NEWS AND RESOURCES

Tax and Financial News for September 2004

Everyone Deserves Independence

In reviewing the articles we have included in this column over the past year, we found we have been a bit remiss in our duties. You see, this column falls under the general heading of Tax and Financial News, but we have concentrated exclusively on taxation. While we believe there to be good reasons for concentrating on taxation, this month we wish to discuss some accounting news. This falls under the sub-topic of If You are in Business and Haven't Heard this One Yet, You Soon Will.

No doubt you have heard about the financial problems of such companies as Enron, Xerox, MCI and a few other companies over the past three or four years. Assuming you have heard of these companies, you've probably heard of their accountants and the trouble they got into over the audit failures of these companies.

While there may have been many reasons for the failure of the auditors to catch improper accounting and outright fraud, one cause in many instances was the auditors' lack of independence. Most of the time this lack of independence resulted from the auditor performing services other than audits for a company. A typical example might be assisting management in designing an accounting system for a client the accountant audits.

Many times, fees for performing consulting type services, also known as nonattest services, far exceed the cost of an audit. The combination of the audit fee and this additional work can make the client so attractive to a firm that the firm would literally do anything to keep the client. If you had a client that paid audit fees of $50,000, but nonattest fees of $250,000 each year, wouldn't you bend over backwards to keep the client happy, even if it meant violating a few accounting rules? Maybe you wouldn't be so accommodating, and truth be told, most accountants are not that accommodating, but unfortunately, this situation arose too often in public companies over the past few years for government regulators and the audit profession to ignore. This is why all auditors of public companies are now subject to more stringent independence rules.

Things would be fairly simple for the vast majority of companies audited annually by smaller firms if our story ended at the public company level, but it doesn't. Even though the regulators of nonpublic companies don't mandate their independence standards be applied to closely held companies, a new ethics interpretation issued by the American Institute of Certified Public Accountants ("AICPA") tightens up considerably on rules governing independence for all CPAs regardless of the size of the company.

Ethics Interpretation 101-3, Performance of Nonattest Services, will, without doubt, cause confusion on the part of accountants and their clients when full implementation begins on January 1, 2005. In general, it broadens the situations in which a CPA will be deemed as not independent and sets up higher hurdles to reaching independence.

It has always been the case that a member of the AICPA had to remain independent to perform either an audit or a review engagement. These are the two higher levels of "attest" engagements performed by CPAs. They are labeled "attest" engagements because the CPA is, in some way, giving the user assurance about the reliability of the financial statements. The lowest level of attest engagement is a compilation. An accountant need not be independent when reporting on compiled financial statements, but must disclose that fact.

Interpretation 101-3 makes it clear that an accountant can't make management decisions or perform management functions without impairing independence. It also sets up documentation requirements for CPAs to follow whenever they perform attest type engagements for a client. In general, a CPA can perform nonattest services for an attest client if the client agrees to all of the following with respect to the nonattest engagement:

  1. Management must make all management decisions and perform all management functions;
  2. Management must designate a responsible employee, preferably within senior management, to oversee the engagement;
  3. Management must take responsibility for evaluating the adequacy of the services performed and their results;
  4. Management must accept responsibility for the results of the services; and
  5. Management must establish and maintain internal controls over the activities that are the subject of the nonattest services.

In short, now there must be someone at the client company who has sufficient knowledge to judge the results of the work performed and this could be potentially devastating to the present roles of the auditor and client, especially where the client is small. Traditionally, many clients have maintained their records throughout the year expecting the auditor to come in and make any adjustments necessary to properly state the financial statements. The understanding is that there will be a fair number of journal entries and, in many cases, the client won't fully understand why the entries are made, just that they need to be made.

Under the new rules, the auditor will not be independent if the auditor makes adjusting entries and the client does not fully understand the nature of, reason for and impact of the entries. The auditor will, in a sense, be making decisions for management that only management has the right to make.

If a firm prepares the monthly books for a client, and makes account coding decisions, or writes checks for the client, independence will be impaired. If this happens, the resulting report will likely be a compilation and the CPA will be able to issue the report if it includes a statement that the accountant is not independent with respect to the client. The problem will arise when the same accountant seeks to perform an audit of the client's financial statements at year-end. The CPA will be precluded from performing such tasks. This will require the CPA to decide which engagement he or she wants to keep. This, in turn, could cause additional costs to be incurred by the client because two accountants will be required.

There are a number of situations where the services previously performed by an auditor or CPA performing a review of financial statements will now be precluded from performing those services. We don't intend to go into all of them here. Suffice it to say that new rules will shortly be in effect and those rules may change the services your CPA can perform for you. In some instances, this could mean only that an additional sentence must be added to a compilation report and in other instances this may mean you will need to find another CPA to provide the services your CPA cannot now perform. Your CPA will be able to guide you on these areas.

Accounting and the rules for reporting on financial information have always been tricky. Now more than ever, the rules are more complicated. If your CPA has informed you that he or she must refrain from some services previously performed, understand that it has nothing to do with your relationship. Your CPA is only trying to follow the rules. If this should happen, give us a call if you need to replace the expertise previously provided by your CPA. We are here to help and always welcome the possibility of helping a new client.

Until October, have a great month.

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