SEC Proposed Rule: Revision of the Commissions Auditor Independence Requirements

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SEC Proposed RuleRevision of the Commissions
Auditor Independence Requirements
James W. Barge Vice President and Controller

• TIME WARNER

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Table of Contents

• Overview
• Summary of Views Relating to Non-Audit Services
• Properly Designed Internal Audit Outsourcing Does
  Not Impair Independence
• Proposal Raises Practical Issues
• Internal Audit Outsourcing with the External
  Audit Firm Results in Efficient and Effective
  Audits
• Changing Service Providers Would Be Burdensome
• Time Warner Proposed Solution
• Anticipated Results of Time Warner Proposed
  Solution

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Overview

• Independence is critical to promote investor
  confidence and efficient capital markets
• Generally, we agree with the SECs four governing
  principles. Our comment letter provides some
  suggestions
• This presentation focuses on experience that we
  have had in the area of internal audit outsourcing

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Summary of Views Relating to Non-Audit Services

• Generally, support precluding non-audit services
  as proposed
• Support proposed disclosure of fees relating to
  non-audit services
• Also, would support a requirement to communicate
  with the audit committee all decisions to
  outsource internal audit
• However, we believe properly designed internal
  audit outsourcing arrangements do not impair
  independence
• Proposal raises practical issues
• Changing service providers would be burdensome
• In addition, we believe outsourcing internal
  audit with the external audit firm is more
  efficient and effective than outsourcing to
  another firm

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Properly Designed Internal Audit Outsourcing Does
Not Impair Independence

• With regard to internal audit outsourcing, we
  agree with the AICPA Ethics Committees
  Interpretation Section 101.15 (ET 101.15)
• The AICPA concluded properly designed internal
  audit outsourcing arrangements provided by the
  external auditor do not impair independence
• ET 101.15 states that internal audit outsourcing
  can be provided by the external auditor without
  impairing independence, if a member of management
  is
• responsible for the internal audit function
• determines the scope, risk and frequency
• evaluates the findings and results
• evaluates the adequacy of the procedures
  performed

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Properly Designed Internal Audit Outsourcing Does
Not Impair Independence (cont.)

• For purposes of evaluating the potential impact
  on independence, we believe internal audit
  consists of two meaningful functions
• Management function - develops plan, oversees
  execution, evaluates results of internal audit
  plan and communicates significant findings to
  operating management and the audit committee
• Procedural function - performs the work necessary
  to execute the predetermined internal audit plan
• The procedural function is not performing the
  original work--only attesting to the
  appropriateness of the original work
• The procedural function represents selective
  testing and review of what is an already
  effective system of internal controls

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Properly Designed Internal Audit Outsourcing Does
Not Impair Independence (cont.)

• We agree that outsourcing the management function
  would impair independence as the auditor would be
  perceived to be acting in a management capacity
• However, the outsourcing of the procedural
  function does not impair independence as such
  procedures are attest in nature and are routinely
  performed in the normal course of any external
  audit
• The external auditors are uniquely qualified to
  perform these attest procedures

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Proposal Raises Practical Issues

• The outsourcing of the procedural function of
  internal audit is no different than
• the external auditor performing agreed-upon
  procedures at the direction of management (e.g.,
  TW requests an annual review of transactions
  surrounding its securitization facility. TW also
  has requested a review of compliance with rate
  contracts entered into with external vendors)
• expanded external audit procedures performed at
  the direction of management (e.g., TW asked for
  extra procedures focusing on our implementation
  of FAS 133)

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Proposal Raises Practical Issues (cont.)

• It seems awkward to preclude services provided as
  a part of the procedural function of internal
  audit, which is under the direction of management
  and the audit committee, that are similar to
  services permitted to be provided as part of
  extended external audit procedures or agreed upon
  procedures

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Proposal Raises Practical Issues (cont.)

• Example TW has a center in Florida that
  services customer fulfillment for TW subsidiaries
  as well as outside third parties
• To satisfy requests from third parties, TW could
  request external auditors to review system to
  ensure it is functioning as intended as part of
  an agreed upon procedures engagement. In this
  circumstance, a report covering such procedures
  would be formally issued by the external auditor
• Alternatively, if TW management wanted general
  comfort on the operations of the system, TW
  management could request that the scope of the
  external audit be expanded to perform certain
  procedures. In this circumstance, no formal
  report would be issued relating to such
  procedures
• Ironically, the proposed release would prohibit
  such a review to be done by the external auditors
  if it were performed under the banner of an
  internal audit outsourcing engagement

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Proposal Raises Practical Issues (cont.)

• The Commission requires an adequate system of
  internal controls
• Registrants establish an effective internal
  control system subject to their own ongoing
  monitoring
• An internal audit function is not required in
  order to have an adequate system of internal
  controls
• However, best practices endorse comprehensive
  testing of the internal control system, including
  the establishment of an internal audit function
• We think the Commission should be encouraging
  best practices (whether achieved through
  outsourcing or otherwise) rather than placing
  restrictive limitations over the pursuit of such
  practices
• Everyone benefits from more extensive testing
  whether performed by internal or external auditors

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Internal Audit Outsourcing with the External
Audit Firm Results in Efficient and Effective
Audits

• Outsourcing with the external auditors provides
  for more efficient and effective audit coverage
• Seamless coordination between internal and
  external audits
• Consistent audit processes and methodologies
• Increased and more efficient use of knowledge of
  the company
• No competitive posturing

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Internal Audit Outsourcing with the External
Audit Firm Results in Efficient and Effective
Audits (cont.)

• Benefits and strengths carry over to external
  audit service
• Increases external auditors understanding of the
  company
• Increases the likelihood that external auditor
  will detect errors
• Improved suggestions from external auditor about
  strengthening internal controls

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Changing Service Providers Would Be Burdensome

• New vendor needs to acquire knowledge of the
  companys businesses and systems
• Higher external audit fees due to
• Review of internal audit work prepared in an
  unfamiliar approach and format
• Less integration of internal and external audit
  efforts
• Overall audit effort is less efficient

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Time Warner Proposed Solution

• Generally support precluding non-audit services
  as proposed, including complete outsourcing of
  internal audit
• Recommend permitting the outsourcing of the
  procedural function of internal audit
• Internal audit team reports to company management
  and audit committee who is responsible for the
  internal audit function
• Internal audit mission, strategy and plan are all
  created by management and approved by the audit
  committee
• Auditors only execute attest procedures pursuant
  to an internal audit plan which has been
  developed by management and approved by the audit
  committee
• Management and audit committee evaluate findings

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Time Warner Proposed Solution (cont.)

• Recommend developing a requirement to communicate
  with the audit committee all decisions to
  outsource internal audit
• Support proposed disclosure of non-audit services

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Anticipated Results of Time Warner Proposed
Solution

• Companies and audit committees will make informed
  judgments about internal audit outsourcing and
  independence
• Companies and audit committees will be able to
  consider using the external auditors for internal
  audit outsourcing thereby achieving more
  efficient and effective audit coverage
• Disclosure will give investors the ability to
  decide whether perceptions of auditor
  independence have been affected by the external
  auditor providing non-audit services
• Cost of capital will reflect investors comfort
  level with judgements about independence and
  force efficient behavior