# Presentation: 519054

## SEC Proposed Rule:Revision of the Commission’s Auditor Independence Requirements

-         TIME WARNER

- James W. Barge
- Vice President and Controller

## 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

## Overview

- Independence is critical to promote investor confidence and efficient capital markets
- Generally, we agree with the SEC’s 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

## 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

## Properly Designed Internal Audit Outsourcing Does Not Impair Independence

- With regard to internal audit outsourcing, we agree with the AICPA Ethics Committee’s 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

## 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

## 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

## 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)

## 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

## 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

## 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

## 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

## 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

## Changing Service Providers Would Be Burdensome

- New vendor needs to acquire knowledge of the company’s 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

## 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

## 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

## 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