June 17, 2003
Chairman William Donaldson
Securities and Exchange Commission
450 5th Street, N.W.
Washington, D.C. 20549
Dear Chairman Donaldson:
Two weeks ago we wrote to you regarding our concerns over practices at Ernst & Young that we believe systematically undermine the recently adopted requirement that audit committees pre-approve non-audit services. Last week the Wall Street Journal revealed new information about abusive practices at Ernst & Young, this time involving its characterization of what were essentially janitorial inspections at HealthSouth facilities as audit-related services for the purposes of proxy statement fee disclosures.(1) If Ernst & Young knowingly caused its audit client to make false and misleading proxy disclosures – and the facts do not appear to be in dispute – it should be sanctioned for that conduct.
Although the misleading HealthSouth proxy disclosures predate the Commission’s new fee disclosure rule, the revelations in the Journal article about just how far a major audit firm was willing to go to distort fee disclosures under the old system also say a lot about what is wrong with the new system. As such, we believe the Journal article buttresses our previous argument that these fee disclosure rules need to be reworked, since they make it more difficult for investors to discern fee-related conflicts of interest that may impair auditor independence.
The fact is, firms have a strong incentive to characterize services as audit-related, because such services are less likely to be perceived by investors as creating inappropriate conflicts of interest. A company that pays $3.55 million for audit and audit-related services, and just $121,580 for non-audit-related services, would appear to have we few if any conflicts to worry about. If, on the other hand, the company has paid significantly more for non-audit services than for the audit – $2.48 million for non-audit services versus $1.16 million for the audit – the picture of auditor independence is very different.(2) In short, when companies are allowed to characterize services that are unrelated to the audit as audit-related they are able to mask the real extent of any conflicts of interest. Ernst & Young is obviously sensitive to that fact. As we noted in our previous letter, it advises its audit clients to combine audit, audit-related, and tax services (based on the definitions in the new fee disclosure rule) and in order to measure whether fees for all other services are of a magnitude to create a serious conflict.
Firms also have an incentive to characterize services as audit-related in order to minimize the chances that those services will be closely scrutinized by audit committees for possible independence concerns. As our previous letter described in more detail, this is certainly the approach being advocated by Ernst & Young in its guidance to audit clients on implementation of the new rules governing audit committee pre-approval of non-audit services. Audit-related services, Ernst & Young asserts, are, “by definition, not the types of ‘consulting’ services that have given rise to concerns about non-audit services in recent years.” They “generally improve audit quality and do not impair independence.”
When the Commission adopted its new fee disclosure rule, it allowed most true audit-related services to be grouped in the audit fee category. It then created a category for other “assurance and related services that are traditionally performed by the independent accountant.” Although these services are classified as audit-related, there is no requirement that the services actually be related to the audit, and there is the very real likelihood that certain of the services in this category could conflict with the audit by requiring the auditor to audit its own work. No wonder the rule change was so eagerly sought by the audit firms, or so widely opposed by investor advocates. The rules permit the firms to mis-characterize a range of services as audit-related and thus downplay the associated conflicts of interest.
The Journal article also illustrates how inadvisable it is to rely too heavily on audit committees to discipline this relationship. Although HealthSouth has now disavowed the disclosures, their excuse for the error is that they “relied on Ernst & Young to classify the audit- and non-audit-related fee information.” Once again we see evidence of an audit committee’s delegating responsibility to the very auditors they are supposed to be supervising. This is just one more reason we believe the Commission and the Public Company Accounting Oversight Board must investigate what advice audit firms are providing to their audit clients on implementation of the new auditor independence rules, including fee disclosure rules, and take action against abusive practices where you find them.
The audit firms give lip service to supporting auditor independence reforms, even while they aggressively defend a business model that threatens that independence. They must be brought into line. We urge you to make it a top priority of the Commission to finish the job that the recently adopted auditor independence rules left undone.
Director of Investor Protection
Consumer Federation of America
Consumer Program Director
U.S. Public Interest Research Group
cc: Commissioner Paul Atkins
Commissioner Roel Campos
Commissioner Cynthia Glassman
Commissioner Harvey Goldschmid
William McDonough, Chairman, Public Company Accounting Oversight Board
Kayla Gillan, Member, PCAOB
Daniel Goelzer, Member, PCAOB
Bill Gradison, Member, PCAOB
Charles Niemeier, Member, PCAOB
Sen. Richard Shelby, Chairman, Senate Banking Committee
Sen. Paul Sarbanes, Ranking Member, Senate Banking Committee
Rep. Michael Oxley, Chairman, House Financial Services Committee
Rep. Barney Frank, Ranking Member, House Financial Services Comm
Sen. Susan Collins, Chairman, Senate Governmental Affairs Comm
Sen. Carl Levin, Ranking Member, Senate Governmental Affairs Comm
1 “What Ernst Did for HealthSouth: Proxy Document Says Company Performed Janitorial Inspections Misclassified as Audit-Related,” by Jonathan Weil, Wall Street Journal, June 11, 2003, page C1.
2 These figures are taken from the Journal article on HealthSouth’s proxy disclosures.