Mr. Jonathan G. Katz, Secretary
U.S. Securities and Exchange Commission
450 Fifth Street N.W.
Washington, D.C. 20549-0609
File Number S7-49-02 - Strengthening the Commission's Requirements Regarding Auditor Independence
Dear Mr. Katz:
Thank you for the opportunity to comment on the Security Exchange Commission's proposed rules, "Strengthening the Commission's Requirements Regarding Auditor Independence." As a 20-year corporate tax professional, tax consultant, investor, and CEO of an enterprise tax software company, I commend the Commission's work in implementing the Sarbanes-Oxley regulations in an expeditious way.
Our comments respond to specific questions posed by the Commission in the proposed rules regarding "financial system design and implementation," specifically:
SEC Question: 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?
Response: Yes. The Commission has repeatedly emphasized three principles to define independence: an auditor cannot (1) audit his or her own work, (2) perform management functions or (3) act as an advocate for the client. Audit firms will violate all three of these principles if the Commission does not adopt financial systems definitions at least as strong as in the proposed rules. We recommend strengthening the financial system definitions further to more quickly restore investor confidence.
When an audit firm selects or operates a system they helped to select, design or implement, they are auditing their own tax software and financial systems, violating principle (1), auditing his or her own work. For example, some tax software packages aggregate source data underlying the financial statements, and some result in information in tax and reserve accounts very material to the financial statements of the issuer. The information generated by some tax software involves multiple cents in an issuer's earnings per share, in areas like transfer pricing, sales and use taxes, income tax credits. We believe the investment community deserves accurate, unbiased information in these areas, subject to a true audit.
By helping select a system, an audit firm violates principle (2), performing a management function. Beyond that, even when not making a recommendation, some auditors may "reverse engineer" the selection criteria to favor their own software or a favored provider, or develop "tests" which result in favorable selection by management. While many firms have exited their large consulting businesses and no longer implement the associated systems, these questionable business practices continue for tax software selection, design, implementation and operation.
Finally, when payment to the audit firm is based on incremental tax savings, sharing in the financial results and paying a contingency fee to the audit firm, this violates principle (3), not to act as an advocate of the client. This is another clear conflict of interest.
As investors continue to demand more non-financial performance information in valuing companies, we believe limiting the definition's scope to "financial systems" to be short-sighted. For example, non-financial information like customer satisfaction metrics, product release metrics, employee turnover and executive compensation will need to be audited if they are significant from an investor perspective. These metrics originate in Customer Relationship Management (CRM) systems, Contract Management Systems, Human Resource Information Systems (HRIS), Product Data Management (PDM) and others. Since all have the potential to be audited, all create the potential for an auditor to be in a self-review situation.
We support a "bright line" around all information system selection, design, implementation and operation as specified in the proposed rules, which the Sarbanes-Oxley legislation intended. In addition, we recommend strengthening the definition of "financial systems" be extended to include any system generating information publicly available to evaluate an Issuer and its performance.
We urge the Commission to strengthen the final regulations to be clear that the design, implementation or operation of any software that creates or aggregates financial transactions and non-financial investor information is a prohibited service. All these software solutions have readily available alternative providers.
SEC Question: 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 for such services make a difference on whether performance of the service impairs independence?
Response: No. "Significance" should be relative to the nature and materiality of information generated by the financial system relative to the company's financial statements, not the size of consulting fees for an engagement. Taken to an extreme, even a "pro-bono" engagement by the auditor that has no fees associated with it could generate information that is "significant" to the audit client's financial statements.
The magnitude of the engagement may be "significant" in determining auditor conflict of interest, as was the case in Enron and Worldcom, where tax and consulting fees exceeded audit fees.
Again, I want to applaud the Commission for its efforts the outstanding work completed in defining the proposed regulations and taking the first step in restoring confidence in our financial markets. Upholding the proposed rules, and implementing them, will require leadership on the part of the SEC that is overdue for the U.S. economy and the business and investment communities.