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September 25, 2000
Mr. Jonathan G. Katz
Secretary
Securities and Exchange Commission
450 5th Street. N.W.
Washington, D.C. 20549-0609
Re: Proposed Rulemaking Regarding Revision of the Commission's
Auditor Independence Requirements
SEC File No. S7-13-00
Commissioners:
Thank you for the opportunity to supplement our oral testimony
with written comments on your proposed rulemaking regarding auditor
independence. These comments reflect the richness and diversity
of the 33,000 members of the New York State Society of Certified
Public Accountants, including the Professional Ethics Committee,
the SEC Practice Committee, the Auditing Standards and Procedures
Committee, and a task force of officers and oversight committee
chairs. The various viewpoints reflect those of individuals who
participated in committee discussions, rather than the firms they
each represent.
We commend the Commission on their goal of enhancing investor confidence
and protection of the public interest through the proposed rules.
As the home of the "Trusted Professional", we agree with the goal,
but concerns about how these proposed rules will affect individual
CPAs and their practices keep us from endorsing them fully. The
following are our major concerns.
Governing Principles
We agree with the "general standard for auditor independence"
and the need for overriding principles. However, these four governing
principles should not be "determinants" of independence, but should
be used to help formulate independence rules. They would better
serve accountants, registrants, and investors as "guiding factors,"
concepts for application in given facts and circumstances in the
context of a more robust framework, such as that which the Independence
Standards Board (ISB) is developing. Significant problems arise
in the application of these four "governing principles" to practice
situations.
The guidance is too abstract for any practical usefulness and,
therefore, may be counter-productive. For example, Society committees
could not reach a consensus on how to assess compliance with the
provisions of the proposed rules because the principles that form
their basis are open to broad interpretation. When exactly does
an independent auditor perform a "management function" that impairs
independence? Since advocacy is anticipated in many situation that
involve auditors, including current SEC requirements for "preferability"
letters, which advocacy activities impair independence. Rules that
are too "broad brush" and open to differing interpretations will
cause confusion and disruption not only for audit firms, but also
for their clients. How will registrants know which specific activities
they should plan to take to someone other than their auditor?
We believe that the proposed "mutual or conflicting interests"
factor requires further definition because all audit firms have
an inherently mutual interest with their audit clients, namely quality
financial reporting. This guiding factor should be restricted to
those interests that subordinate the auditor's judgment to that
of management. Furthermore, we believe that an auditor may acceptably
act as an advocate for an audit client if the auditor's judgment
is not subordinated to management's.
The audit committee requirements already adopted by the ISB, the
New York Stock Exchange, the National Association of Securities
Dealers, the American Stock Exchange and the SEC already create
a mechanism to monitor and evaluate whether the auditor has in fact
subordinated his or her judgment to that of management. Strengthening
the corporate audit committee structure and operation is key to
ensuring that the auditor's judgment is not subordinated to management's.
Non-Audit Services
Recently, the Public Oversight Board Panel on Audit Effectiveness
concluded, "both the profession and the quality of audits are fundamentally
sound." The panel said it could find no evidence that the provision
of non-audit services has hurt audit quality. On the contrary, it
concluded that in numerous instances non-audit services contributed
to a more effective audit. Because "perception" is the issue, we
believe that disclosure of non-audit fees empowers the investor
to assess the potential for impairment. Moreover, coupling full
disclosure with registrants' market choices to use auditors for
non-audit services would provide valuable data for researching the
correlation of auditors' provision of non-audit services to investment
risk and return.
Outsourcing internal audit does not subordinate the auditor's
judgment to management where appropriate levels of management retain
the decision making power as laid out in American Institute of Certified
Public Accountants' Interpretation 101-13, Extended Audit Services.
Furthermore, current rules require the internal audit function,
even when outsourced, to report to the audit committee, another
layer of independent control.
We are very concerned about how the proposed rules on non-audit
services could reduce the quality of financial reporting of smaller
SEC registrants. Committee members have indicated that the financial
accounting sophistication of some SEC clients is insufficient to
completely satisfy the details of certain accounting standards and
that these clients expect their accountants to advise and assist
them in these situations. We recommend an exclusion for smaller
SEC registrants that do not have the trained resources to navigate
the complex SEC reporting and accounting standards without the assistance
of their accountant. The auditors are often the most knowledgeable
participants in very complicated accounting transactions and must
first educate and then guide their clients. In this way the accountant's
navigational assistance keeps the small SEC registrant on course
and actually improves financial reporting.
In a related concern, committee members discussed the potential
unintended consequences that the proposed prohibition of certain
consulting services to audit clients may have on other sectors.
If so, all audit firms, regardless of size or sector of practice,
would be affected. Will other regulators, including other federal
agencies and state boards of accountancy, adopt similar rules to
prohibit consulting services for audit clients? A "no" answer to
this question will cause turmoil, confusion, and conflict. A "yes"
answer causes other problems. What should be a "win-win" scenario
may inadvertently become a "lose-lose" set-up for the audit profession
and their clients, including SEC registrants.
Limiting the provision of expert services that otherwise enhance
financial statement quality could have a very damaging impact on
the general performance of business and the economy. In many communities,
accounting practitioners serve as business advisors and may be the
sole resources in their community for Information Technology and
other consulting services. The success of businesses and the economy
is often linked with the broad availability of consulting services
offered by CPA firms of all sizes.
Affiliate Definitions
The current SEC definition of an "affiliate" in 602.02.b.iii, Interests
in Nonclient Affiliates and Investee Companies, distinguishes
investees that are greater than 50 percent controlled from those
that are less than 50 percent controlled (accounted for on the equity
method). The proposed rules redefine an "affiliate of an audit client"
as any entity that has "significant influence" over the audit client.
Under the SEC's current interpretation, "an immaterial financial
interest in a nonclient investee of a client company would not have
an adverse effect on the independence of the auditor of the client/investor
where the investor's investment in the investee does not exceed
five percent of the investor's consolidated total assets and the
investor's equity in the investee's income from continuing operations
before income taxes does not exceed five percent of the investor's
consolidated income from continuing operations before income taxes."
We prefer the unambiguous current definition of an affiliate to
the proposed redefinition, which is far too broad for reasonable
implementation.
Furthermore, we believe that the proposed definition of an "affiliate
of an accounting firm" is overly restrictive. While we agree that
the concept of independence should extend to controlled entities
of accounting firms, a five percent ownership interest is nominal,
generally immaterial, and too low a threshold for general application.
We suggest that a higher threshold would be more consistent with
the current business environment.
Because of these broadened definitions of "affiliate," every business
alliance or affiliation that the audit client or the auditor enters
into, and in turn the alliances and affiliations of those related
entities that meet the SEC's new definition of an affiliate, will
have cascading independence implications. For example, a 25 percent-owned
investee would be an affiliate of a company under the proposal and
the company's auditor would be required to be independent of it,
even if the company has no control over the investee and the investment
is immaterial to it. Furthermore, the auditor would be required
to be independent of the 20 percent-owned investee of the company's
20 percent-owned investee and so on. Accordingly, a 20 percent-owned
investee of a 20 percent-owned investee of a company that enters
into any restricted relationship with its auditor would preclude
the auditor from auditing the investor company, and this would be
without any regard to any materiality test (i.e., if the second
tier investee is immaterial to the first tier investee which is
immaterial to the investor company, independence restrictions would
still apply).
Private Standard Setting
A recurring concern raised by committees has been the clear preference
for the Independence Standards Board to be given implementation
support and the necessary time to work effectively. Many believe
that the reforms related to disclosures and audit committee requirements
adopted by the Independence Standards Board, the stock exchanges,
and the SEC are steps in the right direction.
We believe strongly that standard setting is best done in the
private sector. At this time the ISB is making progress on a number
of projects; now is not the time for the SEC to step in with dramatic
changes. We believe the ISB's efforts should continue to be supported.
In addition, as we have commented before the Public Oversight Board
Panel on Audit Effectiveness and elsewhere, the Society wholeheartedly
endorses a stronger relationship between the accountant and audit
committee, the first line of defense regarding auditor independence.
Proxy Disclosures
Another concern is the proposed fee disclosure requirements. The
August 2000 CPA Journal includes a commentary on those requirements
by Robert Waxman, which indicates the level of detail required by
the proposed rules. Nonaudit services and the fee information now
go to the audit committee under ISB #1. Perhaps it would be more
meaningful to investors to know that the audit committee has reviewed
this information and is satisfied, with aggregate disclosure of
the audit and non-audit fees similar to the British approach. Disclosure
of fees for non-audit services closes the "perception gap"
Auditor Investment Rules
Many in the Society applaud your proposals that reduce the number
of circumstances in which client employment of family members impairs
independence. All those from two career households know the pressures
that raising a family while meeting the demands of the accounting
profession can create. The arbitrary and inequitable nature of the
unduly restrictive current rules in this area causes problems for
families and inhibits the attraction and retention of high-quality
people for the profession without providing a corresponding benefit
to the public interest.
The potential negative impact of the current rules in a small city
with a single major employer is obvious. However, even in a city
the size of Seattle the job market is often dominated by two employers
that are both audited by the same firm. For far too many families,
normally happy events like admission to the partnership, promotions
and successful audit proposals have required one spouse to resign
a position to resolve an imaginary independence issue.
The proposed rule puts the focus where it belongs - on employment
positions that exercise significant influence over accounting records
and financial reporting, and on positions in the audit firm which
truly have the ability to influence the conduct of the employer's
audit. We encourage you to move swiftly to adopt your family employment
proposals to eliminate the injustice that the current rules unnecessarily
impose on the men and women of this profession and their families.
Concluding Suggestions
On the other hand, we encourage you to move more deliberately in
regards to the proposals related to the provision of non-audit services.
Although the Commission may believe that the proposed rules are
targeted to affect only SEC registrants and their auditors, we believe
the effect will be more widespread. All CPA firms with clients who
may become registrants at some time in the future will have to be
aware of, and comply with, these rules in advance of any registration.
In the same respect, businesses contemplating public offerings will
have to rethink the terms of their engagements with audit firms.
Thank you for the consideration you have given us in accepting
these comments. We would be pleased to respond to any questions
you may have.
Sincerely,
P. Gerard Sokolski, CPA
President
New York State Society of Certified Public Accountants
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