January 9, 2003
Jonathan G. Katz
File No. S7-49-02 Proposed Rule: Strengthening the Commission's Requirements Regarding Auditor Independence
Members and Staff of the Commission:
The American Institute of Certified Public Accountants (the "AICPA") respectfully submits the following comments on the proposed rules of the Securities and Exchange Commission (the "SEC" or the "Commission") to enhance the independence of accountants that audit and review financial statements and prepare attestation reports filed with the Commission (the "Proposed Rule"). The AICPA is the largest professional association of certified public accountants in the United States, with approximately 350,000 members in business, industry, public practice, government and education.
The AICPA is firmly committed to working with the Commission to implement the provisions of the Sarbanes-Oxley Act of 2002 (the "Act") and rebuild the faith of investors who depend on accounting professionals for accurate, timely and relevant financial information. We applaud the enormous effort put forth by the members and staff of the Commission to implement the Act under the extraordinarily tight time constraints mandated by Congress.
We support the Commission's proposal to strengthen the profession's independence rules as they relate to financial statement audits of public companies. Throughout its history the AICPA has been deeply committed to auditor independence. It is a core tenet of the accounting profession, which has a more than 100-year history of working to uphold auditor independence. All members of the profession engaged in auditing and attest services are required to maintain independence from audit clients in accordance with detailed and regularly updated independence rules, interpretations and ethics rulings.
The AICPA supports many of the Commission's proposed rules on auditor independence, and our comments and observations offered herein are intended to assist the Commission in fully implementing both the letter and spirit of the Act and are designed to improve upon the Commission's proposal. We stand ready to meet with the Commission and its staff to further clarify our recommendations.
The comments reflect our strong belief that the Commission should limit its current rulemaking efforts to implementation of the provisions of the Act without creating requirements that go beyond it unless there is a clear need for such additional action. We believe that any such need should develop as the result of implementing the Act in the months ahead.
The AICPA is also concerned about the likely impact of certain of the proposed rules on small publicly traded businesses and the accounting firms that audit them. We believe that the Commission should take special care in this critical rulemaking to address the rule's impact on the complexities and costs of operating small publicly traded businesses, and on the ability of smaller audit firms to serve them. As explained in our comments, it is our belief that the Commission has both the authority and discretion to provide appropriate relief to small businesses through regulatory exemptions that will allow it to implement the Act in a manner consistent with the public interest and protection of investors, and at a time of great concern about the vitality of our economy.
Consistent with our pledge to work with the Commission to implement both the letter and the spirit of the Act, the AICPA offers comments, observations and recommendations regarding the following substantive areas of the Proposed Rule (listed in the order that they appear in the Proposing Release):
THE SEC'S BROAD EXEMPTIVE AUTHORITY
As many of these comments and recommendations suggest, the AICPA believes that the Commission has the authority to craft appropriately tailored exceptions or exemptions from the auditor independence restrictions set forth in the Act. Certain statements in the Proposing Release, however, suggest that the Commission is concerned that the Act limits its ability to exercise its statutory authority to adopt such exemptions. In particular, the Release implies that Congress did not intend to allow the Commission to exercise its existing authority under the Securities Exchange Act of 1934 (the "Exchange Act") when implementing the Act. As a threshold matter, we believe such a view would be mistaken.
Nothing in the Act amends Section 36(a) of the Exchange Act, which provides:
Most of the Act's auditor independence provisions are drafted as amendments to Section 10A of the Exchange Act and, accordingly, fall within the purview of the Commission's authority under Section 36.
Several other factors support the conclusion that the Commission's general exemptive authority was unaffected by the Act. First, Section 3(c)(2) of the Act states that:
Through this provision, Congress explicitly recognized that the Commission had the authority, prior to the Act, to establish independence standards, and should continue to exercise that authority in a manner consistent with the public interest and the protection of investors.
Second, despite some statements in the Proposing Release suggesting that the Commission has little discretion when implementing the auditor independence provisions of the Act, the Commission clearly recognizes that it retains broad discretion with respect to the proposed rulemaking. In particular, the Proposing Release contains numerous questions soliciting comments as to whether the Commission should craft exemptions. For example, the Commission asks whether it is appropriate to exempt small publicly-held businesses or smaller public accounting firms from the employment with clients ("cooling-off"), audit partner rotation and internal audit outsourcing provisions of the Act. Furthermore, the SEC's proposals regarding audit partner rotation and compensation - which the Commission acknowledges exceed any rulemaking obligations imposed under the Act - indicate that the Commission believes that it has considerable discretion when proposing rules to "carry out" the requirements of the Act.
Third, Congress has followed a practice of expressly limiting the Commission's general exemptive authority under Section 36. It did not do so here. For example, Section 36(b) of the Exchange Act specifically provides that the Commission may not exercise its Section 36(a) authority to exempt any person, security or transaction (or classes thereof) from the provisions of the Exchange Act governing the regulation of government securities brokers and dealers. The Act, however, did not limit the Commission's authority to exempt persons, securities or transactions from the operation of Section 10A, as amended. Indeed, if Congress intended the provisions of the Act to be self-executing, without any exercise of discretion by the SEC, it would have been unnecessary to direct the Commission to adopt rules to "carry out" those provisions.
Accordingly, we believe the Commission clearly has both the authority and discretion to craft exemptions, categorical or otherwise, that it considers necessary or appropriate in order to implement the Act in an effective manner consistent with the public interest and protection of investors.
AICPA COMMENTS, OBSERVATIONS, AND RESPONSES TO SPECIFIC QUESTIONS POSED IN THE COMMISSION'S PROPOSING RELEASE, ORGANIZED BY TOPIC1
Alternative Approach: Moving Regulation S-X Rules to Exchange Act Rules
We agree that implementing the independence provisions of the Act as amendments to Regulation S-X, as proposed by the Commission, is the better approach. We do not perceive any benefit to converting the independence regulations into separate Exchange Act rules. To the contrary, members of the profession traditionally have looked to Regulation S-X to locate the independence rules and relocating these provisions could well result in confusion for the accounting profession with little, if any, benefit. Moreover, moving these regulations is unnecessary to "make explicit" that violations of these regulations would be punishable as Exchange Act violations, since the Sarbanes-Oxley Act (and proposed Rule 10A-2) expressly addresses this point. We believe that the most effective and least confusing approach would be to leave the independence rules where they are, in the context of Regulation S-X and its accompanying definitions.
Conflicts of Interest Resulting from Employment Relationships
We believe that, when a member of the audit engagement team accepts employment with an audit client, the public is more thoroughly protected through a combination of restrictions and safeguards (i.e., policies and procedures).2 We do not believe that imposing a "cooling-off" period is necessary or sufficiently mitigates the threats to auditor independence, but recognize that the Act requires one. Specifically, a cooling-off period would not safeguard against the potential risks associated with a former auditor's acceptance of employment with an audit client because of the potential for evading its objectives. For example, a company could employ the former firm professional in a "non-financial reporting oversight role" for a one-year period and then promote the professional to a senior-level position such as Controller. Therefore, in order to adequately protect the public interest, we recommend that the Commission, in addition to the required cooling-off requirement, strengthen its proposal by incorporating the specific safeguards set forth in ISB Standard No. 3, Employment with Audit Clients. The Commission recognized the importance of the ISB No. 3 safeguards, as evidenced by the inclusion of such safeguards in its current rule,3 and we believe that these safeguards are still necessary in order to protect auditor independence. Accordingly, we believe it is necessary to incorporate the additional ISB No. 3 safeguards into the rule.
Services Outside the Scope of the Practice of Auditors
We support the Commission's view that the three general principles enumerated in the legislative history of the Act for auditors of public companies were intended to provide guidance to the Commission in defining the scope of the prohibited services. As is the case with any overarching norm, these principles will not provide clear answers in all situations where a question may arise.5
In addition to identifying these three core principles, the Proposing Release appears to embrace a fourth principle not cited in the legislative history: the need to avoid "mutual or conflicting interests" with audit clients. We recognize, however, that this principle is identified in the existing Preliminary Note to Rule 2-01 of Regulation S-X, as a general standard for accountants to consider when assessing auditor independence.
This principle was excluded from the list prescribed in the legislative history of the Act. We do not believe that its omission was an oversight and respectfully urge the Commission to amend the Preliminary Note to Rule 2-01 to emphasize the three principles endorsed by Congress and eliminate the fourth principle. In our experience, the concept of "mutuality of interest" is too vague and malleable to serve as an effective principle. Moreover, nothing in the Proposing Release provides meaningful guidance as to the scope of activities that this concept is intended to address. As a result, the endorsement of this concept as a "core principle" would tend to foster uncertainty and inconsistent applications in practice.
Bookkeeping or Other Services Related to the Audit Client's Accounting Records or Financial Statements of the Audit Client
We recommend that the Commission incorporate into Proposed Rule 2-01(c)(4)(i) its long-standing exception allowing a public company's audit firm to provide bookkeeping services in emergency/unusual situations and de minimis bookkeeping services to foreign divisions or subsidiaries of the client. The existing exceptions are limited, serve legitimate needs and have not been abused. Some businesses faced with emergencies will find it impossible to complete their financial statements if they cannot obtain assistance contemplated by the current exemption. The need for such an exception was made evident by the tragic events of September 11, 2001.6 These exceptions are both extremely narrow and rarely invoked, and we see no reason why the SEC should not continue to provide for them in its Final Rule.
Financial Information Systems Design and Implementation
The Commission's Proposed Rule 2-01(c)(4)(ii) provides that an accountant is not deemed independent if the accountant designs or implements a hardware or software system that aggregates source data underlying the financial statements or generates information that is significant to the audit client's financial statements taken as a whole. We believe it is important that the SEC clarify what is meant by "design or implement" and provide additional guidance as to the types of services that are expressly prohibited under the rule. For example, if the auditor assists a client with installing prepackaged software, such as Quick Books, would this be considered "implementing" the client's software system, resulting in an impairment of independence? It is also unclear whether assisting an audit client with installing routine upgrades to its existing systems would result in an impairment under the proposed rule. We believe that these types of routine installations of prepackaged software, which currently are common activities, would not impair independence provided that the specific safeguards currently required by the Commission are followed.7 These services pose little or no self-review threat, and none of the other core principles would be violated provided the audit client makes all decisions in connection with the system and the auditor is not involved in establishing the system's controls as part of the systems installation. As we note below under the section Management Functions, we do not believe it would be appropriate for the auditor to issue an opinion on management's assessment of the adequacy of the company's control systems, as required under Section 404 of the Act, when he or she has designed or developed the controls associated with any appropriate installation.
With regard to "designing" a client's software system, we believe independence would be impaired in situations where the auditor was involved in determining the actual specifications of the systems software. In cases where the auditor had no involvement in developing or designing the software, we see no reason why the auditor would be unwilling to challenge the integrity and efficacy of the client's financial or accounting information system during the audit.
We believe that the real threat to independence exists when an auditor installs a client's financial information system that is developed or designed by the auditor or where the auditor makes significant modifications to a client's existing financial information system.
Appraisal or Valuation Services, Fairness Opinions, or Contribution-in-Kind Reports
We do not believe independence would be impaired if an accountant performs a valuation or appraisal service that is unrelated to the financial statements. Specifically, where such services have no impact on the financial statements, the accountant would not be in a position of reviewing his or her own work during the audit of the financial statements. In the Proposing Release, the Commission states that, "[t]he proposals do not prohibit an accounting firm from providing such services for non-financial reporting (e.g., transfer pricing studies, cost segregation studies) purposes."
We agree that, consistent with the three principles set forth in the Act, such services would not impair independence provided the auditor does not perform any management functions or make management decisions.
We do not believe that providing valuation or appraisal services for tax purposes impairs an auditor's independence, provided the auditor does not, under any circumstance, perform management functions or make management decisions.
In addition, the auditor must establish an understanding with the audit client regarding the limitations of the engagement and management's responsibilities to designate a management-level individual, who is in a position to make an informed judgment on the results of the service, to:
The Proposing Release notes, "[o]ur proposals do not prohibit an accounting firm from providing such [valuation and appraisal] services for non-financial reporting." We believe that so-called "tax only" valuations are made for non-financial reporting purposes. In fact, the two examples given in the Proposing Release - transfer pricing studies and cost segregation studies - are principally tax-driven. We believe that the Commission makes an appropriate distinction between financial and non-financial reporting.
Recognizing that most tax valuation engagements fall within the purview of non-financial reporting would be consistent with the Commission's approach to this subject in its December 2000 Release. In that release, the Commission concluded that valuations for non-financial purposes did not impair auditor independence where the results of the valuation do not affect the financial statements. Further, a specific provision was included exempting valuations "performed for the planning and implementation of a tax-planning strategy or for tax compliance services." We believe it would be appropriate to continue both exceptions but, at the very least, we would urge the Commission to include descriptive language in the discussion of the Adopting Release noting that most tax valuation engagements are for the purpose of non-financial reporting.
An example of the difference in conclusions reached regarding independence can be found in purchase accounting. If an audit client acquires the assets of another company, the audit firm may be asked to undertake a valuation of the purchased assets. If the purpose of the engagement is to determine allocated values under tax accounting principles (the tax basis of fixed assets for future tax depreciation, for example), the valuation is for non-financial reporting purposes and the engagement should not impair independence. If the valuation of those same assets is undertaken for purchase accounting under SFAS No. 141, independence would be impaired.
Such pension-related services are typically obtained to comply with regulatory requirements. For example, such valuation/actuarial work is subject to audit by the IRS and reviewed by the U.S. Department of Labor and the Pension Benefit Guaranty Corporation and therefore, is subject to scrutiny by these organizations. In addition, these valuations are performed under specific, detailed standards established by the Financial Accounting Standards Board and are also subject to actuarial practice guidelines. Accordingly, we believe that these types of valuation/actuarial services are a tightly controlled professional service and should be treated differently from other traditional appraisal and valuation services. We also believe that any exemption for these services should be included under Proposed Rule 2-01(c)(4)(iv), as they are more readily characterized as actuarial services, rather than valuation services.
In summary, we see no reason for the Commission to change its current position and believe that this narrow exception should be incorporated into the Final Rule. In all cases, however, the auditor should be prohibited from performing management functions or making management decisions in connection with these services.
The Proposing Release also states that the Proposed Rule:
We agree that this conclusion is appropriate and consistent with the three overarching principles since, in those instances, a third party or the audit client is the source of the financial information subject to the review or audit, and the accountant will not be reviewing or auditing his or her own work. We recommend, however, that this be explicitly stated in the Commission's rule.
Internal Audit Outsourcing
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?
We believe that in situations where the auditor designs (i.e., is involved in developing and establishing) or implements a client's internal accounting and risk management controls, a self-review threat would exist that could not be mitigated by specific safeguards. Under such circumstances, we do not believe it would be appropriate for the auditor to issue an opinion on the effectiveness of internal controls over financial reporting that he or she designed.
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?
We do not believe that independence would be impaired when an auditor assesses or recommends improvements to the client's internal accounting and risk management controls. As part of a financial statement audit, an audit of the effectiveness of internal controls over financial reporting or as part of another attest engagement (e.g., a review of financial statements or a SysTrust engagement performed under the attestation standards), an auditor may observe weaknesses in a client's internal accounting or risk management controls. We believe that the public is well served, and independence should never be considered impaired, when an auditor makes recommendations or provides advice to a client on how to improve the effectiveness of its internal controls or risk management controls, provided the client makes the ultimate decision on how to correct an identified weakness.
As the Commission points out in the Proposing Release, these services "can be extremely valuable to companies, and they may also facilitate the performance of a high quality audit." We do not believe that such recommendations result in a self-review threat or would impair the auditor's independence if the auditor was asked to report on the overall effectiveness of the client's control system, provided the decision to implement any of the auditor's recommendations was made by management.
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?
No, there are no such circumstances. We support the Commission's Proposed Rule 2-01(c)(4)(vi) prohibiting the auditor from performing management functions and believe that such functions should always remain with client management. In fact, the AICPA rules on non-audit services explicitly state that, "[i]n particular, care should be taken not to perform management functions or make management decisions for the attest client, the responsibility for which remains with the client's board of directors and management."11
The prohibition on performing management functions and making management decisions is an overarching principle to which auditors should always adhere. Whether or not a particular service would entail performing a management function, of course, may be open to interpretation.
We support the text of the Commission's Proposed Rule 2-01(c)(4)(vii) regarding human resources services, and note that no change is being proposed to the text of the Proposed Rule. We are concerned, however, that the Commission may be taking certain positions in the Proposing Release regarding the provision of human resources services that are not reflected in the Proposed Rule and do not reflect the overarching principle surrounding the performance of certain human resources services - namely, that the auditor cannot function as part of management of the audit client. For example, the Proposing Release indicates that an auditor's independence is impaired when the auditor advises an audit client about the design of its management or organization structure.
We disagree with that suggestion. In our view, advising an audit client about the design of its management or organization structure is (a) not a service that impairs auditor independence because the auditor is merely advising the client and not performing management functions, and (b) a service that is far removed from human resources activities. For example, advising on management or organizational structures focuses on institutional (as opposed to personnel-specific) issues, such as advice about facility layout, office locations, or division or unit organization. The Proposing Release makes the blanket assertion that human resources restrictions are necessary because assisting management in "human resource selection or development" places the auditor in a position of having an interest in the success of the employees the auditor has selected, tested or evaluated, and that observers may perceive that an auditor would be reluctant to suggest the possibility that those employees failed to perform their jobs appropriately because doing so would require the auditor to acknowledge shortcomings in its human resources service. We appreciate the Commission's observations. However, as discussed above, advising about organizational structure in an institutional context has little, if any, relation to individual client personnel. And, even if the advisory services did not have an institutional focus, an assumption should not be made that such services would result in the auditor's identifying with any particular individual in the manner suggested by the Proposing Release.
We would consider the acts of hiring client employees, terminating client employees and committing the client to employee compensation or benefit arrangements to be human resources activities that impair the auditor's independence.
We believe that the proscribed activities listed in the Commission's Proposed Rule 2-01(c)(4)(vii)(A)-(E) are appropriate with respect to the designated personnel, and do not believe that any benefit is achieved by expanding their scope to personnel other than managerial, executive and director positions. However, we believe that the auditor's independence would be impaired with respect to any personnel if the auditor were to make decisions, including those involving human resources and personnel policy, on the audit client's behalf; interpret human resources policies without management's concurrence; commit the client to the terms of a personnel contract; or consummate a personnel contract on behalf of the audit client.
No. Advisory services with respect to executive compensation arrangements are acceptable services and do not constitute management functions, provided the auditor understands his or her responsibilities not to perform management functions while performing the service and establishes an understanding with the audit client regarding the limitations of the engagement and management's responsibilities to designate a management-level individual, who is in a position to make an informed judgment on the results of the service, to:
Broker-Dealer, Investment Adviser or Investment Banking Services
We support the Commission's Proposed Rule 2-01(c)(4)(viii) and note its consistency with the AICPA rules in this area.12 Specifically, acting as a broker-dealer, promoter, or underwriter on behalf of an audit client would impair independence. In addition, investment advisory services which entail 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, or having custody of assets, would also impair independence since such services involve management functions. We also agree with the Commission that an auditor should not, in an investment adviser capacity, recommend his or her audit client's securities to investment clients. However, we believe it is important that the rule not be construed to prohibit accountants from providing investment advisory or personal financial planning services for attest clients, provided such services do not involve recommending the securities of other attest clients or assuming management functions such as those described above. The SEC's December 2000 Release specifically stated that "[c]urrent AICPA rules specify investment advisory services that accountants may provide to audit clients without impairing their independence...Accountants may continue to provide those services without impairing their independence."
We recommend that the Commission explicitly confirm that such investment advisory services would not impair independence to avoid any confusion in this area.
We submit that both practicality and international comity dictate that the Commission avoid adopting an approach that implicates the myriad of irreconcilable foreign laws. We believe that the Commission's current guidelines governing legal services are effective and represent a more sensible position with respect to services provided outside of the United States.
The Act provides that a registered accounting firm "may engage in any non-audit service (including tax services)" not specifically prohibited by the Act and approved in advance by the client's audit committee.15 The Commission's Proposing Release similarly emphasizes that, "[n]othing in these proposed rules is intended to prohibit an accounting firm from providing tax services to its audit clients when those services have been pre-approved by the client's audit committee." Congressional and administrative intent is clear: tax services are permissible services for auditors to provide their audit clients, with audit committee pre-approval.
We note that while references to tax services are made in numerous parts in the Proposing Release's discussion of non-audit services, the specific section on "Tax Services" is somewhat ambiguous - in part, because it is necessary to refer to other sections to locate further tax service comments. The fact that tax service discussions or references are found in various sections of the Proposing Release results in a lack of focus that we would recommend be corrected in the Adopting Release.
For example, the Proposing Release notes the following with regard to "Principal Accountants' Fees," "[t]ax compliance generally involves preparation of original and amended tax returns, claims for refund and tax payment-planning services. Tax consultation and tax planning encompass a diverse range of services, including assistance and representation in connection with tax audits and appeals, tax advice related to mergers and acquisitions, employee benefit plans and request for rulings or technical advice from taxing authorities." Clearly, this recognizes that tax services are permissible. Accordingly, similar language belongs in the section on "Tax Services" so that it is not necessary to refer for guidance to a tangentially related section a number of pages removed from the primary discussion of the subject.
Similarly, the Proposing Release's discussion of valuation and appraisal services cites transfer pricing studies and cost segregation studies as permissible services, since they are non-financial reporting services. However, they are also tax-driven in many cases, and much of that work will be performed by or directed by members of an audit firm's tax department. These services should also be described in the "Tax Services" section of the Commission's Adopting Release.
Still elsewhere in the Proposing Release, the following tax services are cited with approval: preparation of returns and refund claims; assistance and representation in connection with tax audits and appeals;16 tax advice in connection with mergers and acquisitions and benefit plans; requests for rulings or technical advice; transfer pricing engagements; and cost segregation studies.
Accordingly, we recommend the Commission's Adopting Release provide guidance to audit committees and registered public accounting firms not only by acknowledging, as does the Proposing Release, that nothing in the Commission's revisions to Rule 2-01 is intended to prohibit accounting firms from providing pre-approved tax services to audit clients, but also by including examples of tax services (such as those in these paragraphs) that are considered permissible. Those examples would need to be identified as "not all-inclusive," so as to avoid a bright-line test under which services not described would be considered impermissible.
Tax Strategies / Tax Shelters
While we welcome the Commission's acknowledgement that auditors may provide a broad variety of tax services to their audit clients, we have a significant point of concern with one example of a non-allowable tax service that is set forth in the Proposing Release: "the formulation of tax strategies (e.g., tax shelters) designed to minimize a company's tax obligations." The issue of what is a "tax shelter" is a difficult one; indeed, the Congress, the Treasury Department, the Internal Revenue Service and tax practitioner organizations have all been trying to devise an appropriate definition of the term for the past several years - without success. Moreover, we would like to emphasize that it is clearly inappropriate to equate tax minimization advice or strategies with the pejorative term "tax shelter."
Congress has enacted a federal tax statute of incredible complexity. Inevitably, for many business activities, a taxpayer will have the right to choose among more than one way to accomplish or report a business transaction, and will expect its accountant to advise on the tax costs of alternative approaches. Providing information and advice on options available for minimizing tax liability would not be considered by anyone (including the Internal Revenue Service) to be a tax shelter in the great majority of instances, nor should those activities result in treating the auditor as an advocate or a de facto part of management.
In its essential character, the activity of developing tax strategies to minimize a company's tax obligations is ultimately of significant value to a company's shareholders and, by reference, to financial markets in general. Minimizing tax obligations generally results in lower costs of capital, increases in free cash flow, increases in funds available to make dividend distributions, increases in after-tax earnings per share, and greater value for a company's equity holders. Minimizing tax obligations has long been recognized as a legally supportable activity, and generations of tax professionals have been encouraged to assist clients in accomplishing that objective.17
Any activity that results in less tax than an alternative activity is, in its fundamental sense, a tax shelter since it reduces the overall tax burden on the taxpayer.18 Many tax shelters are not only contemplated, but in fact, mandated by congressional passage of specific sections of the tax code.19 These congressional choices for providing tax-based incentives can, in the broadest sense, fairly be called tax shelters. Accordingly, the use of the term "tax shelter" is too vague and does not help identify appropriately permitted or prohibited services and, therefore, should not be used. In our experience, we have found that tax compliance activities (i.e., reporting annual results of activities to tax authorities), tax representation activities (i.e., explaining to tax authorities the rationale for what was reported on previous tax returns) and tax minimization activities (i.e., formulating strategies to reduce future outlays for taxes) are all essential components of tax services.
We recognize, however, that not all activities that result in tax minimization are appropriate. Therefore, we would urge the Commission to draw a clear line between the very limited class of tax services that accounting firms may not provide to public company audit clients and the great bulk of tax services which may be provided to such clients, with audit committee approval. Unless such a clear line is set out, there is every prospect that the rule will have the consequence, unintended by the Congress and the Commission, of chilling audit committee consideration of tax services by their auditors.
Tax law itself has developed a body of case and regulatory law that disallows the desired results of certain transactions. Perhaps the most well-known of these provisions is the "business purpose" doctrine, which disallows the desired results of a transaction where, upon analysis, it appears that there was not a substantial business purpose other than tax avoidance as the principal motivation for the transaction.20 Accordingly, the Commission's Adopting Release should distinguish tax strategies serving a legitimate business purpose from those that have no business purpose other than tax avoidance, unless they are consistent with the intent of applicable tax laws.
Other judicial doctrines operate as backstops against overly aggressive taxpayer activities. The penalty provisions of the Internal Revenue Code, as administered by the Internal Revenue Service, also constrain overly aggressive taxpayer activities. On the other hand, some specific sections of the Internal Revenue Code exist specifically to provide incentives for taxpayers to enter transactions for which they would otherwise find no particular motivation (such as the tax credit for investments in low-income housing), and we believe that the clear congressional intent of encouraging such transactions should be respected.
In summary, we recommend that, consistent with the above observations, the Commission's Adopting Release should recognize that tax minimization activities are appropriate and, in fact, are in the public interest. In recognition of the concerns that auditors not overstep appropriate bounds, however, we further recommend that the Commission preclude auditors from advising audit clients on tax transactions for which there is no business purpose other than tax avoidance (except, of course, those that are consistent with the intent of applicable tax laws).
We wholeheartedly agree with and support the Congress' and the Commission's objectives behind a partner rotation requirement for auditors of issuers - to assure audit quality while providing a periodic fresh look at an issuer's financial statements. In fact, the AICPA's SEC Practice Section has required lead audit partner rotation for decades, with certain exemptions.21 The Practice Section requirements were adopted after thorough consideration of the effects of the requirements on SEC clients22 and their audit firms, and have served the public well for over twenty-five years.
We believe that any requirement adopted by the Commission should meet four basic criteria:
We fully support the importance of a "fresh set of eyes;" yet the benefit of a "fresh set of eyes" must be appropriately balanced with the cost of loss of continuity and institutional knowledge that a recurring partner brings to an audit engagement. We believe that it is crucial to the health and welfare of the U.S. financial markets that partners assigned to audit engagements are the most competent, knowledgeable and experienced individuals, and that any rule or requirement that would discourage this, without any compelling reason or overriding benefit, would be detrimental to the well-being of the American economy. When experience, knowledge and skill are not appropriately matched to an audit engagement, audit quality and investor confidence suffer. A decrease in audit quality is a mistake that we cannot afford to make.
As the Commission is aware, many issuers operate in extremely complex industries, have intricate business models, and conduct numerous complex business transactions. In addition, many business activities are the result of unique local and national economies.
All of these components require a myriad of highly-skilled auditors, many of whom specialize in a single industry or the accounting treatment of a specific type of transaction. The disadvantages of a rule that unduly restricts the continued availability of partners utilized on such engagements should not be overlooked. To rotate partners who are not responsible for signing off on an audit engagement, who understand a registrant's business environment and who can facilitate and enhance the audit would be detrimental to the financial markets and serve little purpose. If a firm does not have the depth of experience and knowledge in its partner ranks, inappropriate over-reliance will be placed on lower level staff and inexperienced partners.
Our Recommended Approach
We believe that the Act strikes an appropriate balance between the goals of achieving a fresh look and continuity and, accordingly, recommend that the Commission not go beyond what Congress required.
The Act states that:
The legislative history indicates that Congress gave considerable thought to this provision of the Act, and ultimately decided to limit the requirement to the "lead" and "review" partners, whose roles it defined,24 and that the limitation apply in their capacity as partners. The Senate Committee Report notes that, "[t]he bill requires a registered public accounting firm to rotate its lead partner and its review partner on audits so that neither is performed by the same accountant for the same issuer for more than five consecutive years."25 In addition, while not discussed in the legislative history, the Act could be interpreted to provide for a one-year "time out" period.
In light of the above discussion with respect to audit quality, we believe that the public interest would be best served if the Commission adopted what is stated explicitly in the law and the legislative history, and not go beyond those requirements until a proper study of the effects of the law on issuers and the audits of their financial statements can be conducted and assessed. Hastily adopting a rule which extends the prohibition of continued service beyond the requirements of the law could irreparably damage audit quality. Moreover, application to all partners on an audit, including tax and other specialists who are utilized on a limited basis as technical and industry resources, would unnecessarily reduce the available pool of professionals who could serve on the audit team. Both of those consequences would damage the public's interest in high quality audits.
The Commission should recognize that while audit decisions are made every day by all members of the engagement team, the final audit decisions are made by the lead partner and significant decisions made by the lead partner are considered by the review partner. Accordingly, the rotation requirements should be limited to those individuals. This adequately protects the public, while assuring audit quality will not suffer.
Furthermore, we believe the five-year "time out" period is unnecessarily long, and places an undue burden on both registrants and firms. The Commission will be able to achieve its objective of a fresh set of eyes with a "time out" period of significantly less than five years.
The AICPA's SEC Practice Section has required a two-year "time out" period for over twenty-five years and has periodically reassessed the appropriateness of that "time out" period. While we believe the Commission should stay within the confines of the law for the breadth of partners covered until proper study of the Proposed Rule's effectiveness can be conducted, it is our experience that a two-year "time out" period is effective. The Proposing Release states that the five-year "time out" period is necessary because any shorter "time out" period would fail to convince investors that rotated partners were not being placed in a secondary role on the engagement for a year or two, only to later resume the same role that they previously occupied and return to the prior engagement team's approach to accounting and auditing issues. We submit, however, that there is no evidence that firms subject to the current requirement place the rotated partner in a secondary role only to return as lead partner. If the Commission has a concern that firms will not abide by the spirit of the rotation requirements and will not assign the rotated partner to an unrelated audit engagement during the "time out" period, the Commission should simply prohibit the rotated lead or review partner from being assigned to the audit client in any secondary role. We recommend, however, that the Commission acknowledge that there may be instances where the audit engagement team may need to consult with the rotated partner on a specific transaction with respect to an audit on which he or she participated. Such consultations are in the public interest and should not be prohibited under the rule provided the partner is not actively involved in the audit.
Limiting the rotation requirements to the lead and review partners with a two-year "time out" period, together with the other provisions of the Act, particularly the auditor's new relationship with the audit committee and the PCAOB's inspection program, provides the fresh look at the audit that the Commission is looking for and protects investors without compromising audit quality.
If the Commission determines that it needs to adopt rules beyond what was contemplated in the Act, it should consider restrictions only to lead partners auditing the client's major subsidiaries, with differing rotation (perhaps permitting them to audit other subsidiaries) and "time out" periods.
As stated above, we believe that the rotation of key personnel (i.e., the lead and review partners) sufficiently mitigates the potential problems inherent in the long-term relationship between those engagement partners and their clients. In the event the Commission determines that the benefits of extending rotation beyond the requirements in the Act exceed the costs to both issuers and to audit quality, the Commission should limit the expansion of rotation requirements to those partners who provide lead audit services to an issuer and its major subsidiaries and consider extending the rotation period (e.g., to seven years) and reducing the "time out" period (e.g., to two years) for these individuals. The Commission should also consider allowing the rotation of partners between major subsidiaries and from a major subsidiary [to lead or review partner], without independence being deemed impaired. This approach would in our view, pose a lesser risk to audit quality than the current proposal and would assure that at least non-lead partners, partners (lead or otherwise) of non-major subsidiaries and partners who consult in specialized areas, such as tax and other industry and accounting specialists, are not subject to rotation requirements.
Congress contemplated, but did not mandate audit firm (versus audit partner) rotation; therefore, an exemption for smaller public accounting firms that audit publicly-traded companies [or issuers] from the partner rotation requirement should be provided.
The legislative history of the Act indicates that the Congress gave significant consideration to testimony given by numerous witnesses as to whether an issuer should be required to rotate its audit firm after a number of consecutive years, and seriously weighed the costs of audit firm rotation (e.g., reduced audit quality and effectiveness, increased audit costs) against the benefits (e.g., a fresh and skeptical set of eyes). While Congress agreed that there were strong benefits to having a fresh set of eyes evaluate the issuer periodically, it did not conclude that audit firm rotation was necessary.26
This history is an important factor to consider in evaluating the appropriateness of an exemption from the partner rotation rules for smaller public accounting firms. Because smaller public accounting firms are not large enough to have a substantial number of partners available to rotate, as noted above, a partner rotation requirement is tantamount to firm rotation for these firms.
And, audit firm rotation has significant costs that far outweigh the potential benefits, as government agencies (including the SEC and GAO), private organizations and members of academia previously have concluded.27 Those costs include:
The AICPA's SEC Practice Section has successfully exempted firms that have fewer than ten partners and five SEC clients from its partner rotation requirements.30 This exemption was provided for a number of reasons:
Our country has always prided itself on the opportunities it offers to its citizens. We believe that opportunities should be afforded to small businesses and that, by providing such businesses with access to a resource they can afford, the American economy benefits.
To give a sense of the number of firms and their clients that the Practice Section has exempted from its partner rotation requirements, we estimate that of the 767 firms that audit SEC clients that are members of the Practice Section, about 460 firms servicing only 765 SEC clients31 are exempted. We would suggest the Commission consider defining a smaller firm in several ways. Practice Section requirements currently define a small firm as one having fewer than ten partners and auditing fewer than five SEC clients. Another measure could be a combination of annual audit firm revenues (e.g., $10 million) and issuer market capitalization (e.g., $25 million). The Commission should also consider exempting auditors of businesses that file with the Commission, but are not listed on national exchanges and are not actively traded (e.g., benefit plans, limited partnerships).
We understand and appreciate, however, the benefits of partner rotation as a control that provides a fresh set of eyes to an audit engagement. Therefore, we would encourage the Commission to consider other controls that would achieve this objective for small firms under a partner rotation exemption.
For example, the Commission suggested the concept of some type of forensic auditing in lieu of the rotation requirement. We do not believe the Commission should adopt rules requiring that issuers engage forensic auditors periodically to evaluate the work of the financial statement auditors in lieu of the partner rotation requirement. The concept of a "forensic audit" does not currently exist in practice. A forensic accountant (trained in accounting and investigative techniques) is currently utilized to assess specific issues identified by management through complaints, government action, or other reasons. The discipline of forensic accounting is not intended to put the forensic accountant in a position to opine on the fairness of a company's presentation of its financial statements taken as a whole, but rather is undertaken to provide a client or a court of law with an accounting analysis that will form the basis for discussion, debate, and ultimately potentially dispute resolution regarding a specific issue. Because a forensic audit begins when there is evidence or a suspicion of fraud, there would not be a clear indication of what the forensic or fraud auditor would "audit" when there are no signs or suspicion of fraud. Further, it is unclear as to what type of report a forensic auditor would deliver.
In place of the forensic audit, we would recommend something more practical and appropriate such as a requirement that any exempted engagements be subject to a more in-depth review by the PCAOB during its triennial inspections or perhaps moving from a triennial inspection to an annual one for those firms. The inspection could be particularly focused on the risks/costs associated with failure to rotate the lead and review partners. We believe that an enhanced PCAOB inspection, coupled with audit committee review and approval of the auditor, would achieve the objective of a "fresh look" that the Commission is seeking to achieve.
We believe the Commission needs to be absolutely clear that the rule only applies to partners in their capacity as partners, and does not reach back to audit services provided in a non-partner position (such as manager). While we believe the language in the rule clearly reflects this position, the Proposing Release indicates that the proposed rules are designed to ensure that professionals (versus partners) do not "grow up" or spend their entire career on one engagement.
We do not believe the Commission should adopt rules requiring that issuers engage forensic auditors periodically to evaluate the work of the financial statement auditors for the purpose of obviating the need for partner rotation.
The concept of a "forensic audit" does not currently exist in practice. A forensic accountant (trained in accounting and investigative techniques) is currently utilized to assess specific issues identified by management through complaints, government action, or other reasons. The discipline of forensic accounting is not intended to evaluate the fairness of a company's presentation of their financial statements taken as a whole, but rather is undertaken to provide a client or a court of law with an accounting analysis that will form the basis for discussion, debate and ultimately the potential resolution of a dispute regarding a specific issue or set of issues. We believe the PCAOB will be able to provide the oversight and evaluation needed to properly assess and evaluate the work of the financial statement auditor, including requiring enhanced inspection and monitoring procedures in circumstances of heightened risk.
As the "responsibility for the prevention and detection of fraud and illegal acts" properly is shared by auditors, corporate management, and all financial professionals, the AICPA has committed to designing, with the assistance of corporate America and others, suitable anti-fraud criteria intended for public corporations. We have called upon the Auditing Standards Board to enhance our existing attestation standard for auditors to test and report on client anti-fraud criteria once they have been developed - and to develop ways to communicate the results to the public. Statement on Auditing Standards No. 99, Consideration of Fraud in a Financial Statement Audit, stresses procedures that should be performed in every audit to consider financial statement susceptibility to the risks of material misstatement due to fraud. In those audits that have a higher risk profile or identified misstatements which may be indicative of fraud, a fraud specialist or an auditor with training in forensic procedures would likely be engaged. Further, the new fraud standard, which incorporates the "forensic phase" recommendations of the Public Oversight Board's Panel on Audit Effectiveness, will require that auditors perform certain procedures on virtually all audits to respond to the risks of fraud. Encouraging fraud training for auditors and the use of fraud specialists, as well as inspecting firms to see that they are complying with the new fraud audit standard, will be more effective than adding another layer of post-audit second guessing.
We do not believe that the benefits, if any, of providing additional opportunities to other firms outweigh the costs to issuers of a forensic auditing requirement. However, there is merit to encouraging audit committees to hire fraud specialists for special projects. In addressing their responsibilities, audit committees could find a forensic audit focused on a specific issue very valuable, particularly if the audit committee has specific concerns regarding management's integrity.
As discussed above we do not believe forensic audits should be required. However, if such forensic audits were required, presumably the standards should be at least as high as those for firms performing audits in accordance with generally accepted auditing standards. A major difference, however, exists between the two processes. In a financial statement audit, the goal of rendering an opinion on the financial statements is clear; therefore, audit procedures responsive to that goal can readily be designed. Without suspicion or evidence of potential fraud, the goal of a forensic or fraud audit is unclear. As a result, there is no clear indication of where a forensic audit would start or what a forensic audit would cover.
No. See all the reasons stated above.
If the Commission is asking whether the costs of a forensic audit of the entire set of financial statements is more than the cost of a financial statement audit under GAAS, we believe that the cost would be substantially higher. We do not believe that such a tremendous increase in costs would be justified.
Consistent with Section 203 of the Act, the Commission's proposal on partner rotation applies to "issuers." We recommend that the rule should not be revised to apply instead to "audit clients." As defined by Rule 2-01(f) of Regulation S-X, an "audit client" means any entity whose financial statements are being audited, reviewed or attested to, as well as any "affiliate" of the audit client. Affiliates include any person that, directly or indirectly, controls, is controlled by, or is under common control with an audit client, as well as certain significant investees. Under that definition, which may remain appropriate for purposes of other independence requirements (such as financial interest restrictions), the audit partner rotation rules potentially would apply to auditors of an array of individuals, corporations, partnerships, associations, joint-stock companies, business trusts and other incorporated organizations that are not themselves issuers of securities. We believe that Congress did not intend this provision to have such broad and far-reaching implications, particularly inasmuch as the overriding purpose of the Act was to better protect investors.
See Our Recommended Approach above.
See Our Recommended Approach above.
Notwithstanding Our Recommended Approach above, the proposed rule indicates that all partners, principals or shareholders who perform audit, review or attest services for an issuer or any significant subsidiaries of the issuer as a partner, principal or shareholder must rotate off the audit, review or attestation engagement every five years. The proposal would thus apply to all partners who perform audit services for the issuer, including the client service partner, "line" partners directly involved in the performance of the audit, tax partners who perform significant services related to the audit engagement (e.g., tax accrual), partners who serve on the engagement team that conducts the reviews of the registrant's interim financial information, partners who serve on the engagement team that conducts the attest engagement on management's report on the registrant's internal controls, and any other partner who is involved on a continuous basis in the audit of material balances in the financial statements (e.g., actuarial specialists).
The Proposing Release, however, provides for exemptions that are not reflected in the Proposed Rule. Those exemptions include:
We believe that the language of the rule should make clear that these classes of partners are not covered by the restriction.
Furthermore, the proposed rule indicates that all partners, principals or shareholders who perform audit, review or attest services for an issuer or any significant subsidiaries of the issuer as a partner, principal or shareholder must rotate off the audit, review or attestation engagement every five years. Again, notwithstanding Our Recommended Approach above, we believe it is important to indicate in the Final Rule or Adopting Release that the provision applies exclusively to the work performed on an audit, review or attest engagement as a partner, principal or shareholder so there is no confusion that it applies to services performed by an individual as a manager, staff or in any other non-decision making position.
Yes. However, see Our Recommended Approach above. Consistent with the theory behind why these types of partners are excluded, we would suggest excluding other partners that regularly serve the engagement team as a technical resource, such as tax partners and other industry specialists.
We do not believe so. The text of the Proposed Rule should be explicit in exempting these partners and in defining who they are. We prefer the current language used in 17 CFR 210.2-01(f)(7) which states that "all persons who consult with others on the audit engagement team during the audit, review or attestation engagement regarding technical or industry-specific issues, transactions, or events." This language clarifies the persons who fall within the current definition of "audit engagement team," and to whom, in our view, mandatory rotation should not apply.
We do not believe so. The current definition of audit engagement team in 17 CFR 210.2-01(f)(7) includes national office partners. We believe the Commission should be explicit in its exclusion of these partners from the rotation requirements.
Consistent with Our Recommended Approach above and the reasons stated therein, we believe it is appropriate to exclude all non-audit services partners from the rotation requirements.
We do not believe this was the intent of Congress and accordingly do not believe it is either appropriate or in the public interest to include additional personnel. We also believe that the Commission should clarify its intent that the rotation period does not include time spent on the audit, review or attest engagement in a position other than as a partner, principal or shareholder.
Yes. We believe it is appropriate to provide transitional relief where the proposed rules are more restrictive that those currently required by the AICPA's SEC Practice Section. Transitional relief should provide for an orderly transition, take into consideration experience and expertise of auditors, allow for a firm to stagger rotation terms, and not harm the registrant in any way, particularly if an audit is in process. Please see our recommendations under Transition Period later in this letter.
We believe smaller firms should be exempted from the rotation requirements, with required, compensating, quality control safeguards, for the reasons described in Our Recommended Approach above. We would suggest the Commission consider defining a smaller firm in one of several ways. SEC Practice Section requirements currently define a smaller firm as one having fewer than ten partners and auditing fewer than five SEC clients. Another measure could be a combination of audit firm annual revenues (e.g., $10 million) and issuer market capitalization (e.g., $25 million). The Commission could also consider exempting auditors of businesses that file with the Commission, but are not listed on national exchanges and are not actively traded (e.g., benefit plans, limited partnerships).
Audit Committee Administration of the Engagement
We believe it is extremely important to preserve the spirit of the Act's requirement that the audit committee is now the audit client. Consistent with this observation, company management needs to be given the flexibility to carry out the audit committee's objectives. Accordingly, the Commission should create a provision that would allow an audit committee to adopt a policy allowing recurring contracts that are less than a stated dollar amount (set by the audit committee) be entered into by management provided they are periodically reviewed by the audit committee.
As the Commission is well aware, the role and responsibility of the audit committee has increased substantially as a result of the Act. However, the audit committee is not charged with the day-to-day stewardship of the business. That responsibility rests with management and management must be permitted to act quickly when necessary. As such, it is important to find ways to minimize delay as to matters that would come before the committee to allow it to focus its time on substantive issues that require discussion and deliberation. Establishing guidelines within which management is permitted to act is part of the internal control process of the company. Ratification by the audit committee of a contract approved by management is the control over that process, but it cannot be perfunctory. To ensure that all parties take their responsibilities seriously, the internal auditor should periodically test this control and promptly report all exceptions.
We believe it is appropriate, even necessary, for the audit committee to set policies and procedures to guide management about the engagement of non-audit services between meetings of the audit committee. A statement to this effect should be incorporated into the audit committee charter and reviewed annually with the board of directors. It is incumbent upon the board to ensure that the audit committee has appropriate policies and procedures in place and has not delegated its responsibility to management.
We believe that boards of directors and audit committees, as part of the corporate governance process, must have flexibility to adapt operating policies appropriate to the companies which they supervise. As noted previously, it is important that the audit committee be in an oversight role and, without abdicating its responsibilities to management, not participate in management's role.
The audit committee should consider a number of factors prior to engaging the auditor. And, audit committees should be given the flexibility to consider what information it needs based on the many things affecting a company, such as the nature of its business, its size and the depth of knowledge about the company and its auditors by the board of directors and the audit committee. Some factors to consider might include:
(1) Whether the auditor is registered with the PCAOB and is in compliance with all applicable laws, regulations and professional standards;
(2) The auditor's experience auditing SEC issuers;
(3) Any pending or threatened litigation against the auditor with respect to the any work performed for the company;
(4) The length of the relationship between the company and the auditor, as well as individual audit team members to the extent that is practical;
(5) All services provided, or recently provided by the auditor to the company;
(6) Whether the auditor is independent as required by the SEC and AICPA independence rules, and the auditor's communication about its independence under ISB Statement No. 1;
(7) The role of the audit committee in testing management's assertions regarding the company's internal control system;
(8) What the auditor will communicate to the audit committee during and at the completion of the audit; and
(9) Any occasion in the past five years where the audit firm responded to the company's specific request for information on the treatment of a specific accounting matter.
The audit committee should ask the auditor to describe the policies and procedures it has in place to ensure that the audit firm, including its domestic offices and foreign associated firms that are not otherwise involved in the audit, will not provide any prohibited non-audit services to the company.
We fully expect that the cost to maintain the audit committee in a company will increase. For example, we believe the audit committee will need additional meetings each year whether these meetings take place by conference call or in-person. The increased time demands on the audit committee members will also result in increased compensation. We also expect that the new responsibilities will increase the liability of the audit committee, which will increase the cost of Director's & Officer's insurance and make it harder to recruit qualified and willing audit committee members. Finally, we expect that audit committees will hire their own advisors which will increase costs.
We believe that an accounting firm's audit personnel, including partners, should be rewarded and penalized based on both quantitative and qualitative measures, such as technical expertise and audit performance. We support a rule that would prohibit a member of the audit engagement team, from being directly compensated for selling non-audit services to his or her audit client, since such an arrangement has the potential to impair the auditor's appearance of objectivity. We do not believe, however, that the Commission's rule should prohibit an individual from sharing in the firm's total profits, or receiving compensation from a profit pool, which may include fees for permitted non-audit services provided to that audit client, provided such services have been approved by the audit committee.
In practice, there are many different partner profit allocation methods used by accounting firms. These vary from more complex "unit methods" often used by larger accounting firms to simple allocation methods used by smaller accounting firms. Regardless of the method used, accounting firms should design their compensation allocation methods to reward individual partners based on the quality of their work, and to penalize those who do not perform appropriately.
With certain safeguards already in place, we do not believe that the public is served by trying to impose a detailed rule on how an accounting firm allocates its profits. We support the idea that a firm's quality control system should include policies and procedures to provide reasonable assurance that audit personnel, including partners, will not compromise their objectivity due to the economic size or influence of any one client. We would further support, as part of the quality inspection of each registered accounting firm, a review by the PCAOB of the firm's compensation system to determine whether the firm has appropriate safeguards in place to provide reasonable assurance that an audit partner would not compromise his or her objectivity.
The Act has already imposed a ban on certain services being provided to a public audit client. Further, the Act has fundamentally changed the audit/client relationship. Now the independent audit committee will hire, fire and oversee the auditor and thus the auditor will feel that it has to meet the expectations of the audit committee, not management. Also, an audit committee must pre-approve the audit firm's provision of permitted non-audit services. Therefore, when non-audit services are purchased, the audit committee will have made an informed decision to procure these non-audit services from the accounting firm and assured itself that the firm is independent.
For these reasons, we believe that the public is better served by principle-based quality control standards that address client objectivity issues, including safeguards as to compensation. By focusing on the firm's quality control system, there would be no need for firms to devote needless efforts to the creation of allocation methods that artificially interfere with the fair allocation of profits among partners.
Accounting Role / Financial Reporting Oversight Role
We agree with the Proposed Rule's definition of "accounting role" (i.e., a role in which a person is in a position to or does exercise more than minimal influence over the contents of the accounting records or anyone who prepares them.) and note that it is consistent with the SEC's current definition.32 However, we also note that there is an inconsistency between the Proposed Rule and the discussion in the Proposing Release. Specifically, the Proposing Release states that:
We do not believe that individuals in clerical positions are generally in a position to exercise any influence over the contents of the accounting records and therefore, recommend the Commission exclude any reference to clerical positions from the Adopting Release. However, consistent with the Commission's discussion its December 2000 Release, we believe that a person in an accounting role should include "certain individuals, such as an accounts receivable supervisor or manager, who are relied upon by management to calculate amounts that are placed directly into the company's financial statements."
Financial Reporting Oversight Role
As explained in our comment under Conflicts of Interest Resulting from Employment Relationships above, we have concerns on the scope of the "financial reporting oversight role" definition for purposes of the cooling-off requirement. Specifically, the Commission's definition of "financial reporting oversight role" is broader than what is required by the Act and would capture all roles in which the person is "in a position to or does exercise influence over the contents of the financial statements or anyone who prepares them, such as when the person is a member of the board of directors or similar management or governing body, chief executive officer, president, chief financial officer, chief operating officer, general counsel, chief accounting officer, controller, director of internal audit, director of financial reporting, treasurer, or any equivalent position."
We believe that, for purposes of the cooling-off restriction, the requirement should not extend to a "member of the board of directors or similar management or governing body" unless the individual also serves on the company's audit committee. Members of the board generally play a far less extensive role in the company's financial reporting and the safeguards required by ISB No. 3 are sufficient to protect any threat to the auditor's independence. Furthermore, in today's environment there is an even greater need for competent and qualified board members and to limit the pool of available people would appear to only exacerbate the difficulties that companies will encounter in locating qualified candidates. We therefore recommend that, for purposes of the cooling-off provision, the definition of "financial reporting oversight role" exclude members of the board and that such individuals instead be subject to the ISB No. 3 safeguards.
The definition, as presented, adequately describes the kind of body that should be in the role of the audit committee. Organizations that have no designated board of directors or audit committee should make an effort to appoint some related body to serve in that role.
Communication with Audit Committees
Yes. Since the primary responsibility for establishing an entity's accounting policies rests with management, we believe that the discussion should include the CEO and CFO as active participants.
Critical Accounting Policies and Practices
We believe that the disclosures covered by the May 2002 proposed rules are sufficient and that additional information should not be required.
Alternative Accounting Treatments
We believe that the descriptions of the specific transactions and general accounting policies for which alternative treatments discussed with management are required to be communicated is sufficiently clear. However, although we assume the Commission so intends, it is not clear that the requirements extend only to discussions occurring during the current audit period. We believe the Final Rule should clarify that the requirement only extends to discussions occurring during the current audit period.
No. We believe the required communication is sufficient.
Timing of Communications
We believe that, for the communications to accomplish their intended purpose, they should occur before any audit report is filed with the Commission. However, issuers and their audit committees will have to understand that, if they fail to make themselves available to receive the communications, the auditor will not be able to consent to the inclusion of his or her report in such filing.
As discussed above, we do not believe that it is necessary to require these communications in writing. Communications such as these are best when a robust, open and frank discussion takes place.
Principal Accountants' Fees/Audit Committee Actions
We believe that the proposed changes to the proxy disclosure rules regarding the principal accountant's fees provide more meaningful information to investors than the Commission's current proxy disclosure rules.
While we concur with the proposal to expand the definition of "audit fees" to include fees for services that generally only the independent accountant can reasonably provide, such as comfort letters, statutory audits, attest services, consents and assistance with and review of documents filed with the Commission, we believe that the disclosure would be more meaningful if "audit-related fees," which are proposed as a separate category, were combined with "audit fees". Since audit-related fees are, by definition, closely related to the audit, investors will perceive them as such and likely would be confused by separate categories. We would suggest, however, that the disclosure be accompanied by a description of the services provided in a sub-categorical disclosure fees (and since reports on internal controls are now required as part of the audit engagement, sub-categorical disclosure of this should not be required). We further agree that segregating tax fees and all other fees into categorical disclosures generally would provide investors with the information they need to make investment decisions.
We believe the proxy statement is the appropriate location for this disclosure.
No. We believe a more meaningful disclosure would combine audit and audit-related fees with an accompanying requirement for registrants to describe in a subcategory the nature of the services provided. To maintain these as separate disclosure items would be confusing. We believe the additional categories of "tax fees" and "all other fees" are appropriate with a required subcategory description of the nature of the services identified in the "all other fees" category.
As indicated above, we believe a more meaningful disclosure would combine audit and audit-related fees with a requirement for registrants to describe in a subcategory the nature of the services provided. We believe the categories of "tax fees" and "all other fees" are appropriate with a required subcategory description of the nature of the services identified in the "all other fees" category. We recommend, however, that the Commission make clear that tax services related to the audit (e.g., audit of the tax accrual) should be included in the "audit fees" category.
We believe that only the current year fee disclosure is appropriate. Given the nature of this disclosure we do not believe that having comparable information will be useful information to investors.
We believe that investors should have the same information available to them regardless of the type of registrant and filer. Therefore, we would agree that a registrant that is not subject to the proxy disclosure rules should be required to disclose fees in a schedule to a Form 10-K or in a Form 8-K disclosure.
We are troubled by requiring the disclosure of specific policies and procedures of the audit committee in a registrant's proxy statements. We would prefer to see the proxy statement include a disclosure that the company has adopted policies and procedures relating to the pre-approval of the independent accountant to perform both audit and non-audit services. In our view, additional detail regarding those procedures is not necessary and will not aid investor decision making.
No. We believe that annual proxy disclosure is sufficient.
See previous response.
The Act requires registered public accounting firms to comply with auditor independence standards. As registration with the PCAOB may not be required until as late as October 2003, Congress built a transition period into the legislation. In contrast, the Commission's proposed independence rules would revise Rule 2-01 of Regulation S-X and, as currently drafted, would take effect immediately upon adoption of the rule, without any transition period. We strongly believe that a transition period is necessary and appropriate for the effective implementation of the Act. Such transitional relief should: (1) take into consideration the experience and expertise of auditors, (2) take into account auditor continuity and audit quality, (3) allow firms to stagger rotation terms, (4) avoid harming the registrant in any way, particularly if the audit is in process, and (5) consider any existing exemptions from the current requirements.
As soon as the proposed rules become effective, an audit client may be required to decide between continuing to engage an accounting firm to audit its financial statements and continuing to retain the firm to provide non-audit services. It may not be feasible or appropriate for the accounting firm to cease all non-audit engagements (that are not already restricted) immediately. The audit client may require time to find a new provider of those services, allow the accounting firm to complete work in progress and arrange for a smooth transition from one provider to another. Accordingly, we suggest that, for the two-year period following the effective date of the rule, providing the non-audit services set forth in Rule 2-01(c)(4) to an audit client would not impair an accountant's independence, provided: (1) the non-audit services are performed pursuant to a written contract in effect on or before the effective date of the rule, and (2) the performance of the services would not impair independence under pre-existing requirements of the SEC and the accounting profession in the United States.
This approach would allow issuers to wrap-up current work and/or transition to a new service provider with respect to engagements that were permissible for an auditor to perform at the time they were contracted for. The Commission adopted a similar transition approach in its December 2000 Release with respect to (1) appraisal or valuation services, fairness opinions and internal audit services, and (2) other financial interests and employment relationships.34
Proposed Rule 2-01(c)(6) of Regulation S-X would require the rotation of certain audit partners who have performed audit services for an audit client for five consecutive years, and preclude the partner from providing audit services for five additional years following the mandatory rotation. As proposed, the partner rotation provisions would take effect upon the rule's adoption, requiring firms to implement changes immediately in order to comply with these provisions.
As the Commission has noted, these rotation provisions exceed the current requirements of the accounting profession and the Act. Without an adequate transition period for issuers and accounting firms, the implementation of the rule would entail significant disruption. Auditors will have to reorganize audit teams, train partners in new industries and, in many instances, resign from engagements. In addition, it is not feasible to expect firms immediately to identify and reassign partners with expertise sufficient to ensure continuity in providing quality service to clients, as partners will be required to develop general expertise in order to serve a broader range of industries. Firms (and, in particular, smaller firms) will need time to plan for and implement these changes.
For example, a partner currently in the fifth or sixth year of a seven-year rotation cycle under existing rules (or a partner exempted due to firm size) will need to immediately rotate off the engagement the day the rule becomes effective to prevent an impairment of his or her firm's independence. Similarly, a partner who complied with the current standards and rotated off the engagement three years ago and has now returned to the engagement team will be required to immediately rotate off the engagement to avoid an impairment of independence. Without adequate time to prepare for such changes in the composition of audit teams and the transfer of knowledge regarding current engagements, audit quality will suffer. This is hardly the desired result of the Act. These effects would be exacerbated for firms with several public clients, firms with few partners and engagements with multiple partners.
We recommend that the Commission provide a two-year transition period before the partner rotation rules become effective.35 This is consistent with the approach adopted by the AICPA when it implemented partner rotation in the late 1970's. This approach would allow for a smooth transition by permitting issuers and accounting firms to mitigate the effect of the disruptions caused by the rule changes and facilitate the staggering of audit partner rotation cycles on large audits, as recommended by the Commission in the Proposing Release.
Employment with Clients/Cooling-Off
Proposed Rule 2-01(c)(2) provides that independence would be impaired when a former partner, principal, shareholder or professional employee of an audit client's auditor is employed in a "financial reporting oversight role" at the audit client, unless the individual has not been a member of the audit engagement team for the audit client's financial statements during the one year period preceding the initiation of the audit. Under the proposal, the cooling-off provision would become effective when the rule is adopted. We believe that a transition period is needed to prevent disruption and unanticipated effects, particularly if the Commission adopts a rule that applies to audit clients, rather than issuers.
For example, as drafted, an audit firm's independence would be impaired if an employee who formerly worked for the accounting firm was hired by the client in March 2002 to serve in a "financial reporting oversight role." Although there was no restriction against hiring the individual at the time he or she accepted employment, the audit client would be placed in the immediate position of choosing between firing (or reassigning) the individual and replacing the auditor. Such results are unreasonable and were not contemplated by Congress in enacting the legislation. We suggest that the rule should apply prospectively to employees hired in a financial reporting oversight role after the effective date of the rule.36
Depending on the nature of the rule adopted, we believe that firms could have difficulties in complying with this requirement if there is not an appropriate transition period. We suggest you review responses from firms of varying sizes to determine the appropriate transition period.
General Request for Comments
Section 201 of the Act prohibits a registered public accounting firm, "and any associated person of that firm, to the extent determined appropriate by the Commission," from performing certain non-audit services contemporaneously with the audit. The Proposing Release, however, does not discuss whether it is appropriate to extend the application of Section 201, or any of the auditor independence provisions of the Act, to "associated persons." Instead, under the structure contemplated in the Proposing Release, the SEC would implement most of the Act's auditor independence provisions by amending Rule 2-01 of Regulation S-X, which by its terms applies to an "accounting firm" and its "associated entities." Since the term "associated entities" is not defined in the SEC's regulations but appears broader than the term "associated persons" (which, in comparison, is specifically defined in the Act), the Commission's proposed regulations broaden the requirements of the Act. In addition, they may lead to confusion as to the range of entities to which they apply, without any discussion or finding as to whether the broader application serves the public interest.
As noted, the Act contemplates that the Commission may extend the scope-of-services regulations to "associated persons" of an accounting firm. We believe that, before adopting such an approach, the Commission should publish for comment its reasons for applying the restrictions to entities other than registered public accounting firms, such as their "associated persons."
Similarly, we believe that the SEC should not rush to extend the restrictions on non-audit services and audit committee pre-approval requirements to services provided by "associated entities" of public accounting firms.
We support the Act's provisions and SEC's proposals that: (1) strengthen the reporting relationships between auditors and audit committees, (2) require that material written communications between auditors and management be provided to the audit committee, (3) impose obligations on audit committees to play an active role in monitoring corporate financial reporting, and (4) require the audit committee to hire, fire, compensate and oversee the auditor. We believe that these elements fundamentally change the auditor/client relationship, complement and enhance the profession's existing audit standards, as set forth in AU 380, Communication with Audit Committees and help alleviate any pressure that might be placed on auditors by management to acquiesce in their views.
We support the Commission's proposal that an auditor of an issuer would not be considered independent if, at any point during the audit and professional engagement period, a partner, principal or shareholder of the accounting firm who is a member of the audit engagement team directly earns or receives compensation based on the procuring of engagements with that audit client to provide any services other than audit (or audit-related), review or attest services. Although we are not aware of specific situations in which such forms of compensation have been found to lead an accountant to acquiesce in a client's views on an accounting issue, we agree that the direct compensation of an auditor for procuring any services other than audit (or audit-related), review or attest services may create an appearance that the accountant may not be objective. Moreover, we believe that doing anything further would be both counterproductive and not in the public interest.
Initial Regulatory Flexibility Act Analysis
Small Entities Subject to the Proposed Rules
The Commission has indicated in its Proposing Release that the proposals would affect small registrants and small accounting firms that are small entities. In fact, at the Commission's meeting on November 19, 2002, at least two Commissioners commented on the economic impact on small business and small accounting firms and the Commissions Chief Economist stated, "[t]here can be no doubt that the constraints [regarding the proposal with respect to partner rotation] are more costly to, and have a greater adverse effect on, the smaller firms." As we have indicated throughout our response, we are also concerned about the impact the Proposed Rule will have on small business and small accounting firms (e.g., partner rotation and cooling-off requirements).
While we do not have the exact information the Commission's is looking for, we can provide information that may be useful in the Commission's analysis of the impact that the proposals would have on smaller accounting firms.
As of December 10, 2002, the AICPA's SEC Practice Section had 767 firms that audit SEC clients37 as defined by the Practice Section. Since the Commission has never required membership in the Practice Section by auditors of SEC registrants, there is a population of firms that we cannot identify. However, of the individual firm revenues of 767 firms, we estimate that 565 firms servicing 2,340 SEC clients have revenues of $6 million or less per year.
Thank you for the opportunity to comment on this Proposed Rule.