services could be considered advocacy (e.g., tax strategies designed to minimize a company's tax obligation or providing private consultation to an audit client's legal counsel). Such roles do not involve speaking out in a public proceeding on another's behalf, which is what we believe Congress had in mind when it identified acting as an advocate as the principle underlying the Act's prohibition on "legal and expert services unrelated to the audit." A promoter of a company's stock would be an advocate as the promoter publicly makes the case for why others should buy the company's shares. Similarly, a lawyer whose function is to argue the client's position in a public forum is also plainly an advocate. Conversely, an accountant privately advising his or her client as to accounting or tax issues or providing technical or factual support for the client's use, based on the accountant's own work, or representing a client's tax position before a member of the Internal Revenue Service or equivalent in meetings or tribunals which are not public or courts of law, is an advisor and would not be regarded as an advocate in a public forum. Advocacy does not extend to general support services where an auditor provides technical information and analysis to a client or a client's lawyers and likewise should not apply to non-public forums where there is no appearance issue.
Statements in the release create the false impression that "advocacy" could capture anything that could be viewed as bringing an accounting firm's expertise to bear in assisting a client with any third-party matter. Because all manner of clearly permitted advisory services, and even audit services, could be characterized as assisting a client in this manner, the "acting-as-an-advocate" principle needs to be clearly defined in the final release to resolve the ambiguity created by the commentary. Furthermore, as stated in our letter of December 26, 2002, Congress did not intend to prohibit an auditor from assisting or representing a client in a tax administrative proceeding although a prohibition on representing clients in judicial tax courts is an appropriate prohibition. Accordingly, we suggest that the Commission make it clear that "acting as an advocate" means speaking on behalf of a client in a public forum in order to achieve a specified result on the client's behalf. The Commission also should clarify that the advocacy principle does not prohibit an audit firm from articulating a client's technical position in connection with regulatory inquiries, such as meeting with the Division of Corporation Finance or tax audit and related appeal activities in those countries where such matters are dealt with before a tribunal or other similar administrative body (as distinct from judicial tax court representations). These meetings and communications do not present the kind of appearance concerns that would arise in situations involving public proceedings.
The Commission should clarify that the listed services are prohibited only in connection with the issuer and its consolidated subsidiaries, not the entire affiliate group of the client.
The application of the rules to an entire affiliate group of the audit client is unwarranted and in certain circumstances unworkable. Many companies, for example major oil companies, banks, investment companies and entities in other specialized industries, typically have extremely complex and dynamic structures, and the extension of the rules to the entire affiliate group will present significant practical difficulties. For example, groups that typically enter into joint venture associations or are active in taking a shareholding participation in other entities have a constantly changing set of "affiliated entities" making the maintenance of independence very difficult.
We support including the "reasonably likely" to be subject to audit procedures test in the rules relating to Bookkeeping, Appraisal or Valuation Services, and Actuarial Services. This limitation is essential given that the justification for prohibiting these services is that they present a risk of self-review. This standard appropriately allows an auditor to provide those services to an affiliate of an audit client when it is reasonably likely that the results of the service will not be subject to audit procedures by the auditor.
This creates an anomaly, however, as there is no similar limitation that applies to the remaining categories of prohibited services. As a result, an auditor could, for example, provide bookkeeping services to an affiliate of an audit client that is not consolidated in the audit client's financial statements, but could not assist in the internal audit function, design a management information system, or deliver any other service on the prohibited list to that same non-consolidated affiliate. Indeed, the Committee Report indicates that Congress believes there are self-review concerns associated with internal audit and financial information systems design and implementation services, and identified those services along with bookkeeping, appraisal/valuation, and actuarial services as services that give rise to self-review concerns. Thus, to be consistent with the threat identified by Congress, the application of the reasonably likely criterion should apply to all five services.
More importantly, nothing in the three basic principles suggests extending the non-audit service rules to non-audit entities other than the issuer and its consolidated subsidiaries. As we stated earlier, the application of the non-audit services rules in connection with a broad range of entities has created significant confusion among audit committee members and auditors because intuitively non-audit service restrictions should not apply to entities whose financial position, results of operations, and cash flows are not consolidated into the issuer's financial statements. This is especially true for entities that are part of an investment company complex.
We encourage the Commission to use this opportunity to restrict the application of the final rule on non-audit services to the issuer and its consolidated subsidiaries.6 To achieve this, Proposed Rule 2-01(c)(4) could be revised to read, "An accountant will be deemed to be not independent if it provides any of the following non-audit services to the issuer or its consolidated subsidiaries during the audit and professional engagement period."
- Is the meaning of the general principles sufficiently clear? No. As discussed above, the principles must be more clearly defined. The Commission should (1) clearly articulate that general advice on accounting and tax treatments does not put the auditor in the position of auditing his or her own work, (2) directly tie the principle on prohibiting management functions to the definition in the rule on the same subject, and (3) affirmatively state that to "act as an advocate" means to speak on the client's behalf in a public forum to achieve a specified result on their behalf and does not include assisting the client in routine regulatory or business matters.
1. Bookkeeping or other services related to the audit client's accounting records or financial statements of the audit client
We support the proposed rule on bookkeeping and believe that the inclusion of the qualifying language that the service would be prohibited only where it is "reasonably likely that the results of these services will be subject to audit procedures" conforms the rule to the stated Congressional intent. Since the primary justification for this prohibition is concern about self-review, clearly permitting services that "could conceivably fall within this category" but present no risk of self-review is critical.
The commentary to the final rule should state that identifying adjusting entries as part of the audit process is not prohibited bookkeeping. The identification of such errors and suggestion of the appropriate correction does not impair the auditor's independence. Indeed, this is what auditors should be expected to do and, to the extent it is necessary to do so, it is a key part of any audit engagement.
To avoid any confusion in the marketplace, we urge the Commission to clarify in the commentary that an auditor can assist a client in preparing statutory accounts when they will not form the basis of financial statements to be filed with the Commission. For instance, this would include situations where the statutory auditor's assistance with the preparation of such accounts occurs after the audit of the consolidated financial statements has been completed and filed with the Commission.
The Commission should further clarify in the final rule that it does not intend to prohibit the auditor from providing assistance in the conversion of financial statements prepared in accordance with another set of accounting principles into financial statements, or reconciled information, using a different set of accounting principles (e.g., conversion of German GAAP to International Financial Reporting Standards or U.K. GAAP reconciled to U.S. GAAP). In that situation, the auditor is simply providing necessary technical advice to the client to assist it in proper GAAP presentation. The underlying financial information has been maintained entirely by the company and is subject to audit with no self-review. The auditor's role is to educate the client on, for example, U.S. GAAP and suggest adjusting entries where they are required; this is parallel to the auditor suggesting adjusting entries as a result of inaccurate accounting discovered in the audit process. Neither service impairs auditor independence. Not only is this work essential to ensure the quality of reporting by foreign issuers, but it is entirely consistent with the objectives of the Appendix K requirements for membership in the SECPS, which were adopted at the urging of the Commission's staff.
- Should the definition of bookkeeping be further clarified? If so, how? The rule is sufficiently clear, but we suggest that the Commission clarify its application in the manner set forth above.
- Should an auditor be permitted to provide bookkeeping services to an audit client if it is not reasonably likely that the results of those services will be subject to audit procedures during the audit of the client's financial statements? Why or why not? Yes. The justification for disallowing these services is the self-review risk, however, if the services will not be audited, there is no principled reason to prohibit them. Indeed, if that qualification were removed from the final rule, the rule would prohibit necessary and important services that do not violate any of the three principles and could have a deleterious effect on clients in remote and developing jurisdictions.
- Is the standard of reasonably likely sufficiently clear? If not, should we use some other standard? If so, what standard should we use? "Reasonably likely" is an appropriate standard.
- Is the phrase "preparing statutory statements which form the basis of U.S. GAAP statements" sufficiently clear? If not, how might the phrase be revised? Preparing statutory statements is a traditional auditor function in many jurisdictions, particularly in situations where the accounting staff of a client in any given territory may lack the expertise necessary to prepare the accounts appropriately. As discussed above, those services should be permitted in any instance where the statutory accounts at issue would not be the subject of audit in connection with the financial statements filed with the Commission. This is the case in most jurisdictions where statutory accounts are prepared after the primary financial statements prepared by management have been audited. In these situations, the underlying accounting information in the books and records has already been audited and consolidated and assistance with the preparation of the statutory accounts presents no self-review risk.
2. Financial information systems design and implementation
We support the prohibition set forth in the proposal. We voluntarily exited this line of business in order to directly address the concerns in the marketplace about auditor independence.
Auditors offer their clients various services related to hardware and software systems that are of great value and present no auditor independence concerns. For instance, we provide software tools designed to assist with assessing synergies with a potential merger target. That software is designed to provide management with information on which to make decisions regarding the purchase and to assist it in setting priorities for integration. There are also software applications designed to enable companies to improve security over their information resources and to assist management in their compliance activities. These types of applications do not generate balances for inclusion in the financial statements and should clearly be outside the scope of the rule. Similarly, there are tax compliance software products that interface with an audit client's accounting system to make tax decisions regarding certain types of transactions which are offered by audit firms in connection with their tax practice that are currently in use around the globe. Given the clear statutory language broadly permitting tax services, it would be appropriate for the Commission to note in the commentary that tax-related software products do not constitute "financial information systems" as used in the rule.
- Is an auditor's independence impaired when the auditor helps select or test computer software and hardware systems that generate financial data used in or underlying the financial statements? Why or why not? Consistent with our comments above, we agree that there has developed a common perception in the marketplace that the delivery of these services in connection with the installation of new systems negatively affects the appearance of auditor independence and, therefore, the rule is appropriate. However, testing of systems as part of an advisory service aimed at providing an objective assessment of a system's functionality and ability to meet a client's needs should not be prohibited when the auditor is not designing or implementing the system.
- Whether a system is used to generate information that is "significant" to the audit client's financial statements may depend on the size of the engagement. Does the magnitude as a percentage of either audit fees or total fees of the fees for such services make a difference on whether performance of the service impairs independence? The "significance" test is essential to avoid banning any services that "could conceivably fall within this category," even when the service does not violate any of the principles. The significance should be measured by reference to the audit client's financial statements, not by the size of the engagement fees. Since the concern is risk of self-review, tying the "significance" test to the company's financial statements ensures that the rule does not extend to ban useful services that do not offend the three principles. Assessing the potential for impairment of independence because of the size of the fees related to non-audit services should be left to the judgment of the audit committee through the pre-approval process, subject to the oversight of the investing public informed by the required fee disclosures in the proxy statement or other annual filing with the Commission. It appears that Congress intended that monitoring the overall relationship between the auditor and the company - including the overall quantum of services provided, their type and the related fees involved - should be left to audit committees, and the Commission should refrain from having the scope of prohibited services turn on those issues.
3. Appraisal or valuation services, fairness opinions, or contribution-in-kind reports
We agree with the Commission's analysis that the principal threat to independence in the provision of valuation-related services is the self-review risk. If it is not reasonably likely that the results of such services will be subject to audit procedures, there will be no self-review risk and no impairment of independence.
- Does providing valuation or appraisal services that are unrelated to the financial statements, such as for certain regulatory purposes, impair an accountant's independence? No. The commentary states that the proposed rule would not prohibit an accounting firm from providing such services for non-financial reporting purposes, and we support that concept. However, we believe that it would be very useful for issuers and their auditors if the Commission provided a clear definition of what is meant by the term "non-financial reporting purposes." This would clarify whether it is the intention of the Commission that any valuation service that does not directly impact amounts that are recoded in the accounting records or financial statements should be considered as for non-financial reporting purposes, or whether the Commission intends to limit the use of this term to tax valuations (as implied by the examples in the proposals) and perhaps certain regulatory purposes (as implied by this question). Any valuation service that does not directly impact the amounts recorded in the accounting records or financial statements that are being audited or is clearly immaterial does not generate a self-review threat and should not impair auditor independence. As long as management remains responsible for key assumptions, these services also do not represent a management function. As an example, investment appraisals, in which the accountant advises and assists in the analysis of choices to allocate resources between a company's competing investment proposals, do not directly impact amounts recorded in the accounting records or financial statements.
Therefore we encourage the Commission to provide a clear definition of non-financial reporting purposes, together with any necessary illustrative examples in the discussion of the rule. We suggest that other terms, such as "unrelated to the financial statements," be avoided in the interest of clarity.
- Does providing valuation or appraisal services for tax purposes impair an accountant's independence? No. Based on the language of the Act, its legislative history and the proposal's acknowledgement of the general permissibility of tax services, we do not believe that the Commission intended to prohibit an auditor from providing valuations that are primarily for a tax purposes and urge the Commission to clarify that such valuations remain permissible.7 Tax valuations are an integral part of providing a tax service. The same safeguard that is acknowledged by the Commission as being support for the continuance of general tax advisory work (i.e., the unique link with quality auditing and the rigorous independent review by the revenue authorities) applies to tax valuations which are subject to particular scrutiny by tax authorities. Further, the language in the commentary citing transfer pricing studies and cost segregation studies as examples of permissible valuation services for non-financial reporting purposes supports the view that the Commission did not intend to prohibit valuations in the context of tax services. For the sake of clarity, however, we urge the Commission to state directly that valuations performed as part of a tax service are permitted, rather than just provide a list of examples that suggests that conclusion. For auditors and audit committees who will be struggling in good faith to understand and comply with these rules, further clarity would be very useful.
- Are there certain types of appraisal or valuation services, or certain instances in which they are provided that do not raise auditor independence concerns? Are there circumstances in which an accounting firm may be required by law or regulation to provide such services, either in the United States or abroad?
(1) Valuations for Primarily Tax Purposes: As discussed above, appraisal and valuation services do not raise independence concerns when undertaken primarily for tax purposes.
(2) Advice and Assistance in Connection With Valuations: Providing advice and assistance in relation to clients preparing their own valuations does not impair independence provided the client's management is responsible for all significant assumptions and for deciding on the use of any data provided by the independent accountant. Far from impairing auditor independence, the dialogue that results from such advice and assistance should allow the auditor to confirm at an early stage that appropriate methodologies have been used by the client, that relevant market data have been appropriately extracted and to assess the reasonableness of the assumptions and data used in the valuation process during the course of the valuation exercise, rather than later in the audit. This allows the auditor to express concerns about any inputs which he or she believes would not withstand audit scrutiny while the valuation is being carried out, when it is still relatively easy to amend them.
(3) Contribution-In-Kind Reports: In Securities Act Release No. 7919, the Commission stated that contribution-in-kind reports were akin to fairness opinions. The nature and purpose of a contribution-in-kind report are different from those of a fairness opinion, and we respectfully request that the Commission re-evaluate its conclusion. Contribution-in-kind reports do not raise auditor independence concerns when they are an attest service provided during an auditor's tenure as auditor of record.
In many jurisdictions a contribution-in-kind report is required when shares are issued for non-cash consideration. For example in Europe the Second EC Company Law Directive introduced requirements that are intended to protect a company's creditors by preventing the company from issuing shares at a discount to their nominal value (plus any contractual share premium).8 The prohibition prevents a publicly listed company from reporting its share capital and shareholders' funds at an inflated amount.
An auditor is required to carry out this valuation and report because this is deemed to be an audit function. A party independent of the listed company must carry out the valuation to protect the company's creditors, and the EU legislation recognizes that the auditor is independent. The EU legislators did not allow investment banks to carry out this work because of the obvious conflicts of interest. Nor did they allow valuation boutiques to carry out this work as they would not necessarily be subject to any professional standards. A contribution-in-kind report is fundamentally different from a fairness opinion, because it does not require the auditor to consider whether the proposed transaction is `fair' to any party. It no more produces a mutuality of interest than does the audit of a set of financial statements by the auditor. Furthermore, if the auditor's work creates no figures for the registrant's financial statements there is no self-review threat. Accordingly, the independence rules should not provide for an automatic prohibition on the issuance of contribution-in-kind reports. Finally, in a number of European countries, the company's auditor of record is required to provide the contribution-in-kind report.
(3) Valuing Pension, OPEB and Similar Liabilities: We urge the Commission to clearly permit the auditor to continue to provide valuations for these purposes, which are required for compliance with FASB accounting standards. In connection with the performance of these services by accounting firms, the client's management maintains the data and makes all judgments involved in selecting the data and assumptions to support the valuation. Accordingly, these services do not involve performing management functions nor do they cause the auditor to act as an advocate for the client. Because the assumptions are selected by the client in consultation with the audit firm's actuaries, the firm is able to assess their reasonableness on a contemporaneous basis and advise the client up front as part of the valuation process (rather than waiting until the year-end audit to make that assessment) if it believes that one or more of the assumptions, or the data selected by the client, are not consistent with the requirements of the relevant accounting standards (e.g., FAS 87 and 106) and thus would not withstand audit scrutiny. Whenever necessary to ensure appropriate compliance with the relevant accounting standards, the firm's actuaries alert not only the client but also the audit engagement team when such matters arise. Thus, a meaningful review of those inputs is conducted on a real-time basis on the highest risk audit areas involving the pension and OPEB numbers, which represent increasingly significant components of registrants' financial statements. There is no self-review involved in making that assessment. Moreover, the involvement of the firm's actuaries in this manner contributes to the quality and effectiveness of the audit.
After the client has established the required inputs and those inputs have been assessed for reasonableness, the calculations that are performed follow the detailed methodologies prescribed by the accounting and actuarial standards. Those methodologies are very specific and yield highly consistent outputs (generally yielding results that are within two to three percent of one another) regardless of who performs them, thus presenting very little risk that the audit team will feel that participation in the process by the firm's actuaries constrains their ability to objectively challenge the final numbers. Accordingly, there is little of the self-review concern that typically arises in connection with other calculation processes. Moreover, as noted above, meaningful challenges to the numbers will have already occurred if the firm's actuaries are concerned about the reasonableness of the inputs and advised the audit team accordingly.
We believe there are significant differences between an accounting firm performing pension, OPEB, and similar calculations for audit clients, and accounting firms performing other types of calculations for audit clients, such as depreciation calculations and calculations for FAS 133 purposes. First, unlike depreciation calculations, pension and OPEB calculations are sufficiently complex that a high level of expertise is required in order to properly interpret and apply the relevant tax, accounting and actuarial rules, and therefore to perform an effective audit. Second, the rules governing pension, OPEB, and similar calculations, while complex, nevertheless do not allow for any material level of subjective input on the part of the individual or firm running the calculations (unlike the higher degree of subjectivity or discretion inherent in performing the calculations for FAS 133 purposes), and therefore yield consistent results regardless of the party performing them.
Permitting audit firms to continue to provide these services is essential to maintain audit quality. In addition to providing valuation services for audit clients, audit firms need highly qualified actuaries to serve as part of the audit team in order to properly conduct audits of pension, OPEB, and similar liabilities where the audit firm does not provide the valuation services. Currently, our actuaries serve this role for a large number of audits, particularly those where the audit partner has some enhanced concern about the financial statement disclosures. We believe that maintaining the number of professionals with the requisite skill set necessary to perform these audit functions will be impossible if such professionals cannot continue to provide valuation services for audit clients as well.
Currently, our practice provides actuarial valuation and related services to both audit and non-audit clients. If accounting firms are precluded from providing these valuation services to audit clients, many non-audit clients who desire not to restrict their choice of an accounting firm in the event they were to decide to change auditors in the future, may decide to no longer use an accounting firm for these services. In that case, we could lose virtually all of our experienced actuaries, and most of our ability to provide expert audit support in connection with FAS 87 and106. That would result in a potential for reduced audit quality. In our case, in order to maintain our level of quality we would need to consider retaining the requisite level of support from third-party actuaries at a cost that we believe would be significant in comparison to the cost of maintaining that expertise in-house. Accordingly, a new prohibition on these services would likely increase overall audit costs to audit clients.
- Should we provide an exemption for such services provided to a foreign private issuer by its accountant where local law requires such services (e.g. contribution in-kind reports)? It is in the public interest for the Commission to allow the auditor to issue such reports when the strict application of the rule would produce a result that is in direct conflict with local law. Any protection of the public interest that could be construed from precluding the statutory auditor from issuing these reports must be weighed against the consequences of such a conclusion including the following:
- To preclude a company from registering its securities in the U.S. is not in the public interest.
- To prevent the auditor from meeting local law requirements is not a viable proposal.
- To prevent issuers, both foreign and domestic, from entering into certain transactions which would be possible for a non-issuer is not in the public interest.
- To require an issuer to engineer a short-term change of auditor solely to facilitate the issuance of the contribution-in-kind report should not be encouraged.
- To require the company to have two auditors (one to sign the contribution-in-kind reports and the other to sign filings made with the Commission) would greatly increase the cost for issuers (both foreign and domestic) to raise capital or list in the U.S. to the detriment of their shareholders.
- To require other countries to change their laws to accommodate the Commission independence rules is not a reasonable or an appropriate expectation.
If the Commission adopts the approach to determining permissibility of contribution-in-kind reports that we suggest, the need for such exemptions will be rare.
We also observe that the need to accommodate local law is not limited to situations involving foreign private issuers. For example, the need for relief could arise with respect to a domestic registrant with consolidated subsidiaries that are domiciled outside of the U.S.
- The Commission's staff, when providing interpretations of the application of the auditor independence rules to contribution in-kind reports, has worked with foreign jurisdictions to accommodate the statutory requirements in those jurisdictions. Should the Commission's rules provide that similar practices or arrangements be permitted where contribution in-kind reports are required by foreign statute? It is not clear whether the practice of accommodation that is referred to in the proposal has produced beneficial results. Italy is an example of a country in which the staff has provided an alternative form of report in an attempt to accommodate both the existing rule and local law. The form of the report required under this arrangement is lengthy and confusing to both the shareholders and creditors of the company. It also appears to do nothing to further the cause of auditor independence. We are not aware that the Italian courts have accepted this form of report in satisfaction of a company's obligation to obtain and provide a contribution-in-kind report from the auditor of record. This approach may also prevent issuers (both foreign and domestic) from consummating transactions, as it is unclear whether the alternative form of opinion will satisfy the local legal requirements until it has been tested in the local courts.
As stated above we believe that contribution-in-kind reports do not raise independence concerns and should not be proscribed. The final rule should provide an exemption when the strict application of the rule would produce a result in direct conflict with local law. We would point out that any such services would be provided subject to audit committee approval and the related reporting requirements.
4. Actuarial services9
Based on the language in the proposal, it appears as though accountants can provide non-audit actuarial services in situations where the results of the services are not subject to audit procedures and accountants are not assuming a key management role. The commentary, however, could easily be construed as a blanket prohibition on non-audit actuarial services to public audit clients. In reference to actuarial advisory services generally the commentary states, "to perform these services would violate two of the three basic principles espoused in the legislative history of the Act." (67 Fed. Reg. at 76786). We believe that many actuarially-oriented advisory services do not impair independence, as they do not violate any of the three basic independence principles discussed in the Commission's proposal for the reasons set forth below:
1) An accounting firm should not audit its own work. Audit clients, particularly insurance companies, usually possess internal actuarial resources that provide management with primary actuarial capabilities. In these cases, the client provides primary support for balances recorded in financial statements to the accountant. However, management may request non-audit actuarial services from the accountant for specific regulatory (e.g., Statements of Actuarial Opinion for property/casualty insurance companies in the U.S.) or non-financial (e.g., cost allocation) purposes, or simply to provide additional attestation comfort for various stakeholders (e.g., Board of Directors, shareholders, regulators, rating agencies) much like an audit opinion. Some actuarial services are also integral to broader services offerings traditionally performed by the audit firm (e.g., due diligence related to mergers and acquisitions). A total prohibition on actuarial services is inconsistent with other proposed rules that allow the auditor to provide such services and might not operate in the best interests of the client particularly in relation to due diligence services.
2) An accounting firm should not function as a part of management or as an employee of the audit client. When a client possesses internal actuarial capabilities and provides primary support for the balances recorded in its financial statements, management determines all significant actuarial methods and assumptions. In providing non-audit actuarial services, confirmation of such responsibility is typically verified by the accountant through engagement/representation letters, the language of any actuarial opinions, and supporting reports.
3) An accounting firm should not act as an advocate of the client. Aside from expert services, which are separately addressed in the proposed rules, property/casualty, life insurance and pensions actuarial services do not commonly involve situations in which the specialist functions as the client's advocate.
Given this, we respectfully request that the Commission consider the following alternatives in its commentary on the Actuarial Services rule:
- Eliminate wording that implies that all actuarial services "violate two of the three basic principles espoused in the legislative history of the Act."
- Affirm that purely advisory non-audit actuarial services do not violate the three general principles and are therefore permissible.
- Similar to the proposed rule on Appraisal or Valuation Services, Fairness Opinions, or Contribution-in-Kind Reports, indicate that the rule does not prohibit an accounting firm from providing such services for non-financial reporting purposes (e.g., analysis of new policies and markets, business acquisitions, cost allocation, reinsurance needs).
- Are there certain circumstances under which an accountant can provide actuarial services to an audit client without impairing independence? Yes. Purely advisory services regarding the proper interpretation of accounting standards should be permitted. The commentary states that the auditor is not independent if the auditor provides "any advisory service involving amounts recorded in the financial statements..." (67 Fed. Reg. at 76786). Read literally, this sentence would mean that an auditor could not provide any advice to the client on interpretations of the accounting guidance in any accounting standards, such as FAS 87, Employers' Accounting for Pensions, or FAS 106, Employers' Accounting for Postretirement Benefits Other Than Pensions. These standards also provide guidance on the selection of actuarial assumptions and methods. This sentence should be revised so that it cannot be read to preclude auditors from providing interpretive advice on accounting standards. An auditor who gives advice on accounting rule interpretations does not impair his or her independence. In fact, as discussed in our general comments above, this is a critical obligation of the auditor.
Have we appropriately described the actuarial services prohibited by the Act? No, for the reasons stated above, the commentary inappropriately implies that purely advisory services are prohibited and further would prohibit services that are attest in nature even though unrelated to the financial statement audit. We are also concerned by the statement in the commentary that "[T]he proposed rules provide that the accountant may utilize his or her own actuaries to assist in conducting the audit provided the audit client uses its own actuaries or third-party actuaries to provide management with the primary actuarial capabilities." (67 Fed. Reg. at 76786). Though we believe unintended by the Commission, that language could be read to mean that if management did not use actuaries when preparing the financial statements, the auditor cannot use actuaries when auditing those financial statements. This increases the likelihood of undetected errors, which is not helpful to investors, and we recommend that the statement be revised.
5. Internal audit outsourcing
We have been convinced that the public perceives that internal audit outsourcing impairs the auditor's independence, and it is within this context that we respond below.
- Is the definition of the "internal audit function" sufficiently clear? Yes. The definition of internal audit function provided in footnote 1 to AU Section 322, The Auditor's Consideration of the Internal Audit Function in an Audit of Financial Statements, is sufficiently clear. Paragraph .04 of AU Section 322 is also clear that when obtaining an understanding of internal control, as required under AU Section 319, Consideration of Internal Control in a Financial Statement Audit, "the auditor should obtain an understanding of the internal audit function sufficient to identify those internal audit activities that are relevant to planning the audit." An internal audit function may consist of one or more individuals who perform internal auditing activities within an entity. However, under AU Section 322, personnel who have the title internal auditor but, who do not perform internal auditing activities as described therein, would be excluded.
- Does it impair an auditor's independence if the auditor does not provide to the client outsourcing services related to the internal audit function of the audit client, but rather performs individual audit projects for the client? The commentary refers to the performance of nonrecurring evaluations of discrete items or programs that are not in substance the outsourcing of the internal audit function. Although the commentary does not elaborate on what is contemplated by the term "discrete items or programs," we believe that there are many diagnostic and evaluative services that an auditor can provide to a client that would not be considered to be in substance the full outsourcing of the internal audit function, including services that involve the performance of audit procedures. However, if fully outsourcing the internal audit function to the auditor is prohibited, it should not be permissible for an auditor to provide services in a manner (e.g., a series of individual projects) that in the aggregate would be equivalent to full internal audit outsourcing. Services that are nonrecurring would prevent the auditor from being in a position of conducting the internal audit function on behalf of the client. Accordingly, we believe discrete one-off projects of an audit nature would not impair the auditor's independence. Further, performing extended scope external audit work does not compromise independence and the commentary should clarify that point.
- Are there safeguards that can be established by the auditor that would allow the audit client to outsource the internal audit function to the auditor without impairing its independence? No. We are not aware of any safeguards that can be established that would satisfy the letter and spirit of the Sarbanes-Oxley Act and permit the client to outsource the internal audit function to the external auditor.
Is additional guidance necessary to distinguish the services that would be prohibited under this proposed rule from those services that would be permitted as operational audits? No. The commentary makes it clear that permissible operational audits must be unrelated to the client's internal accounting controls, financial systems, and financial statements. This position is wholly consistent with existing guidance in AU Section 322, paragraph .07, which states that internal audit activities that are relevant to the independent auditor when obtaining an understanding of an entity's internal control are those activities, "that provide evidence about the design and effectiveness of controls that pertain to the entity's ability to initiate, record, process, and report financial data consistent with the assertions embodied in the financial statements or that provide direct evidence about potential misstatements of such data." We do, however, request that the final rule recognize the fact that "operational audits" and "compliance audits" often have the same characteristics and, provided they do not violate the prohibition noted above, are permissible.
6. Management functions
The proposed rule is clear that independence is impaired if the auditor is "acting as management:" that is performing any decision-making, supervisory, or ongoing monitoring functions for the client, or taking direct responsibility for the design or implementation of controls. However, "assisting" management in the design and implementation of controls is difficult to distinguish from assessing the effectiveness of and providing recommendations for improvement in the audit client's internal accounting and risk management controls, which would not impair independence. The commentary should clarify that such assistance is not prohibited, and that assisting the client with routine administrative or ministerial functions is not a management function.
- Do services related to designing or implementing internal accounting controls and risk management controls result in the auditor auditing his or her own work? Would such services impair an auditor's independence when the auditor is required to issue an opinion on the effectiveness of the control systems that he or she designed or implemented? Were an auditor to take responsibility for designing and implementing internal accounting and risk management controls, he or she would be required to audit his or her own work in connection with Section 404 of the Act, which would impair auditor independence. As noted above, we are, however, concerned that the line between assisting with a client's design and implementation and taking direct responsibility for "design and implementation" is not sufficiently clear. A company's management often calls upon its audit firm's expertise for advice in developing appropriate controls or processes when implanting new systems, adopting new accounting rules or otherwise re-engineering its business processes. This work often takes the form of an assessment of management's design or implementation plan and the development of detailed recommendations. It is generally most effective for both the auditor and the company to assess the internal accounting and risk management controls when the systems are being designed and implemented. It would make no sense, nor do we think it was the intent of the proposed rule, to require a company to complete the design and implementation process before the auditor can make observations and suggest improvements that could result in some re-engineering when those same comments if delivered earlier in the process could be addressed in a more cost-effective manner. The commentary should acknowledge that it is appropriate for the auditor to assess the effectiveness and suggest improvements to internal accounting and risk management controls, provided that the auditor does not make decisions as to design or actually implement any internal accounting or risk management control procedures.
- Do services related to assessing or recommending improvements to internal accounting controls and risk management controls result in the auditor auditing his or her own work? Would such services impair an auditor's independence when the auditor is required to issue an attestation report on the effectiveness of the control systems that he or she has assessed or evaluated for effectiveness? No. As the commentary makes clear, gaining an understanding, assessing effectiveness and suggesting improvements to controls are essential parts of the audit function, and it would undermine U.S. GAAS to prohibit these services. In order to discharge our attest function under Section 404 of the Act, the auditor will need to gain an understanding of the controls and test their effectiveness. It would be unduly punitive to prevent companies from having the benefits of the auditor's observations about improvements given the assessment work that they are doing. We reiterate that the auditor should not be limited as to when he or she may perform testing or offer recommendations on internal controls.
- We request comment on whether there are circumstances under which an accounting firm can perform or assume management functions or responsibilities for an audit client without impairing independence. As discussed in our general comments above, the non-audit service rules should apply only to issuers and their consolidated subsidiaries. Consistent with that approach, we believe that providing management functions for other affiliates should be permitted. Likewise, we believe the rule should make it clear that routine administrative or ministerial functions performed for a client are not management functions - for instance, the filing of tax or other forms or returns (possibly accompanied by the issuer's check to the relevant authority).
7. Human resources
The proposal does not represent any change from the current rules, and we believe that that is appropriate. We note, however, that in two places the commentary appears to go beyond the restrictions set out in the proposed rule and in the current rules. In discussing the basic principles, the commentary in Section B cites designing compensation packages for the officers, directors, and managers of an audit client as a human resource service that would cause the auditor to function as part of management. Also, under the heading "Human Resources," the commentary states that advising an audit client about the design of its management or organizational structure would impair independence. We disagree in both cases. Both situations involve the auditor utilizing his or her expertise to provide counsel and advice to the client upon which the client makes decisions. The text of the rule would not prohibit these services, and the commentary should be consistent. There is no basis to disturb the longstanding advisory services model under which the auditor lends his or her expertise to the client in the form of counsel and advice when the client makes all necessary decisions.
- Would an auditor's independence be impaired if the auditor provided personnel hiring assistance for only non-executive or non-financial personnel? No, provided that the auditor does not make the decisions about which individuals to hire or perform other management functions.
- Does it impair an auditor's independence if the auditor provides consultation with respect to the compensation arrangements of the company's executives? No. Provided that the auditor does not negotiate the actual compensation packages on behalf of the company, providing advisory services with respect to compensation arrangements would not violate any of the principles and should not be prohibited. As we noted above, the commentary appears to suggest otherwise, and we encourage the Commission to revise it accordingly.
8. Broker-dealer, investment adviser or investment banking services
The proposed rule makes one change to the Commission's current independence rules by adding "registered or unregistered" to the proscription of acting as a broker-dealer. The permissibility of a service should not depend on whether or not an entity has completed the registration process, but additional clarity is required around what constitutes broker-dealer activities (whether registered or unregistered). "Broker-dealer" is a term of art and defined by law in the U.S., but it has no common meaning in the rest of the world. As the rules will be applied internationally, it is essential to define the specific activities that create a threat to independence rather than making reference to a uniquely domestic concept.
The Commission has made it clear, and we agree, that the following activities violate one or more of the fundamental principles and would impair independence:
- Acting as a promoter, or underwriter, on behalf of an audit client,
- Making investment decisions on behalf of the audit client or otherwise having discretionary authority over an audit client's investments,
- Executing a transaction to buy or sell an audit client's investment, and
- Having custody of assets of the audit client.
Footnote 48 of the proposal, however, suggests that performing any one of the following activities may result in a firm operating as an unregistered broker-dealer:
- Assisting an issuer to structure prospective securities transaction,
- Helping an issuer to identify potential purchasers of securities,
- Soliciting securities transactions,
- Receiving transaction-related compensation,10 or
- Holding itself out as a broker-dealer.
Helping an issuer identify potential purchasers of securities and assisting an issuer to structure prospective securities transactions (including advice on the tax structure) does not, in our view, threaten any of the three fundamental principles if the role is one of an advisor rather than one who implements aspects of a transaction. We assume, therefore, that it is some combination of the above that the Commission believes impairs independence.
In order to facilitate consistent application of the rule, the Commission should make clear whether it intends that engaging in any one of the activities listed in footnote 48 amounts to acting as a broker-dealer or whether it is a combination of these activities. If it is a combination of these activities, the Commission should provide additional guidance as to which activities are more likely to influence the determination as to whether one is engaging in broker-dealer activities.
Further, the guidance in the Commission's current independence rules permits "corporate finance consulting services" and recognizes that the AICPA guidance is appropriate.11 None of the activities defined in the AICPA guidance violate the three fundamental principles. The Commission should clarify whether the AICPA guidance continues to be appropriate and, if not, specify which activities (or combinations of activities) breach the underlying principles and impair independence.
- We solicit comment on the scope of the proposal. Are there other securities professional services that the rule should expressly identify as impairing independence? The scope of the Commission's proposal is appropriate, subject to our comments above. There are no other securities professional services that the rule should expressly identify as impairing independence.
- Would an auditor's independence be impaired if the auditor acted as a securities analyst covering the sector or industry of an audit client? PwC does not offer securities analyst services. As recognized accounting and tax experts in many industries, the firm does from time-to-time publish industry surveys and analyses. These are not for investment decision-making purposes and do not advocate the investment potential of any client or non-client of the firm. If the Commission should see fit to introduce rules relating to securities analysts, we request that care be taken not to prohibit industry surveys and analyses that are part of a recognized role of accounting firms and not related to securities transactions.
- Should we adopt rules that would clarify when the auditor is acting as an unregistered broker-dealer? If so, what should those rules be? Yes. As discussed above, the term "broker-dealer" is not universally recognized, and the rules need to be very precise in defining the specific activities that in combination would fall within the definition of broker-dealer activity. Some of the activities apparently proscribed in the proposed rule (i.e., listed in footnote 48) do not violate any of the three fundamental principles, and the simple fact that a broker-dealer might conduct them in the U.S. should not be grounds for categorizing the whole service as a proscribed broker-dealer service.
9. Legal services
The Act and its legislative history are devoid of any suggestion that the current prohibition on legal services in the existing independence rules is not sufficient. The legislation was enacted against the framework of the existing rules and there is nothing in the record to suggest that Congress found the current prohibition wanting. Accordingly, the Commission should maintain the existing definition of legal services: "Providing any service to an audit client under circumstances in which the person providing the service must be admitted to practice before the courts of a United States jurisdiction."
The rule as proposed contains a complete prohibition on the provision of legal services to an issuer in circumstances where such services can only be provided by someone licensed, admitted or otherwise qualified to practice law in the jurisdiction in which the service is provided. This area of the proposed rule has far-reaching implications in many jurisdictions. The compressed time for rule-making and the short comment period make reasoned consideration of the impact virtually impossible. Moreover, the Commission can fully deliver on its Congressional mandate by leaving the existing rule in place.
Nowhere will the impact of this confusion be greater than in the area of tax services. Despite the clear Congressional judgment that tax services are consistent with the audit function and should be permitted,12 subject to audit committee approval, the legal services rule as proposed would make it impossible for auditors of registrants or their subsidiaries to provide tax services in certain jurisdictions where only lawyers are permitted to do so (e.g., France, Norway and Portugal). Accordingly, a multi-jurisdictional tax planning project that involves permissible activities when judged by U.S. standards could be prohibited if, for example, expertise about the French tax system were required. This result would obtain notwithstanding the fact that the services involved would not violate any of the three principles. The Commission should revise the proposed rule to ensure that such an inconsistent result would not obtain.
Bar rules, law society rules, laws, regulations and tradition as to what professionals can provide what services around the globe are as varied as the nations themselves. Furthermore, the rules are subject to change according to the political climate and the relative influence of various professional groups within different territories. Accordingly, the rule as proposed fails to draw any bright lines around what services are permitted and puts issuers in the position of being able to use their accounting firm to provide certain services in one territory when those same services could be prohibited in another territory. There is no rational justification for this approach and issuers and investors will be negatively affected by the unpredictable and irrational outcome such a rule would yield.
As noted above, we believe that no further amendment is required to the Commission's current rule, given that additional restrictions on legal-type services are embodied elsewhere in the proposed new rules (e.g., in advocacy, expert services and human resources). However, if the Commission is unwilling to revert to the existing rule on legal services we urge the Commission to make it explicit that foreign lawyers in an associated law firm of a network of accounting firms should be able to perform services that a registered public accounting firm could perform for an audit client in the U.S., and that materiality should be considered when determining what services are appropriate. An approach such as this, which addresses the issue on a functional and practical level, avoids the inconsistencies that would otherwise result from the current proposal.
- Are there any particular legal services that should be exempted from the rule? Legal services outside the U.S. should be permitted in the same manner as they are currently. If the Commission is not comfortable with its current definition, it should clarify that those services permitted in the U.S. should be permitted in all jurisdictions.
- Should there be any exception for legal services provided in foreign jurisdictions? For example, in some countries only a law firm may provide tax services. Should a foreign accounting firm be permitted to provide, through an affiliated law firm, tax or other services that a U.S. accounting firm could provide to a U.S. audit client without impairing the firm's independence? Why or why not? Yes. Such an exception is appropriate, because services that are consistent with auditor independence when provided in one jurisdiction should not impair independence when provided in another jurisdiction.
- Should there be an exception for legal services provided to issuers in foreign jurisdictions? Should any such exception be tailored to avoid undermining the purpose of the restriction? For example, could fees for legal services be limited to a small percentage (e.g., 5% or 10%) of the amount of fees for audit services? Could partners providing audit services be prohibited from being involved in the provision of legal services or from receiving compensation based on such services? If the approach discussed above were adopted, no special exemption for legal services provided to issuers in foreign jurisdictions would be required. If that approach is not adopted and the Commission decides to enact the legal services language as proposed, we believe that there should be an exemption for all tax services provided to issuers in foreign jurisdictions and an exemption for services related to matters that are not material to the issuer's financial statements. As discussed in the section related to design and implementation of information systems, exemptions should be measured by evaluating materiality with reference to the issuer's overall financial statements and not by the size of an engagement from a fees perspective. Assessing the potential for impairment of independence because of the size of the fees related to the non-audit services ought to be left to the judgment of the audit committee through the pre-approval process, subject to the oversight of the investing public informed by the required fee disclosures in the proxy statement.
- Should any such exception have a "sunset" provision that would both allow foreign private issuers a transition period and allow the Commission to review the situation regarding legal services? No. General transition provisions need to be addressed but, if an exception is granted for services provided in foreign jurisdictions, it should be granted without a sunset provision. If the Commission or PCAOB later determines that such an exemption was not warranted, it can undertake rule-making to change the rule, with appropriate time for public comment.
10. Expert services
The proposed rule defines a category of "expert services" that are prohibited. As the Commission has recognized, virtually everything an auditor does could be characterized as an expert service. Accordingly, the final rule should clearly define what is prohibited.
Since it is the appearance of advocacy that justifies prohibiting expert services, "proceeding" needs to be defined to capture only public forums, because the visibility of those forums creates a risk of the auditor appearing to advance the client's position.
Given the actual role of the expert in the U.S. adversarial system (as well as many others around the world), we disagree that a testifying expert acts as an advocate for his or her client. It is well recognized in rules of civil procedure, legal opinions and professional literature that the expert's obligations run to the court or the jury (whichever happens to be the trier of fact) to provide objective, impartial testimony - the duty does not run to the client for whom the expert happens to offer the testimony. Additionally, unlike a lawyer, the expert testifies under oath, subject to cross-examination and rigorous qualification processes aimed at ensuring that there is an objective basis for his or her opinions. Having said this, we recognize that the Commission may have concluded that the "appearance" of advocacy associated with any public appearance is sufficient to justify prohibiting the service even when court rules control such appearances.13
Because the concern is driven by appearances, the requirement that the services be "in connection with a legal, administrative or regulatory proceeding" is an appropriate limitation. However, without guidance on what constitutes a proceeding, the rule is not sufficiently precise to draw a "clear line around" the services that are prohibited. A meeting or other communication with administrative or regulatory officials can take many forms; some are not public and, therefore, create no issues with respect to the appearance of advocacy. Many such communications are traditional services provided by auditors. For instance, a tax audit and appeal in the U.S. might be viewed as a "regulatory or administrative proceeding," but the Act and the proposed rule read in their entirety make it clear that those services continue to be appropriate.14 Similarly, a meeting with the Division of Corporation Finance in connection with a client's accounting issue in which the auditor is providing technical and factual support is an essential part of performing the audit function and should not be prohibited.
In order to address this ambiguity, the Commission should add a sentence to the rule, clarifying that a proceeding is a "formal, public forum for dispute resolution, rule-making or standard setting." This formulation would clearly capture all "expert witness" engagements, including the "rate setting" example cited in the commentary. It also would remove any doubt created by the language in the commentary regarding the auditor's ability to assist the client or its counsel with regulatory communications that do not involve appearing on behalf of the client in public settings.
Further, the rule should state that it is "serving as a retained expert" in a proceeding rather than "providing expert opinions" for an audit client that is prohibited. Without that clarification, an auditor or tax professional that is called as a factual witness and testifies as to the expert opinions they formed in performing the underlying services could be in violation of the rule. Since neither Congress nor the Commission intended that outcome, the language should be changed to conform the rule to the intent.
The proposed rule is consistent with the Act in prohibiting actual advocacy by the auditor on behalf of the client. The commentary, however, creates ambiguity by suggesting that advisory and routine support services also are prohibited.
The commentary on expert services conflicts with the Act and the proposed text of the rule to the extent that it states "[the] prohibition on expert services would include providing consultation and other services to an audit client's legal counsel in connection with litigation, administrative or regulatory proceedings." (67 Fed. Reg. at 76789). As noted above, being an advocate for an entity means to speak on its behalf in seeking a particular outcome, not simply providing consultation or information on technical matters. Prohibiting an auditor from providing any consultation or advice to a client's counsel on the ground that doing so is advocacy unduly strains the plain language and concept of advocacy. The commentary wrongly suggests that when an auditor is hired to provide consulting services to a company's counsel in connection with a proceeding, the auditor takes on the lawyer's duty of zealous representation. That is not accurate: the role of the consultant is not to advocate the client's case but to answer technical questions so that the client and its counsel understand the framework within which they are operating. This activity is no different from an auditor providing technical consultation on how accounting or tax rules operate in order to facilitate a company's decision making in connection with any given transaction.
Consulting and support services provided to counsel present no threat of self-review, do not comprise a management function, and cannot be reasonably construed as advocacy. Thus, there is no principled reason to extend the prohibition on expert services to include such services, and the commentary should not suggest otherwise. Indeed the commentary is at odds with the Act and the rule to the extent that it purports to prohibit the auditor from providing consultation to legal counsel when no expert testimony or advocacy is involved.
- Are there circumstances in which providing audit clients with expert services in legal, administrative, or regulatory filings or proceedings should not be deemed to impair independence? The obligation of an expert to the trier of fact to provide independent, objective analysis makes it clear that serving as an expert in a proceeding should not be inconsistent with independence. Therefore, we believe there are no circumstances in which providing such services should be deemed to impair independence. Consistent with our comments above, however, if the Commission believes that the appearance of advocacy is sufficient to justify prohibiting these services, it should clearly prohibit only those services where the appearance of advocacy is present: appearing as an expert witness in a proceeding that is public.
- Should an auditor be permitted to serve as a non-testifying expert for an audit client in connection with a proceeding? Yes. If the auditor is not appearing in a public proceeding as an expert witness or otherwise publicly advancing the position of the client, there is no basis in any of the principles to prohibit the auditor from advising a client or its counsel on technical matters. Similarly, the auditor is frequently in the best position to compile information for presentation to the company and its counsel, who then make decisions on how to use that information. Doing so should not be construed as advocacy, presents no self-audit risk and is not a management function. Indeed, the proposed rule seems to permit this type of service, but the commentary prohibits it without justification.
- Is the definition of prohibited expert services appropriate? Why or why not? No, because the term "proceeding" needs to be defined and advocacy needs to be addressed consistently with the comments above.
- Is the distinction between advocacy and providing appropriate assistance to an audit committee sufficiently clear? No. As stated above the advocacy principle needs to be clarified. Having said that, we support the Commission's efforts to make it clear that audit committees, pursuant to their authority under Section 301 of the Act, can retain the auditor for a wide variety of services.
11. Tax services
We have several concerns about the proposal as it relates to the scope of permissible tax services. Please refer to our December 26, 2002 comment letter. Our main comments are summarized as follows:
- Congress clearly expressed its view that tax services do not violate auditor independence and should be permitted.
- The commentary regarding tax services casts unnecessary doubt over the scope of permitted tax services.
- For clarity, the Commission should be explicit if it believes that there are services provided by tax professionals that impair auditor independence.
For completeness we also provide our responses to the specific questions the Commissions has asked.
- We request comment on whether provided tax opinions, including tax opinions for tax shelters, to an audit client or an affiliate of an audit client under the circumstances described above would impair, or would appear to reasonable investors to impair, an auditor's independence. No. Providing a tax opinion to a client is more closely analogous to providing an audit report than to being an advocate. The tax professional applies his knowledge of the law to give the client and objective read on how the laws and regulations will be applied to a given situation. This exercise is subject to an umbrella of regulation and oversight provide by the tax authorities in the relevant jurisdiction. If the client provides the opinion to a third party, the their party still makes its own independent judgment on whether to proceed. This is analogous to a client providing an audit opinion to a lender to obtain financing; a practice which has never been - and is not now - viewed as impairment to auditor independence.
- Are there tax services that should be prohibited by the Commission's independence rules? No. As discussed in our December 26, 2002 comment letter, Congress clearly intended to continue the Commission's unbroken tradition of recognizing that tax services are fully consistent with auditor independence and that is beneficial to corporate America and investors alike to allow audit firms to continue to provide tax services as doing so enhances both audit quality and tax compliance.
- Is it meaningful to categorize tax services into permitted and disallowed activities? If so, what categories and related definitions would make the demarcation meaningful? As stated in our December 26, 2002 comment letter, we believe that Congress rightfully intended all tax services to be permitted and thus, no such categorization should be required. Having said that, if the Commission determinates that prohibiting certain tax services is appropriate, it should follow the suggestions made in our letter to narrowly define such services, and then directly and clearly prohibit them while specifically allowing all other tax services. That is the best way to provide the certainty that Congress intended and the marketplace deserves.
Transition Issues Relating To Services Outside The Scope of the Practice of Auditors:
The proposal anticipates an effective date coincident with the adoption of the final rule. That approach is overly simplistic and will result in a number of difficult implementation issues. Accordingly, we make the following recommendations:
- The rule as to scope of services should have a delayed effective date. We offer the following alternatives for consideration:
(a) Upon a firm becoming a Registered Public Accounting firm with the PCAOB;
(b) 30 days after the PCAOB becomes operational; or
(c) 90 days after publication of the final rule in the Federal Register.
Under any alternative above, the Commission should allow for completion of engagements/contracts in process provided that they are not materially modified and do not extend beyond 18 months from the publication date (i.e., 1(c) above). Given that the rules change the existing framework, some services that will in the future be prohibited may have been provided in the last calendar year, and if the rule were immediately effective auditors would be deemed to lack independence for services they provided at a time when such services were clearly permitted. Thus, an appropriate grandfathering provision should be included to cover pre-existing non-audit services, some of which (e.g., legal services), may have significant contractual or other commitments.
- Expert witness engagements that were commenced prior to the effective date should be grandfathered. Courts have varying rules governing the conduct of expert witnesses. In most jurisdictions, parties are required to identify their experts by a certain date after which switching or adding additional experts to a witness list is prohibited. Accordingly, without relief the rule would force litigants who had previously hired and designated an individual from their audit firm as an expert to either change auditors to protect their litigation position or prejudice their litigation position to protect their auditor's independence. Neither companies nor their shareholders would be benefited by such a situation. Moreover, often substantial work (documentation, deposition testimony, etc.) has been invested, and the client will be prejudiced (often significantly) by being forced to change experts so late in the process.
- When a company switches auditors, expert witness engagements in place at the time of the switch should be grandfathered. The same considerations noted in the previous point apply when a company changes auditors. An audit committee should not be prohibited from selecting the audit firm that they believe will best serve their company, because that firm has an outstanding expert witness engagement. In many cases expert witness engagements have long life cycles because of the time required to litigate a case to conclusion. Accordingly, the Commission should make it clear that the prior existence of an expert witness engagement would not disqualify a firm from being selected as a company's auditor provided no new expert witness engagements commence after the audit relationship is initiated.
- Legal service engagements that were commenced prior to the effective date should be grandfathered. If an engagement was commenced in a manner consistent with existing independence rules, the audit client should not be forced to seek new legal counsel in the middle of the legal process. An abrupt change in legal representation could jeopardize the timely resolution and, perhaps, the final outcome of the matter.
- When a company switches auditors, legal services engagements in place at the time of the transition should be grandfathered. For all the reasons existing legal services should be grandfathered, similar relief should be provided for companies switching auditors.
- With regard to actuarial and valuation services, specifically, the rules should have a longer transition period. If the final rules prohibit an accounting firm from providing pension, OPEB and similar valuation services to clients, the new rules should not apply to any actuarial or valuation service related to amounts in the 2002 or prior years' financial statements, even if that service is completed after the date the final rules are adopted. In addition, because the completion of an actuarial valuation generally takes several months and it would take registrants some time from the adoption date to engage a new actuarial firm, auditors should be allowed to complete the 2003 actuarial valuation in order to have an effective transition to a new actuarial firm. This would also be consistent with the new IFAC independence rules, which become effective in 2004.
- When there is a change in a company's circumstances during an accounting period, there should be an appropriate period of transition for non-audit services. There are circumstances which may arise during a year that would require a reassessment of the auditor's independence such as an acquisition by another issuer, obtaining a listing or becoming a registrant, or changing the auditor. In each situation an accounting firm may be providing either potentially prohibited services or non-audit services that would require pre-approval as a result of the change, and it is important that appropriate transitional provisions be established to deal with each circumstance.
II. C. Partner Rotation
While we support the changes made by the Act regarding partner rotation involving the lead engagement and review (concurring) partner, we do not support the expanded applicability of rotation.
As the Commission has indicated, the concept of partner rotation is not new. The SEC Practice Section requires that all lead engagement partners rotate after seven years and cannot serve again as the lead engagement partner for a two-year period. PwC supports this policy, and our internal polices go beyond the requirements of the SECPS and apply the seven-year requirement to the concurring partner. However, the concurring partner can, after the seven-year period, serve as the engagement partner for a further seven years.
1. Rotation versus continuity
The Benefits of Partner Rotation. There is a concern, both real and perceived, that after a period of time auditors tend to grow too close to the client's management, and that they could begin to identify with management's problems and lose the requisite skepticism. The Commission indicated in the proposing release that it is concerned about partners who routinely interact or develop relationships with the audit client. Also, there is the concern that auditors can become stale, viewing the examination as a repeat of earlier examinations. Partner rotation is appropriately designed to address these concerns.
The Benefits of Continuity. Unquestionably there are benefits to continuity in partner service. The more experience a partner has both with respect to the industry and with respect to a client, the more likely that errors, fraud, and significant accounting and reporting issues will be identified. In short, a knowledgeable and experienced partner will be able to better serve the company's stakeholders. These benefits are even more important given the increasingly complex business and accounting environment. Audit quality is best achieved when the rotation requirements properly balance the benefits of rotation and continuity.
The Act and Proposed Rules. The Act requires that the lead engagement partner and concurring partner rotate off an engagement after five years. The Commission's proposal significantly expands upon this requirement in two distinct ways:
- It applies the concept to all partners participating on the engagement team of the registrant and any significant subsidiaries as defined by Regulation S-X; and
- It restricts the ability to return to an engagement for a five-year period.
2. Concerns with the proposal
We are concerned that expanding the number of partners to whom rotation applies will hurt audit quality by forcing the rotation of knowledgeable partners when the benefit of continuity outweighs the benefit of rotation. The proposal applies the rotation requirements to all partners that are involved with the engagement team of the issuer or that of a significant subsidiary as defined by Rule 1-02(w) of Regulation S-X. As described in more detail below, due to unusual events, breakeven results, etc., every subsidiary could be significant based on this definition and, therefore, all partners involved with an audit would be subject to the rotation requirements. Neither issuers nor engagement teams will be able to predict which subsidiaries will be significant and, therefore, to be safe, rotation requirements may be applied to partners on all subsidiaries.
To illustrate the challenges of implementing this proposed rule, we use the example of one of our clients, a large consumer products company in the U.K. In addition to the lead engagement and concurring partner, we have over 181 partners assigned to this engagement in 88 countries. These totals do not include a number of other partners who play critical supporting roles, including partners who perform the filing review to comply with the SECPS Appendix K requirements regarding compliance with U.S. GAAP, U.S. GAAS, etc., as well as the national office partners in the U.S., U.K. and other countries. Applying the Commission's proposed criteria to this client would appear to subject at least 183 partners to the rotation requirements.
3. Critical relationships
The critical relationship that exists between the client and the engagement team for which rotation is considered necessary are those between the client and the lead engagement partner and the concurring partner. The lead engagement partner is the one who has a close and continuous relationship with management responsible for preparing the financial statements.
The lead engagement partner is in regular and direct contact with the client. The lead engagement partner is responsible for all decisions made in the course of the engagement, including those about scope of services, the audit strategy, and the resolution of significant accounting and auditing issues. The other partners on the job, excluding the concurring review partner, assist and support the lead engagement partner. This responsibility is not pro rata allocated among all of the other partners. The lead engagement partner has full responsibility for signing the opinion.
Given this, there does not appear to be a need to expand the applicability of the rotation requirements beyond the lead engagement partner and concurring partner. The relationships for which rotation is considered necessary exist at the executive level at the company's corporate headquarters and not throughout the various subsidiaries. It is at this level that the lead engagement partner and, to a much lesser extent, the concurring partner, interact and develop relationships with management.
A large number of the partners who would be subject to rotation requirements under the Commission's proposed rule will not be in a position to interact and develop relationships with the audit client that justify rotation for two reasons:
- The portion of the audit for which they are responsible is not significant to the consolidated entity.
- They are not in a position to interact and develop relationships with the key people at the issuer level of the consolidated entity.
These two points are described in more detail below:
Portion of the Audit is not Significant. There can be subsidiaries that are regularly insignificant but because of an unusual event or other aberration meet the significance test under Rule 1-02(w) of Regulation S-X in a particular year. Such aberrations will be primarily attributable to the income test. Meeting the significance test because of an aberration would not cause the partner assigned to the subsidiary to have the type of critical relationships with key people in the issuer's management similar to that of the lead engagement partner. This test would have to be applied after year-end and, therefore, it will not be known if a subsidiary is significant until that time. Because of the nature and timing of the test, it would not be possible to plan in advance which subsidiaries will be significant. Since the issuer and the accounting firm would not wish to risk a violation of the rotation rule, the firm would probably be forced to rotate any partner at any level serving for more than 5 years.
Not in a position to interact and develop relationships with key people. In many instances partners, who are not the lead engagement partner, work directly under the supervision of the lead engagement partner. Although such partners are highly qualified and important to the overall audit, the people that they interact with generally will not be the key people making the critical decisions impacting the issuer's overall financial reporting.
There are also many partners who advise the lead engagement partner who should be exempt from rotation. The Commission indicated that the rotation requirements should not apply to national office partners because they do not routinely interact or develop relationships with the audit client. We agree with this conclusion. For the same reasons, other partners in advisory roles should not be required to rotate. Those advisors include, but are not limited to:
- Specialists in taxes that assist in auditing the tax provision
- System control specialists
- Specialists on U.S. GAAP and U.S. GAAS that assist non-U.S. companies under the SECPS Appendix K requirements
In all situations, these roles support the lead engagement partner. The lead engagement partner assumes full responsibility for their work.
4. Implications of the proposal
Despite being the largest accounting firm in the world, we are concerned that we may not have sufficient resources to properly support the lead engagement partner if all partners on the engagement must rotate and that audit quality could be impaired. As accounting and reporting become increasingly complex, partners must develop industry expertise. A banking partner cannot properly serve a multi-national oil and gas company. We believe that the rotation of a large number of partners will result in partners being assigned to jobs for which they are less qualified than the partners being forced to rotate, resulting in a decline in audit quality.
While this problem exists in the U.S., it is compounded outside of the U.S. - not just for foreign private issuers, but also for subsidiaries of domestic and foreign companies located outside of the U.S. There are a number of factors that make the rotation issue more complex outside of the U.S.
- Accounting firms in other countries are substantially smaller than the U.S. firms and many do not have the depth of experience at the partner level to be able to rotate partners without hurting audit quality. They will have many of the same issues that the Commission has noted regarding smaller firms. These non-U.S. firms will have a much smaller percentage of partners with the necessary knowledge of U.S. GAAP, U.S. GAAS and industry skills. It is also not always possible to relocate a qualified person to another country because of licensing requirements, language capabilities, working papers, disproportionate cost, etc. In addition, it will be more difficult to retain qualified people in the profession if they are forced to leave their home country as a result of rotation requirements.
- Many countries require statutory audits. Accordingly, the partner in a particular country is serving two roles - assisting the engagement team on the consolidated financial statements and serving as the engagement partner on the financial statements issued by the subsidiary. The partner signing those accounts will frequently need to be a person duly licensed in that country. These two roles cannot logically be split.
In discussing the potential costs of the proposed rule and addressing the impact on small firms, the Commission stated that to allow rotation it may be necessary to admit more partners into the partnership that have the necessary qualifications to serve these clients. We believe that admitting more partners into the firm than would otherwise be admitted is not an appropriate solution and will hurt audit quality. There are a finite number of people that are qualified to be partners and provide this service. We admit as partners only those who possess the requisite qualities for admission. The admission of further partners merely to facilitate rotation means inevitably a dilution of the quality of partners. In addition, shareholders are best served when the most qualified partners are serving on an audit.
5. Our proposal
The Commission should adopt only those rotation provisions that are required by the Act. The Commission should not implement rules that apply rotation requirements to more partners until it has the opportunity to evaluate the implications of the mandatory changes. The Commission has not provided evidence that there is a need to expand the applicability of the Act beyond that stipulated by Congress, and the proposed rules do not address the impact on audit quality. As the benefits of continuity will be lost, we strongly recommend that the provisions not be adopted as proposed.
International Harmonization. We encourage the Commission to work with IOSCO to evaluate the need for rotation requirements for partners beyond the lead engagement and concurring partner. A large number of both U.S. and foreign companies operate in a variety of different jurisdictions. The accounting firms are being forced to comply with changing requirements regarding rotation in different jurisdictions. We are concerned that this will only hurt audit quality by forcing partners knowledgeable about a company and its industry off a particular client. If another country imposes different rotation requirements it can impact the pool of partners that can serve on companies registered with the Commission - both domestic companies and foreign private issuers. It will be extremely difficult to comply with the requirements of different countries in the future with the same pool of partners while attempting to maintain audit quality.
Audit Committees. The Act has empowered the audit committee with oversight responsibility over the auditor. In lieu of applying the rotation requirements to all partners, we believe the Commission could require the auditors to provide the audit committee with information on the partners involved with the audit, their respective responsibility on the audit, qualitative and quantitative, and the years they have been involved with the audit. The audit committee could make its own determination regarding partner rotation based on what it believes is in the best interest of the company's shareholders.
6. Alternative proposal
If the Commission concludes that the rotation requirements need to be applied to partners beyond the lead engagement and concurring partner, we would recommend limiting the number of partners subject to the rotation requirements. In this regard, we would group all of the partners on an assignment into the following categories:
We agree that the lead engagement partner and concurring partner should be subject to the rotation requirements after 5 years. We do have a number of recommendations about transition issues described below. We also agree that they should not resume involvement with the audit for 5 years - subject to some comments below.
We believe that partners under the direct supervision of the lead engagement partner should not be subject to the rotation requirements. They typically do not interact and develop relationships with key executives of the issuer - this is the domain of the lead engagement partner.
Bearing in mind the objective of partner rotation as described above, we believe that only those partners that are responsible for both a significant portion of the audit and spend considerable time on the audit - in relation to the lead engagement partner - should be covered by this requirement. We propose a two-part test, and only those partners that meet both criteria would be subject to the rotation requirements.
A - a subsidiary that is significant using the asset test under Regulation S-X but substituting 20% for 10% in applying that test, and
B - a subsidiary in which the partner has incurred total hours equal to a specified percentage of hours of the person (or persons if there is a change) serving as lead engagement partner over the last five-year period - say 80% of the lead engagement partner's hours.
Some subsidiaries could be large in size but have very few issues or problems and the audit work is routine. On the other hand, some subsidiaries could require a substantial amount of partner time to ensure compliance with statutory requirements. The benefit of combining these two criteria is that it will include only those partners that audit a large subsidiary and that, by virtue of the amount of time they expend on the assignment, could conceivably be in a position to have a close and continuous relationship with management of the subsidiary. For purposes of determining which subsidiaries are significant, the asset test in Rule 1-02(w) of Regulation S-X is the best indicator. It eliminates the volatility and unusual results that arise from the income test. The investment test is also not a proper indicator because significance would be affected by whether the subsidiary is capitalized through debt or equity. That distinction should not impact partner rotation.
If the partners in this group are subject to rotation, it should be the same as that of the lead engagement partner - maximum of five years. However, they should be allowed to come back on the job after two years reflecting the fact that their relationships are with subsidiary management and not the key management of the issuer.
The Commission has indicated that partners in the national office should not be subject to the rotation requirements, in part because they do not interact and develop relationships with the client. That reasoning should extend to this group of partners. These positions would include the following:
- Specialists in taxes who assist in auditing the tax provision
- Systems control specialists
- Specialists in U.S. GAAP and U.S. GAAS that assist non-U.S. companies under the SECPS Appendix requirements
In all situations, these roles support the lead engagement partner.
There is no question that auditing the tax provision is a critical part of the audit. It requires significant expertise on tax rules and regulations and engagement partners work closely with the tax partner in conducting this aspect of the audit. However, a partner that specializes in taxes will generally not develop the relationship with the client that the rotation requirement is aimed at. In fact, because of its specialized nature, there can often be several tax partners involved - state taxes, international taxes, etc. - and none of them will develop the kind of relationship or position that would influence the audit. While providing important assistance, the responsibility for the tax provision belongs to the lead engagement partner.
As noted above, we are concerned about the implications of expanded application of rotation outside of the U.S. In such situations, there will be more difficulties with respect to tax advisors and other specialists as the number of people in any jurisdiction that are knowledgeable about U.S. GAAP, local GAAP and the applicable tax laws and regulations will be very small. If rotation is required for these individuals, audit quality will decline and costs will rise.
We are also concerned about the implications of an expanded application of rotation in specialized industries especially outside of the U.S. For example, in the U.S., our firm currently has a limited number of tax partners with the requisite experience and skill to provide audit services to our extensive banking practice. Those same partners spend the majority of their time providing tax advisory services to assigned bank clients. Mandatory rotation of these partners will result in loss of client specific knowledge and ultimately impact the quality of service to these clients. This situation is even more pronounced outside of the U.S. where the depth of partners with both the specific technical knowledge and industry expertise is less.
We are also concerned that rotation may require extensive additional travel obligations for our partners as well as relocations that in turn will affect the ability of our firm to retain them. Moving partners across national borders is frequently not a viable option because of licensing requirements, language skills, etc. These problems are even more acute with respect to tax advisors. Not only will they have the same issues as the audit partners, they have the added responsibility of needing to become familiar with the applicable tax laws and regulations before they can serve as a tax advisor. It would be unreasonable to assume that an American tax partner could transfer from the U.S. to, say, Germany and provide tax advice on German tax matters. The number of people in any jurisdiction that are knowledgeable about U.S. GAAP, local GAAP and the applicable tax laws and regulations is going to be very small. If rotation is required for these individuals, audit quality will likewise decline.
7. Other issues
Rotation with less than five years of service. The proposed rule is not clear about the number of years a partner may serve on the audit if they have been on the audit for a period of less than five years. For example, if the partner served for one year and is off for a year can the partner come back on the audit for five years, four years, or does the partner need to wait for a five-year period? We believe in practice there are going to be a number of situations in which a partner will need to take time-off from an engagement for personal (e.g., maternity leave) and professional reasons (e.g., tour in the national office), and it would not be in the best interest of audit quality to conclude that they are precluded from serving for a five-year period. On the other hand, the rotation rules should not be circumvented by, for example, coming off the engagement after working less than five years and returning shortly thereafter to begin a new five-year period.
An appropriate balance between allowing the most qualified partners to serve on the job and ensuring that the engagement receives a fresh look would be a requirement that the five-year service period must be completed within a seven-year period. Upon completion of the five years during this period, the partner would remain off the engagement for five years. To illustrate, a partner worked on an engagement in 2003, 2004, and 2005. During 2006 and 2007, the partner worked in the firm's national office. Under our proposal, the partner would be allowed to serve as the lead engagement partner for 2008 and 2009, would be required to come off in 2010, and could not serve again until 2015.
An alternative proposal is for the partner to only be required to wait the number of years the partner worked on the engagement before returning, subject to the five-year maximum. For example, if the partner first started on the engagement in 2003, the five-year period would end in 2007. If the partner were the lead engagement partner for 2003, 2004, and 2005, but was not involved during 2006 and 2007, the partner could not return until 2009 (i.e., the partner would be on the engagement for three years and off for three years).
We believe either alternative would more properly balance the role the person played with the need to be away from the audit.
Other auditors. If another auditor audits a subsidiary and the principal auditor refers to the other auditor, under Rule 2-05 of Regulation S-X, the other auditor's report would be required to be filed with the Commission. In this situation, we believe the other auditor should be subject to the rotation requirements. We distinguish this from situations in which the partner auditing the subsidiary is with the same firm as the lead engagement partner. The difference is that the other auditor is not under the direction or oversight of the lead engagement partner for the issuer but is, in substance, the equivalent of the lead engagement partner, only for the subsidiary. In fact, the partner signing the report that is filed under Rule 2-05 has the same responsibility as the lead engagement partner. We recommend that the adopting release address this point.
Concurring review partner. The concurring review partner should be allowed to serve on the engagement team immediately upon completion of their service as concurring partner because that partner would not have had any direct audit responsibility as a concurring partner.
Succession. Audit quality is best served when there is a smooth transition from one lead engagement partner to another. To accomplish this it is generally necessary for the new partner to have a role in the audit prior to assuming responsibility as a lead engagement partner. We believe that this involvement should not count in determining whether the partner has served five years. We recommend the adopting release address this point.
First Time Filer. The Commission should indicate in the adopting release that, consistent with the existing SECPS requirement, that lead engagement partner and concurring partner may spend two additional years in their respective roles before needing to change when a company first registers with the Commission.
Further, the Commission should indicate that initial audits that cover more than one year count as one year for purposes of rotation. For example, if a company is audited for the first time and the financial statements cover 2003, 2002, and 2001, we believe only one year (not three) should count in determining whether the partner has served five years. Likewise, if there is a restatement, the Commission should indicate in the adopting release that correcting a prior year does not result in an additional year of service for purposes of rotation.
- Should the Commission adopt rules requiring that issuers engage forensic auditors periodically to evaluate the work of the financial statement auditors? If so, how often should the forensic auditors be engaged? What should be the scope of the forensic auditors' work? Would doing so obviate the need to require partner rotation for the audit firm? Alternatively, could the company obtain the necessary expertise by engaging other outside consultants? If so, what type of consultants should it engage? No. We do not support the use of a forensic auditor to evaluate the work of the financial statement auditors. The audit of the financial statements is conducted in accordance with U.S. GAAS. A forensic audit is not a GAAS audit and there are no standards by which such an audit would be conducted. The use of a forensic auditor would not enhance investor protection. The fact that today forensic auditors are not hired to audit the auditor demonstrates that there is no market or demand for this service. Moreover, a firm's audit work will be subject to both internal and external quality reviews, and a forensic review would not provide additional benefit. In short, this is not a viable alternative to rotation and the Commission should not pursue it.
- Would the establishment of rules requiring companies to engage forensic auditors periodically provide an opportunity to other firms to enter the market to provide these services? If such a rule were adopted, the forensic accountant would need to be of comparable size to the engagement team.
- Should the Commission establish requirements for firms conducting forensic audits? If so, what should those requirements be? There is no role for the forensic auditor to audit the auditor. However, if the Commission were to establish one, we believe the Auditing Standards Board should establish the procedures that should be followed by the forensic auditor.
- Should issuers be given a choice between engaging forensic auditors periodically and having the audit partners on their engagement team be subject to the rotation requirements? Why or why not? No. Requiring rotation of an engagement and concurring partner benefits the investors by allowing a fresh look at the audit. A forensic audit would simply be someone testing the work done by the auditor, and it would not provide a fresh look at the key judgments made during the course of the audit.
- What are the costs and benefits of engaging forensic auditors to evaluate the work of the financial statement audit firm? It is not possible to determine the cost of engaging a forensic auditor, as the scope of their work is not defined. As described above, we do not see any benefit of this service, and we do not believe issuers will be willing to pay for it.
- This proposed rule would apply to the audits of the financial statements of "issuers." Should the Commission consider applying this rule to a broader population such as audits of the financial statements of "audit clients" as defined in 2-01(f)(6) of Regulation S-X? Why or why not? The rules regarding partner rotation should be limited to partners involved in the audit of the financial statements of the issuer. The cost of applying this provision in other situations will exceed the benefit and is not necessary for investor protection. For example, assume the issuer acquires a business that is not a reporting company under Section 13(a) or 15(d) of the Exchange Act and the engagement partner of the subsidiary has been on the audit for six years. Financial statements are required to be filed pursuant to Rule 3-05 of Regulation S-X. If the rotation rules were applied in that situation, the issuer would need to incur the cost to have the financial statements re-audited. As this is only a one time filing, the cost of switching partners or having the audit conducted by another firm would exceed the benefit. The fact that they are not the financial statements of the issuer makes many of the concerns about the need for rotation irrelevant. The same would be true for equity investees under Rule 3-09 of Regulation S-X.
Other situations further illustrate why the requirement should not be extended to "audit clients." If two audit clients are affiliated as sister companies, for example, the audits are distinct. Each issuer has a distinct audit committee and management and accounting/auditing issues. There would be no "fresh look" benefit and the accounting firm's administration of rotation requirements would be further complicated. As described in our response below with respect to investment companies, we are also concerned that use of the audit client definition would put the Commission in the inappropriate position of regulating the conduct of audits of private companies.
- For organizations other than investment companies, the rotation requirements would apply to significant subsidiaries of issuers. Should a different approach be considered? Is so, what approach would be appropriate? As described in our general comments regarding the proposal, we do not believe the rotation rules should apply to partners at significant subsidiaries. If the Commission does not agree with us, we would favor modifying the definition of significance to eliminate the income test and apply the criteria as described above.
- Is the proposed guidance sufficiently clear as to which audit engagement team partners would be covered by the rule? Is the proposed approach appropriate? If not, how can it be improved? For the reasons mentioned in the response above it is not clear because the partners that are covered could change on very short notice as a result of applying the significance test.
- Is the distinction between a member of the engagement team and a national office partner who consults regularly (or even continually) on client matters sufficiently clear? There should be further clarification regarding the role of the filing or designated reviewer who is used to comply with the SECPS Appendix K requirements. The Commission should indicate whether this role is subject to the rotation requirements. We believe it should not be because, while not part of the national office, these reviewers are acting as advisors and consultants to the engagement team and are not assuming responsibility for the audit. Please see comments above.
- Should certain partners performing non-audit services for the client in connection with the audit engagement be excluded from the rotation requirements? Partners performing non-audit services should not be subject to the partner rotation requirements.
- Should additional personnel (such as senior managers) be included within the mandatory rotation requirements? No. The rule should be limited to partners. In practice, a person will not be in the same role for a sufficiently long period to create the need for them to rotate. More importantly, managers do not have the ability to influence the audit nor to develop relationships with key executives in the same manner as a partner.
- Is it appropriate to provide transitional relief where the proposed rules are more restrictive that the provisions of the Sarbanes-Oxley Act? Transition relief should be provided in all instances, with additional transition relief for those provisions of the proposed rules that are more restrictive than the provisions of the Act.
In addition, the Commission should provide relief for companies that are registering with the Commission for the first time. Currently, the SECPS requirements allow a partner to serve two additional years after a company registers. We believe there should be similar relief under the Commission's rules. The logic of the SECPS accommodation is not to force a company to change lead engagement partners at the time of one of its most critical reporting events - the initial public offering. Please see comments above.
- Are there situations in foreign jurisdictions that extended partner rotation could be modified with additional safeguards or limitations that would recognize the jurisdictional requirements as well as logistical limitations that may exist? There are some countries that have required rotation, including firm rotation. For example, Italy requires an audit firm to rotate off a company after nine years - in Brazil it is 5 years. In situations such as in Italy it will be difficult to comply with the rotation requirements under both the Act and the Italian requirements. We believe those countries that have firm rotation should not be required to comply with the rotation rules stipulated in the Act.
As stated above, more and more countries are addressing issues regarding partner rotation and we believe this issue would be best addressed by IOSCO so there is consistency around the world.
- 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? A five-year "time out" for the lead engagement and the concurring partner is reasonable. However, if the Commission requires other partners to be covered by the rotation requirements, we believe a two-year period is sufficient. Please see comments above.
- Are the partner rotation requirements, as proposed, for investment company issuer's or other entities in the investment company complex too broad? Should we only prohibit a partner from rotating between investment company issuers within the same investment company complex? Why or why not? Yes, the proposed requirement is overly broad. The corporate entities (and non-registered fund products) in an investment company complex present significantly different audit environments with different accounting and reporting issues; an engagement partner who served on the corporate audit engagement team could still bring a "fresh look" to the fund audits. The proposed requirement would restrict the availability of partner resources in a specialized industry with no benefit to audit quality.
Further, the proposed rule could be read to imply that an audit engagement partner performing an affiliated hedge fund engagement for six consecutive years would impair independence with respect to the registrant investment companies -- this places the Commission in the inappropriate position of regulating the conduct of audits of non-public entities that do not flow into or otherwise affect the financial statements of a registrant.
We believe that there is a stronger case for precluding partners from rotating between investment company issuers within an investment company complex, as there is often a common audit environment across a group of investment company issuers. However, consistent with our earlier discussion about audit committees, we believe the audit committee should be permitted to accept the assignment of an audit engagement partner who has been on the audit engagement team for other investment company issuers in the complex when the circumstances indicate that the audit engagements are sufficiently distinct to assure that the objectives of the rotation rule have been met. For example, a partner who served on the audits of funds that were part of fund group A is now the audit partner on funds that are part of fund group B. Fund group A and fund group B are part of the same investment company complex, but continue to operate as distinct groups with a separate board of directors and systems of controls, but are now part of the group A. In this circumstance, there is no "fresh look" benefit to be obtained by precluding the audit partner from serving the B funds.
- 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? It would not be possible to rotate all partners at the same time. This would serve no benefit to the investors and would not be feasible because of normal turnover, etc.
Transition Issues Relating To Rotation
Given the significance of this change, we believe the Commission should allow adequate transition periods so that changes can be made without disrupting audit quality. Assuming this rule is adopted in January 2003, we do not believe it should apply to the lead engagement and concurring partners until client fiscal years beginning after December 15, 2003.
Audits of many jobs are continuous. Required rotation should not go into place once a year has started. There would not be sufficient time to make the necessary changes for a large number of jobs, particularly considering the need to have industry skills, etc. We estimate that we will need to change 87 engagement partners on our 266 Fortune 1000 clients based on the provisions of the Act. We have not been able to determine yet the impact that the Commission's proposed rule would have, but certainly more partners would be affected. The changes that will be required on our foreign issuer clients are as significant, as they will immediately impact at least 120 out of 413 companies based on just the provisions of the Act.
We have planned succession changes based on the existing rules, and we believe changes that are as fundamental as those proposed should be adopted over a period of years. Again, large unplanned changes will reduce audit quality.
To reduce the concerns regarding audit quality, we propose the following key points for transition:
- Rotation requirements should not apply until years beginning after December 15, 2003.
- Any lead engagement partner that has five or more years of experience should be allowed to continue on the job for a period as allowed by existing SECPS rule - i.e., up to seven years.
- Rotation requirements for partners in non-U.S. firms should not apply until years beginning after December 15, 2005. The smaller number of partners knowledgeable about U.S. GAAP and U.S. GAAS with the appropriate industry expertise justify the need for a longer transition period.
- Service in roles other than the lead engagement partner prior to years beginning after December 15, 2003 should not count towards the rotation requirement. That is, the rule should be applied prospectively. For example, if a partner served for seven years on a subsidiary through December 31, 2003, the partner should be able to continue to serve for an additional five years. Under the succession plan that has been developed for many companies, a partner has worked on a subsidiary with the expectation of becoming the lead engagement partner. These partners should be allowed to serve as the engagement partner for a full five years immediately.
II. D. Audit Committee Administration of Engagement
All of our comments on this aspect of the proposal are reflected in our answers to the following specific questions.
- Should the Commission create other exceptions (beyond the de minimis exception) that would allow an audit committee to adopt a policy that contracts that are recurring (e.g., due diligence engagements in connection with a series of insignificant acquisitions) and less than a stated dollar amount (such as $25,000) or less than a stated percentage of annual revenues (such as 1% or 5%) could be entered into by management and would be reviewed by the audit committee at its next periodic meeting? We would support measures that would make it easier for audit committees to carry out their responsibilities under the Act. Many audit committees already provide management with guidelines for procuring non-audit services, and either require or encourage management to consult with the committee when a potential service might raise independence questions. We believe such an approach is a best practice that provides audit committees with flexibility to ensure that their focus and attention is appropriately directed to matters that could legitimately raise questions about independence. We would not, however, encourage the establishment of bright lines such as a stated dollar amount or percentage. Instead, the Commission should acknowledge that audit committees are permitted to establish thresholds that they deem appropriate for their organizations, taking into consideration their organization's size, structure, personnel, and service needs.
- Is allowing the audit committee to engage an auditor to perform non-audit services by policies and procedures, rather than a separate vote for each service, appropriate? If so, how do we ensure that audit committees have rigorous, detailed procedures and do not, in essence, delegate that authority to management? Pre-approval based on policies and procedures is appropriate. Such an approach will not only satisfy important cost/benefit considerations for a number of audit committees and their companies, but will enable committees to establish policies and procedures that are tailored to their specific needs and will meet the expected difficulties in respect of overseas subsidiaries of U.S. (or other) issuers. Further, audit committees will be required under the proxy disclosure rules to disclose their pre-approval policies or include a copy of those policies and procedures with the proxy statement. This would enable investors and others in the marketplace (as well as the Commission and its staff) to assess the rigors of an audit committee's policies and procedures, and compare them to the policies and procedures used by other audit committees. We believe the level of scrutiny that will be brought to bear in this area by investors and others in the marketplace will help to ensure that audit committees take this responsibility seriously and do not delegate it to management.
- Should more or fewer aspects be left to the discretion of the audit committee? For purposes of pre-approvals, we believe the extent of the guidance proposed is appropriate. This is an area where it is appropriate for the rules to prescribe broad unambiguous objectives and to provide clear guidance or "bright lines" for the audit committees to allow them to determine how to best meet those objectives within their individual organizations, considering their organization's size, structure, personnel, and service needs.
- Are there any specific matters that should be communicated to or considered by the audit committee prior to its engaging the auditor? We would leave this to individual audit committees to decide based on their facts and circumstances. However, one matter that audit committees may wish to consider in connection with the rendering of non-audit services is an understanding of why the service would not be inconsistent with the independence rules. Further, where the rendering of a non-audit service will result in synergies with respect to the audit, audit committees may benefit from an understanding of that fact. When services benefit the conduct of the audit and are not inconsistent with the independence rules, it is in the public interest for audit firms to provide them. It should be noted that partners and managers in the audit firm who would perform the non-audit service are precluded under current independence rules from owning any investment in the audit client. This enables them to make objective recommendations to the client without being influenced by how their recommendations might ultimately affect their personal net worth. Non-audit service providers from other organizations often are not precluded by either regulatory or professional restrictions from investing in their clients. Accordingly, when considering the audit firm and another service provider, audit committees may wish to understand the extent to which other service providers own stock or other investments in the client entity.
- What, if any, audit committee policies and procedures should be mandated to enhance auditor independence, interaction between auditors and the audit committee, and communications between and among audit committee members, internal audit staff, senior management and the outside auditor? Independence Standards Board Standard No. 1 (ISB 1), Independence Discussions with Audit Committees, mandates that auditors annually disclose to the audit committee all relationships (e.g., business, service, family, and employment relationships) between the audit firm and the client that in the auditor's professional judgment may reasonably be thought to bear on the auditor's independence and discuss the auditor's independence with the audit committee. This requirement promotes a healthy interaction between the auditor and the audit committee about auditor independence.
Although ISB 1 applies only to audit firms (i.e., the onus is on the auditor rather than the audit committee to ensure that this dialogue takes place), we would not object if the requirement for a discussion were extended to audit committees as well and included a mandate for at least an annual private meeting with the auditor. We believe a private meeting between the auditor and the audit committee without management and the internal audit staff present would be more conducive to a candid and forthcoming discussion, and would meet the objective of encouraging an open, frank, and meaningful dialogue between the two parties.
- Our proposed rules do not contain exemptions for foreign filers. Are there legal or regulatory impediments which may make it difficult for certain foreign filers to comply? If so, what safeguards can these foreign filers employ to ensure that they comply with the proposed rules? We believe there are impediments to compliance with the specific requirements as proposed; however, they need not be impediments to achieving the goal of having oversight of the auditor's engagement by a body independent of management. Among the impediments are combinations of the following:
- Lack of requirement for an audit committee as structured in the U.S.
- Mandatory employee representation on the board of directors and its committees.
- Requirement for shareholders (as opposed to the Board or one of its committees) to approve auditor appointment and/or fees.
- Provision for auditor appointment and fees to be approved by subsidiary boards.
The requirements for audit committee administration of the audit engagement by foreign private issuers will be workable if they allow flexibility for the company to conduct these activities. In particular, the rules should recognize that the audit administration activity requirements have been satisfied if those functions have been performed by any subset of the board of directors that does not include management or employees of the company.
- In addition to legal or regulatory impediments, are there practical impediments which would make it difficult for certain foreign filers to comply with the pre-approval requirements? If so, what are these impediments? What safeguards can such an entity establish to better implement the proposed rules (which is to separate the decision to engage the auditor for non-audit services from management)? Please refer to our response above. If a foreign filer does not have an audit committee, the pre-approval requirements could be carried out by any subset of the board of directors that does not include employees that are considered executive management of the company, or if those matters are approved by a vote of the shareholders. This will allow situations in which a member(s) of the workers' union or other group representing the rank and file workers are required to serve on the board and/or its committees. It will also reflect the fact that in a number of jurisdictions, the shareholders have the rights that are given the audit committee in the U.S.
- Should the Commission provide additional specific guidance to assist audit committees when deliberating auditor independence issues? What topics would be helpful? The dialogue between the auditor and the audit committee is an effective means of assisting audit committees in deliberating questions about independence. This is particularly true when questions involve the appearance of independence, for which it would not be productive for the Commission or any other body to attempt to issue guidelines. However, as we discuss in other sections of our response, we believe that audit committees need greater clarity in connection with prohibited services, specifically regarding the general permissibility of tax services, and the application of the three principles.
- Our proposed rules would require the audit committee of an investment company to pre-approve the non-auditing services provided by the accountant of the investment company to the investment company's investment adviser and any entity controlling, controlled by, or under common control with the investment adviser that provides services to the investment company. Should the audit committee of an investment company registrant be required to approve any non-auditing services provided to the investment adviser and any entity controlled, controlled by, or under common control with the investment adviser that provides services to the fund? Should the scope of the pre-approval requirement be expanded or narrowed? Why or why not? The scope of this requirement should be narrowed to be consistent with the Act, which prescribes a pre-approval requirement in connection with only the issuer. Nothing in the Act or its legislative history states or suggests that the term "issuer" is intended to include affiliates. The Committee Report supports this. It states, "Accordingly, the bill requires the audit committee of a public company to pre-approve all of the services, both audit and non-audit, provided to that company by a registered public accounting firm (emphasis added)."
The pre-approval process provides an audit committee with an opportunity to assess the benefits of engaging the auditor to perform a permissible non-audit service. Although audit committees are in a position to make this assessment with respect to their own organizations, they would generally be unable to make this assessment for other entities for which they have no governance responsibility. Accordingly, we believe the audit committees of investment company issuers should not be placed in a position of having to evaluate non-audit services for entities other than their own.
Arguably, the pre-approval process also provides an audit committee with an opportunity to assess whether a permissible non-audit service to be rendered to another entity within the investment company complex would affect the auditor's independence of the audit committee's investment company. Services rendered to entities other than the investment company issuer would typically be unrelated to the investment company's operations. For example, tax compliance services rendered to the adviser or its affiliates would not bear upon the auditor's independence with respect to the investment company issuer. In those cases, we see no reason for the investment company issuer's audit committee to pre-approve them. A similar issue arises in connection with non-subsidiary affiliates generally.
Moreover, audit committee members for investment company issuers have significant responsibilities under the Investment Company Act of 1940 in their capacity as independent directors. From a cost/benefit standpoint, going beyond the Act's requirements in this area would increase their workload and responsibilities but would not bring about a commensurate benefit in terms of enhanced auditor independence. If the Commission extends the pre-approval requirement beyond the requirements of the Act, we urge it to confine the requirement to non-audit services that while rendered to the adviser or its affiliates would nonetheless relate directly to the operations, controls, or financial statements of the investment company issuer. That way audit committee members would have a basis to evaluate the service as if it were being rendered directly to the investment company.
Another reason to narrow the requirement is to avoid situations where multiple audit committees would be required to pre-approve the same non-audit service from the same auditor. The adviser and its affiliates, particularly its parent company, often have their own audit committees, and multiple audit committees can exist within many investment company complexes. If those audit committees engage the same audit firm for audit services, it appears that under the proposal the multiple audit committees would be required to pre-approve the same service from the same auditor. Such multiple approvals would be inefficient, could result in conflicting conclusions requiring additional time and effort to resolve, and would not pass a cost benefit test. Although a solution would be to permit an audit committee to rely upon the pre-approval process of another audit committee within the same complex, we believe for the reasons stated that the requirement should be confined solely to the investment company issuer.
- Under the proposed rules, the pre-approval of non-auditing services would permit, for purposes of determining whether a non-auditing service meets the de minimis exception, the investment company's audit committee to aggregate total revenues paid to the investment company's accountant by the investment company, its investment adviser and any entity controlled, controlled by, or under common control with the investment adviser that provides services to the fund. Should the de minimis exception be determined separately based on the total revenues paid to the investment company's accountant by each entity? If applied separately to each investment company, the de minimis test would be at an unreasonably low level in light of the overall auditor/audit committee relationship. We believe that a more appropriate denominator for the de minimis exception would be aggregate fees billed with respect to all investment companies that engage the auditor and for which the audit committee has oversight responsibility. However, if the final pre-approval rules will require pre-approval of non-audit services to the investment company's investment adviser and entities in a control relationship with the adviser that provide services to the investment company, application of the de minimis exception should include those non-audit service fees in the denominator as well.
- This proposed rule would apply to "issuers." Should the Commission consider applying this rule to a broader population such as "audit clients" as defined in 2-01(f)(6) of Regulation S-X? Why or why not? No. For the reasons we described in our response to the questions in the tenth bullet point above, the rule should remain focused on the "issuer" and should not be broadened to apply to "audit clients." The concerns we described are magnified if the pre-approval requirement is applied to all of the members of an investment company complex or to sister and parent entities of a non-investment company issuer.
Transition Issues Relating to Audit Committee Administration of the Engagement:
We recommend that the pre-approval provisions of the final rule take effect 90 days after the final rule is published in the Federal Register and apply to new services on and after that date. This will provide audit committees with time to study the final rules, discuss it with company management, agree on pre-approval processes that are appropriate for their organizations, and revise their current pre-approval policies and procedures to meet the new requirements. Because many boards and audit committees meet on a quarterly basis, our recommended transition period should enable those audit committees to conduct this task within their normal meeting cycles. However, even where meeting cycles are longer than quarterly, three months should provide audit committees with sufficient time to accomplish this task. Services in process 90 days after the final rule is published in the Federal Register should be grandfathered. In addition, we believe there should be transitional arrangements covering pre-approvals of non-audit services when an entity becomes an entity for which the provider of non-audit services needs to be independent (e.g., on acquisition, listing or a change of auditor).
We believe that the proposed rules regarding the sale of non-audit services should apply only to the "lead and concurring review partners." Extending these requirements, which are not mandated by the Act, to a broader set of partners will not improve auditor independence or enhance shareholder protection, since the lead and concurring review partners make all significant accounting and auditing judgments. If the Commission does extend the application of these rules, they should do so in a manner consistent with the alternatives we have offered in connection with partner rotation.
We agree that accounting firms should not evaluate or set performance goals for lead and concurring review partners based on the sale of non-audit services to their audit clients. However, we also believe that the proposed rules should acknowledge/clarify that it is a responsibility of all partners to grow their respective firms, thereby providing for an increase in income available for investment or for distribution to all partners and consequently an increase in equity unit values. Accordingly, while accounting firms should not provide "direct" incentive payments to a lead or concurring review partner for selling non-audit services to an audit client, it should be recognized that the sale of these services indirectly increases the overall equity unit value of the firm.
- What economic impact will our proposal have on the current system of partnership compensation in accounting firms? We do not expect this proposal will have a significant economic impact on our current partnership compensation system.
- Are there other approaches that should be considered with respect to compensation packages that pose a concern about auditor independence? If so, what are they? No.
- Would the proposed rule change be difficult to put into practice? If so, why? How could it be changed to be more effectively applied? We do not believe that the proposed rule change will be difficult to implement.
- Should managers, supervisors or staff accountants who are members of the audit engagement team also be covered by this proposal? We do not believe that the rule should be extended to cover other members of the engagement team, as it is the lead and concurring partners who are responsible for the ultimate decision making on an audit.
- Does this proposal cover the appropriate time period or should a measure other than the audit and professional engagement be considered? We agree with the time period set forth in the proposed rule and have no further comment.
- Will this compensation limitation disproportionately affect some firms because of their size or compensation structure? If so, how may we accomplish our goal while taking these differences into account? If this proposed rule is applicable to all engagement team members globally, it will be difficult to monitor. We do not have a global partner income system, although we have common principles for remuneration, and it is difficult to know and impossible to control how each partner outside the U.S. is compensated.
Transition Issues Related to Compensation:
The compensation provisions of the final rule should be effective in the audit firm's next fiscal year beginning on or after 90 days after the final rule is published in the Federal Register.
Accounting Role: The proposed definition of "accounting role" refers to individuals in a "clerical position" who are responsible for accounting records such as for payroll, accounts payable, accounts receivable, purchasing, and sales. This appears to be a broader definition than the definition in the current rule, which was purposely designed to not reach as many persons in the audit client's accounting department as were covered by the then existing AICPA category "audit sensitive." Unless persons in a clerical position meet the test in the current rule (i.e., are a supervisor or manager who is relied upon by management to calculate amounts that are placed directly into the company's financial statements), there is no reason to consider them to be in an accounting role and thus subject them to the other requirements of the rule. Accordingly, we suggest that the definition in the final rule be revised to ensure that it does not inadvertently sweep in such lower level positions.
II.G. Communication with Audit Committee
All of our comments on this aspect of the proposal are reflected in our answers to the following specific questions:
- In light of the requirements for the CEO and CFO to certify information in the company's periodic filings, should the auditor be required to communicate information on critical accounting policies and practices and alternative accounting treatments to management as well as to the audit committee? No. The audit committee is the auditor's client, not the CEO and CFO. However, a CEO and CFO should be interested in the views of their company's auditors on all of these matters and will most likely seek those views prior to making the certification. Accordingly, it is unnecessary to require the communication to occur. But more importantly, there should not be a requirement aimed at the auditor to undertake this communication. If such a communication is mandated, the requirement should be that the CEO and CFO have the affirmative duty under the law to make the certification.
1. Critical Accounting Policies and Practices
- Should the auditor be required to provide additional information to the audit committee regarding the company's critical accounting policies? It is unnecessary for the rule to prescribe further information that should be part of the communication. If an audit committee desires additional information, they can request it. The suggested minimums set out in the release are sufficient guidelines, with the exception of the requirement that the discussion include the reasons why certain estimates or accounting policies are not considered critical and how current and anticipated future events impact those determinations. Requiring that the discussion include these matters would essentially mean that the discussion would cover all accounting policies, not just those considered to be critical. That would be inconsistent with both the requirements of the Act and the proposed rule and would not be a productive use of an audit committee's time. We recommend that the discussion not be required to include such matters.
- When should the communication take place? We agree with the proposed requirement that the communication should take place prior to the filing of the audit report with the Commission. The exact timing of the communication and the frequency with which it occurs should be determined by the audit committee and the auditor based on the relevant facts and circumstances.
- Should the auditor be required to provide the communication in writing? No. Whether the communication is made in writing should depend on individual audit committees who can request it according to their needs. The objective of this communication requirement is for the auditor and the audit committee to engage in a dialogue. Requiring that the matters to be communicated be put in writing is not necessary for that interaction. Further, putting matters in writing, other than as a prompt for the discussion, could stifle the candor of the dialogue, as participants tend to focus more on the written words than on the substance of the issues.
- Is it appropriate that investment companies would be subject to the rules regarding critical accounting policies? Yes.
2. Alternative Accounting Treatments
- Is the discussion of which accounting policies require communication with the audit committee sufficiently clear? The rule should be clarified to indicate that if there is no choice under GAAP, there is no requirement to report to the audit committee, except for the requirement to discuss critical accounting policies and practices. Accounting issues for which specific rules or criteria have been established by standard setters to determine the proper accounting treatment should not fall under the alternative treatment definition, even if the application of those criteria (1) require significant judgment based on the individual facts and circumstances and (2) could lead to different accounting answers. Judgment versus bright line tests should be addressed in the discussion about critical accounting policies and practices.
Further, extensive discussions of trivial accounting matters would be impractical, would fail a cost/benefit test, and we believe would undermine the intended purpose of this provision. We believe that the discussion should focus on important treatments, that is, those that would have a material effect on the issuer's financial statements and were the subject of significant debate and disagreement. This should lead to more reasonable reporting that passes a cost/benefit test.
- Should additional matters be required to be communicated to the audit committee? If so, which matters? The communication should also include alternatives considered in terms of presentation in the financial statements, as well as the location of the disclosure within the financial statements. The discussion of the ramifications of the alternatives should include an analysis of the current and future financial statement impact of the alternatives considered and the proposed disclosures for the alternatives considered.
- Is it appropriate that investment companies would be subject to the proposed rules regarding alternative accounting treatments? Yes.
Nature of communications of critical accounting policies? If so, what instructions should be provided and why? The release notes that the Commission is not proposing to require that the communications follow a specific form or manner, other than the expectation that certain minimum information be communicated with which we disagree. (Please refer to our comments above on critical accounting policies.) It also notes that guidance has been provided in FR 60 and in the Commission's May 2002 proposed rule on disclosures in MD&A about critical accounting policies. We believe that guidance is useful in understanding the nature of the information to be communicated and suggest that it be incorporated into a set of instructions in the final rule.
3. Other Material Written Communications / 4. Timing of Communications
Transition Issues Relating to Communication With Audit Committees:
These communications should be required beginning with audits of financial statements for periods ending after December 15, 2003.
II.H. Expanded Disclosure
All of our comments on this aspect of the proposal are reflected in our answers to the following specific questions:
Principal Accountants' Fees and Audit Committee Actions
- Is the proxy statement the appropriate location for this disclosure? If not, why? It is an appropriate location for the disclosure. Entities, other than mutual funds, that file proxy statements typically hold annual meetings and the statements often serve as a focal point for the discussion at those meetings, thus making it more likely that the information about fees will be read and discussed.
- Should we permit incorporation by reference into the company's annual report? Yes. We believe companies should be permitted to meet the proposed disclosure requirement in annual reports by incorporating the required disclosures from the proxy statement by reference. This would be a cost effective way for companies to meet the new disclosure requirement for annual reports.
- Would expansion of the proxy disclosures of professional fees paid to the independent auditor from three categories to four provide more useful information to investors? Yes. The new categories will enhance investors' understanding of the nature of the services that auditors provided to their audit clients because the fees and services will be presented in categories that are more representative of the nature of the services and their relationship to the audit. In particular, we believe that the two new categories, Audit-Related Fees and Tax Fees, and the expanded definition of Audit Fees are more representative of the nature of the services and will enable investors and others in the marketplace to better ensure that auditors continue to provide both audit and non-audit services to audit clients that are in the public interest.
- Are the new categories of disclosure appropriate? Are they well defined, or should they be more accurately defined? Should there be additional (or fewer) categories? We believe that fees for consultations concerning financial accounting and reporting standards that are necessary to conduct the audit should be classified as Audit Fees instead of Audit-Related Fees. Such consultation services are a necessary part of an audit firm's ongoing responsibility as an auditor to help ensure that audit clients interpret and apply financial accounting and reporting standards in a manner that the auditor will agree with when it comes time to judge whether the client's financial statements present information fairly in accordance with generally accepted accounting principles. This is similar to assisting clients by reviewing documents to be filed with the Commission, the fees for which the Commission has stated in the commentary in the release would be classified as Audit Fees.
In addition, there appears to be conflict between the definition of Tax Fees in the proposal and the commentary. Section H.1 of the commentary states "The `Tax Fees' category would capture all services performed by professional staff in the independent accountant's tax division." This would seem to suggest that fees for tax professionals who participate on the audit would be classified as Tax Fees rather than Audit Fees. Section B.11, on the other hand, states, "Reviewing tax accruals is part of audit services and is not, in and of itself, deemed to be a tax compliance service." This would suggest, appropriately in our view, that the tax professionals' fees would be classified as Audit Fees rather than Tax Fees. We suggest that this conflict be addressed by revising the sentence in Section H.1 so that it cannot be misread as calling for such fees to be classified as Tax Fees. One way to fix the sentence would be to change the word "all" to "most" and add at the end "apart from those that are part of the audit."
Other conflicts between the language in the proposal and in the commentary should be addressed and include the following:
- The proposal calls for disclosure of fees "billed." The commentary states that the proposed rules continue to require issuers to disclose fees "paid." The proposal is consistent with the current disclosure requirements. We believe "billed" fees is the appropriate disclosure because we think investors should be informed of the total amount that the auditor has charged for a service, even if the client has not paid for it yet. We suggest the commentary be revised to conform to the notion of "billed" rather than "paid."
- The proposed rule refers to the registrant while the commentary refers to issuers. Because the disclosure requirement will now apply to a broader group of entities (i.e., entities that have not registered their debt or equity securities with the Commission), we believe the final rule should refer to "issuer" rather than "registrant."
- Is disclosure of two years of fees appropriate? Should the proposed additional fee disclosures be expanded to three years or remain at one year? Two years of fees is appropriate. Not only would that be consistent with the two-year presentation of information in most financial statements, but it would enable investors to see whether a spike in fees or services in one year is an aberration or an indication that the auditor is regularly providing added value to the company. However, we recommend that entities required to make this disclosure for the first time be permitted to transition to the new requirements over a two-year period at their election. That is, those entities should be permitted but not required to make the new disclosures in the first year the disclosure requirement is effective, including disclosing information for only one year instead of two in their next annual filing if they so elect. This will permit many entities that will have difficulty gathering the relevant fee information for their next filings to transition to the new requirements in a cost effective manner.
- What, if any, additional information about professional fees would be useful to investors? Please refer to our comments above. One aspect of the proposed disclosure that we believe would not be useful is the requirement to disclose the percentage of fees for non-audit services that were approved pursuant to paragraphs (c)(7)(ii)(A), (c)(7)(ii)(B), and (c)(7)(ii)(C). By singling out the approvals in this manner, the disclosure has the potential to mislead investors into thinking that pre-approvals are not as credible if they occur pursuant to policies and procedures. In our view, if pre-approval occurs, it should not matter how it occurred. One method of pre-approval is not inherently better than another. Accordingly, we recommend eliminating the percentage breakdown in the final rule to avoid misleading investors and allow audit committees to determine the best way under the circumstances to meet the pre-approval requirements without fear of being second-guessed by investors, regulators, and others regarding their methods of pre-approval because of the percentage disclosure.
- For a registrant not subject to the proxy disclosure rules, such as foreign private issuers, should we require that the same disclosures be placed in annual reports? Yes. However, it can be difficult for foreign filers to obtain this information, particularly if the disclosure requirement is for two years. Accordingly, we encourage adoption of a reasonable transition period for this provision as described in our comments above.
- Is there any additional disclosure concerning the activities of audit committees that would be beneficial to investors? The proposed fee disclosures combined with the proposed disclosures about audit committee pre-approval activities will sufficiently inform investors and others in the marketplace. However, see our comments on the section entitled Audit Committee Administration of the Engagement regarding the requirement to disclose the percentage of Audit-Related Fees, Tax Fees, and All Other Fees that were pre-approved pursuant to pre-approval policies and procedures or approved prior to the completion of the audit under the de minimis exception.
- Should companies be required to provide the information in their quarterly reports? Should it be required that the information be included in other filings such as Form 10-Q or 10-QSB? No. Requiring fee information to be disclosed on a quarterly basis would not pass a cost/benefit test, particularly given the extent of work necessary to gather billed fee information on a worldwide basis. Additionally, an annual disclosure would be consistent with the requirement for all filers and it makes sense to have one rule across the board for everyone.
- Should registered investment companies be required to provide the information in their semi-annual report to shareholders on proposed Form N-CSR? We believe that Form N-CSR is an appropriate place for the disclosure to be made. However, we suggest that the disclosure be made annually rather than semi-annually for the same reasons we recommend against quarterly disclosures. Our concerns about the difficulty in gathering fee information to meet this requirement apply equally to registered investment companies. Under the proposal, a registered investment company would be required to disclose non-audit service fees billed not only to the investment company but also to the investment company's investment adviser and to any entities in a control relationship with the adviser that provide services to the investment company. The cost of this task should not be underestimated. (Please refer to our comments below.) Additionally, because registered investment companies will be providing this information for the first time, we recommend a transition period consistent with the recommendation in our response to the questions in the fifth bullet above.
As discussed above, we recommend that the disclosure requirement apply solely to the investment company issuer. If the requirement extends to entities in a control relationship with the adviser that provides services to the investment company, we recommend that the Instruction to Item 9(e) clarify that the phrase "that provides services" (used to describe entities in a control relationship with the adviser that provide services to the investment company) contemplates an ongoing service relationship - for example, custody or transfer agent services that are typically performed on a regular basis in exchange for compensation pursuant to a contract with the investment company. We believe that "providing services" is typically understood in the industry to mean such an ongoing service relationship, rather than a service that is provided on an isolated or intermittent basis.
- Registered investment companies are required to provide disclosure of audit fees billed for the registrant only, but are required to disclose other types of fees in the aggregate for the registrant, its investment adviser, and certain other parties. Is this appropriate, or should we also require disclosure of audit fees on an aggregate basis? In the alternative, should we require disclosure of audit-related fees or any other fees for the registrant only and not on an aggregate basis? We believe the disclosure requirement should be for the investment company issuer to disclose only the fees that their auditors billed it for services rendered to it. As discussed more fully in our responses to the questions on pre-approval, we believe that non-audit services rendered by an investment company's auditor to the investment company's adviser or to any of the adviser's affiliates that provide services to the investment company generally would not adversely affect the auditor's independence of the investment company. Consequently, we believe non-audit service fees billed to the adviser or to its affiliates for services provided to them do not give rise to independence concerns with respect to the investment company. In our view, audit committees should not be burdened by the duty of evaluating non-audit services rendered to entities for which they have no governance responsibility and, accordingly, we believe their investment companies should not be required to disclose the fees for those services.
Our recommendation regarding pre-approval is to narrow the scope of the pre-approval requirement to be consistent with the requirements of the Act (i.e., aimed at the issuer only), and our recommendation regarding fee disclosures is the same. We believe there should be consistency between the pre-approval and fee disclosure requirements in the final rule; there should be consistency between the disclosure requirement and the audit committee's governance responsibility. Accordingly, we recommend that the final rule follow the requirements of the Act and that investment company issuers be required to disclose only the fees that their auditors billed them for services rendered to them.
If the final rule goes beyond the requirements of the Act, and extends the disclosure requirement to some or all services rendered to the adviser and its affiliates that provide services to the investment company, we believe a more balanced disclosure would be appropriate. That disclosure should include audit and non-audit fees billed by the investment company's auditor to any investment company issuers in the investment company complex that are subject to the oversight of the issuer's audit committee. This aggregation would provide a better perspective on the non-audit fees billed to the adviser and its affiliates than the comparison of those fees to the audit fees billed to a single investment company issuer.
We do not recommend, however, that the investment company issuer disclose audit fees billed to the adviser or to entities in a control relationship with the adviser that provide services to the investment company issuer. Many advisers and their affiliates are part of larger financial services organizations in which the audit fee is determined on a consolidated basis. We question whether the consolidated audit fee could be allocated to subsidiaries on a cost-effective, consistent, and reasonable basis.
Because different investment company issuers in a complex and the adviser and its affiliates might have various fiscal year-ends, we suggest that the final rule permit any aggregate disclosure for non-audit services to be based on a calendar year-end (or prevalent fiscal year-end within the group) in a manner similar to the current disclosure of cross-complex director fees. This would eliminate duplicative computations of similar information as of different fiscal year-ends.
- If we adopt such a requirement, should we require or permit registrants to recalculate and report fees already disclosed for more than two years so that all fee information is consistently reported and available? Recalculation should be permitted but not required. Entities should undertake to recalculate past reported fees only if that can be done in a cost effective manner. Whether that will be the case will depend on the facts and circumstances of each entity. Accordingly, each entity should be permitted to make this assessment based on their unique situations.
Transition Issues Relating to Expanded Disclosure Requirements:
Our responses above include certain of our recommendations on transition provisions. In addition to those recommendations, we believe the final disclosure rules should not become effective immediately after January 26, 2003. In our view, that would not provide entities with sufficient time to study differences between the proposed and final disclosure rules, develop the necessary processes to gather the needed fee information, and decide which of the new fee categories their auditors' fees should be disclosed in. This is particularly important for entities that will present these disclosures for the first time. Accordingly, we encourage the Commission to permit but not require the new disclosures for filings that occur after the final rule is published in the Federal Register and to require the disclosure in filings for fiscal years ending June 30, 2003 and later. If the Commission retains the disclosure of the percentage breakdown of services pre-approved on an engagement-by-engagement basis, pursuant to policies and procedures, and pursuant to the de minimis exception, it should be required for fiscal years ending June 30, 2004 and later to ensure that a full year's worth of pre-approval activity has occurred to make the disclosure meaningful.
II. I. Transition Period
We have discussed transitions issues in connection with each of the proposed amendments and refer to those discussions.
- Are there special considerations that we should take into account in providing a transition period for foreign private issuers? Particular consideration should be given to requirements that relate to audit committee functions. The final rules should recognize that in many jurisdictions audit committees (or their surrogates) will need time to organize and to become educated about their responsibilities under the rules. Accordingly, transition provisions regarding administration of the audit engagement by foreign private issuers (including related disclosure requirements) should not require those activities to take place until calendar 2004. This means, for example, that calendar year reporting companies would be required to disclose fees paid to the auditor in annual reports on calendar 2003 activities, but would not be required to disclose pre-approval policies and related matters until annual reports on calendar 2004 activities.
III. GENERAL REQUEST FOR COMMENTS
All of our comments on this aspect of the proposal are reflected in our answers to the following specific questions:
- Would the proposals related to audit committees and partner compensation help alleviate the pressure that clients may place on engagement partners or accounting firms to acquiesce to the clients' views on accounting issues? What are some of the other scenarios where such pressures might exist? Making the audit committee directly responsible for the auditor's engagement is a positive step in addressing perceived concerns about auditors succumbing to client pressure. The compensation rules go further than necessary to accomplish the stated goal; please refer to our complete comments above.
|1|| PricewaterhouseCoopers refers to the network of member firms of PricewaterhouseCoopers International, Ltd., each of which is a separate and independent legal entity.
|2|| This is the case without regard to whether the issuer is an investment company.
|3|| Under current SEC independence rules (and under the proposal), those individuals would no longer have influence over the audit firm's operations or financial policies, a capital balance in the firm, or a financial arrangement with the firm other than one providing for regular payment of a fixed dollar amount pursuant to a fully funded retirement plan, rabbi trust, or similar vehicle. Accordingly, they generally have no incentive to adversely influence the quality or effectiveness of the audit.
|4|| This timeframe currently is used for determining when non-audit service partners and managers must be independent of the client.
|5|| In the release associated with the final rule, the Commission should make it clear that the commentary associated with the proposing release was designed to generate dialogue and should not be read in the future as a guide to the meaning of the final proposed rule. The Commission should state unequivocally that the final rule itself, together with its issuing release, is the only relevant interpretative guide for purposes of assessing auditor independence.
|6|| As noted in our opening comments above, application of rules to affiliates in the investment company setting is unworkable and, if the Commission is unwilling to limit the extension of the rules to affiliates generally, it should at least do so in relation to investment companies.
|7|| Please refer to our December 26, 2002 comment letter regarding tax services.
|8|| A simple example illustrates the legislative requirement. Consider a listed company with shares whose nominal value is $1.00 per share and whose market price is $10.00 per share. If the listed company wishes to issue 1 million shares in exchange for a non-cash consideration, the auditor would be required to opine on whether the value of the non-cash consideration exceeds $1 million (plus any contractual share premium). The auditor is not required to report his or her valuation and if, say in his or her opinion, the non-cash consideration had a value of $2 million, the auditor would be required only to report that the value was not less than $1 million (plus any contractual share premium). This is not a test to establish whether the transaction is either `fair' to the existing shareholders or non-dilutive.
|9|| We have already highlighted issues around the arguments for allowing auditors to continue to undertake valuations for FAS 87 and 106 in the section on valuations. What we say in this section is subject to those arguments.
|10|| The term "transaction-related compensation" has a specific meaning in the lexicon of U.S. Broker-Dealer rules related to fees that are contingent upon the completion or consummation of a securities being purchased or sold. This term will not be widely understood outside the U.S. and without such a definition, audit committees may adopt their own vernacular definition that may unfairly result in the prohibition of other transaction-related work by audit firms, where fees are time-based or fixed in advance.
|11|| The AICPA guidance provides that "an accountant's independence would not be impaired if that accountant assists in developing corporate strategies, assists in identifying or introducing the client to possible sources of capital that meet the client's specifications or criteria, assists in analyzing the effects of proposed transactions, assists in drafting an offering document or memorandum, or participates in transaction negotiations in an advisory capacity."
|12|| Please see our December 26, 2002 submission on tax services for a more complete discussion of Congressional intent demonstrated in the Act and in its legislative history.
|13|| We urge the Commission to consider whether there is a reasonable "appearance" of advocacy when an expert witness appears in a jurisdiction where the rules of practice specifically provide that the expert has a duty of objectivity that runs to the court or the trier of fact (e.g., the jury) rather than to the client (those where the witness is specifically proscribed from acting as an advocate). If the Commission agrees that there is no reasonable appearance of advocacy in those situations, it could simply add the clause "where the expert witness is not otherwise bound to be independent and objective in rendering his or her opinion" after the first use of the word "proceedings."
|14|| Please refer to our comment letter on tax services that was submitted on December 26, 2002, for a complete discussion of tax audits and appeals.