Independence Update for CPA firms – the Little Squeeze | AccountingWEB

Independence Update for CPA firms – the Little Squeeze

 Independence Update for CPA firms – the Little Squeeze


The GAO FINALLY came out with an internet version of Yellow Book in late August.  Why an internet version and not a ‘final version’? Because the AICPA also has a major update pending as they ‘clarify’ their auditing standards.  (Here is hoping that the clarification project actually make those onerous standards clear!  Please!)


The GAO and AICPA work very closely on their standards and don’t tend to surprise each other with radical moves, so what we see in the internet version should be final.  But the GAO is leaving itself a little flexibility in case something unexpected happens at the AICPA.


No one expects the independence section of the 2011 Internet Version of GAGAS to change much – as it is based on old AICPA standards regarding independence.  In this version of the Yellow Book, the GAO extracts what the AICPA has to say about independence in its Code of Ethics Section ET Section 101  and adds a few more tidbits that apply to government organizations OR that the GAO can’t help but emphasize specifically.


What is the bottom line for CPAs in public practice following the yellow book standards?  This version of independence viewed in tandem with SAS 115 is going to make it harder to justify creating the financial statements of entities that don’t have financially savvy people on hand.  As you know, the standards are heavily influenced by the jumbo accounting firms that don’t have little tiny, two-person, not-for-profits as clients.


Here are the main points that CPA firms should pay attention to as I dissect this revised pronouncement (I will dissect it from the perspective of an internal auditor or legislative auditor in a future newsletter):


1. Creating the financial statements is a non-audit service


2. The client needs to claim the responsibility for the results of the non-audit service in order for the auditor to maintain their independence


3. The client needs to have the knowledge, skills, and experience to be able to discern whether the non-audit service was done correctly


4. SAS 115 encourages us to report when the client is unable to create their own financial statements and point out that the client does not have anyone knowledgeable about finance on staff (in other words, no one on staff to discern whether the non-audit service was performed correctly)


5. The auditor must document their reasoning that performing the non-audit service  does not impair their independence


Did you catch that little squeeze there?  You can’t prepare the financial statements if the client can’t discern whether you did a good job.  And you are supposed to report it – per SAS 115 - when the client can’t discern whether your work is any good.  SO, if you are dealing with a client who can’t discern whether your work is any good ( that the financial statements are prepared correctly), you are going to have a hard time justifying why you prepared the financial statements.  


Let’s see how this all breaks out in the 2011 internet version (I added bolded text for emphasis!):


1. Creating the financial statements is a non-audit service


Relevant clauses under the yellow book header “Consideration of Specific Nonaudit Services” include:


3.45 By their nature, certain nonaudit services directly support the entity’s operations

and impair auditors’ ability to maintain independence in mind and appearance. The

nonaudit services discussed below are among those frequently requested of auditors

working in a government environment. Some aspects of these services will impair an

auditor’s ability to perform audits for the entities for which the services are provided.

The specific services indicated are not the only nonaudit services that would impair an

auditor’s independence.


3.52 Services related to preparing accounting records and financial statements that an auditor may be able to provide to an audited entity if the conditions in paragraph 3.46 are met include:

a. recording transactions for which management has determined or approved the appropriate account classification, or posting coded transactions to an audited entity’s general ledger;

b. preparing financial statements based on information in the trial balance;

c. posting entries that have been approved by an audited entity’s management to the entity’s trial balance;

d. preparing account reconciliations that identify reconciling items for the audited entity management’s evaluation; and

e. proposing standard, adjusting, or correcting journal entries or other changes affecting the financial statements to an audited entity’s management provided management reviews and accepts the entries and the auditor is satisfied that management understands the nature of the proposed entries and the impact the entries have on the financial statements.


2. The client needs to claim the responsibility for the results of the non-audit service in order for the auditor to maintain their independence


Relevant 2011 internet versions of GAGAS clauses here include:


3.51 Management is responsible for the preparation and fair presentation of the financial statements in accordance with the applicable financial reporting framework, even if the auditor assisted in drafting those financial statements. Consequently, an auditor’s acceptance of responsibility for the preparation and fair presentation of financial statements that the auditor will subsequently audit would impair the auditor’s independence.


3.37 Auditors performing nonaudit services for entities for which they perform audits should obtain assurance that audited entity management performs the following functions in connection with the nonaudit services:

a. assumes all management responsibilities;

b. oversees the services, by designating an individual, preferably within senior

management, who possess suitable skill, knowledge, or experience;

c. evaluates the adequacy and results of the services performed; and

d. accepts responsibility for the results of the services.


3.39 In connection with nonaudit services, auditors should establish and document their

understanding with the audited entity’s management or those charged with governance,

as appropriate, regarding the following:

a. objectives of the nonaudit service;

b. services to be performed;

c. audited entity's acceptance of its responsibilities;

d. the auditor’s responsibilities; and

e. any limitations of the nonaudit service.




3. The client needs to have the knowledge, skills, and experience to be able to discern whether the non-audit service was done correctly


Under the header “Requirements for Performing Nonaudit Services” in the 2011 internet version of the yellow book:


3.34 Before an auditor agrees to provide a nonaudit service to an audited entity, the auditor should determine whether providing such a service would create a threat to independence, either by itself or in aggregate with other nonaudit services provided, with respect to any GAGAS audit it performs. A critical component of this determination is consideration of management’s ability to effectively oversee the nonaudit service to be performed. The auditor should determine that the audited entity has designated an individual who possesses suitable skill, knowledge, or experience, and that the individual understands the services to be performed sufficiently to oversee them. The individual is not required to possess the expertise to perform or reperform the services. The auditor should document consideration of management’s ability to effectively oversee nonaudit services to be performed.


3.35 If an auditor were to assume management responsibilities for an audited entity, the management participation threats created would be so significant that no safeguards could reduce them to an acceptable level. Management responsibilities involve leading and directing an entity, including making decisions regarding the acquisition, deployment and control of human, financial, physical, and intangible resources.


3.38 In cases where the audited entity is unable or unwilling to assume these responsibilities (for example, the audited entity does not have an individual with suitable skill, knowledge, or experience to oversee the nonaudit services provided, or is unwilling to perform such functions due to lack of time or desire), the auditor’s provision of these services would impair independence.



4. SAS 115 encourages us to report when the client is unable to create their own financial statements and point out that the client does not have anyone knowledgeable about finance on staff (in other words, no one on staff to discern whether the non-audit service was performed correctly).


The appendix to SAS 115 (Exhibit B) gives auditors examples of weaknesses in internal control that might be reportable.  Although this list was not intended by the AICPA to be a checklist of reportable conditions, the inability of the client to create the financial statements is mentioned specifically.


Exhibit B of SAS 115: Examples of Circumstances That May Be Deficiencies, Significant Deficiencies, or Material Weaknesses:

Paragraph .15 of this section identifies indicators of material weaknesses in internal control. The following are examples of circumstances that may be deficiencies, significant deficiencies, or material weaknesses:

• Employees or management who lack the qualifications and training to fulfill their assigned functions. For example, in an entity that prepares financial statements in accordance with generally accepted accounting principles (GAAP), the person responsible for the accounting and reporting function lacks the skills and knowledge to apply GAAP in recording the entity's financial transactions or preparing its financial statements….


And a reportable condition is defined in SAS 115 (a.k.a. AU 325.05)  a deficiency in internal control exists when the design or operation of a control does not allow management or employees, in the normal course of performing their assigned functions, to prevent, or detect and correct misstatements on a timely basis.  


So, the auditee may have their act together in some other way to prevent or detect misstatements – but if you decide that having financially savvy staff is a key control and you have reported it in the past as a material weakness or significant deficiencies, you may have just painted yourself into a corner!  If in the past you have said the client is unable to review your work, then how can you justify creating their financial statements?


5. The auditor must document their reasoning that performing the non-audit service  does not impair their independence.


And unlike the AICPA standards where we get to reason through independence in our heads, in the GAO world, we get to write our reasoning process down.


Under the header “Documentation”:


3.59 Documentation of independence considerations provides evidence of the auditor’s judgments in forming conclusions regarding compliance with independence requirements. GAGAS contains specific requirements for documentation related to independence which may be in addition to the documentation that auditors have previously maintained. While insufficient documentation of an auditor’s compliance with the independence standard does not impair independence, appropriate documentation is required under the GAGAS quality control and assurance requirements.35 The independence standard includes the following documentation requirements:

a. document threats to independence that require the application of safeguards, along with safeguards applied, in accordance with the conceptual framework for independence

as required by paragraph 3.24;

b. document the safeguards required by paragraph 3.30 if an audit organization is structurally located within a government entity and is considered independent based on those safeguards;

c. document consideration of audited entity management’s ability to effectively oversee a nonaudit service to be provided by the auditor as indicated in paragraph 3.34; and

d. document the auditor’s understanding with an audited entity for which the auditor will perform a nonaudit service as indicated in paragraph 3.39.


Read c and d above one more time.  J


I must admit to being a little disappointed – again – that the GAO didn’t expressly come out and prohibit auditors from creating the subject matter that they later opine upon.  If you have read my writings over the years or seen me harp on this topic in person – then you know my perspective on this subject.


But in a sly, backdoor sort of way – the GAO has made it hard for auditors of financially immature small entities to justify creating the financial statements.  Yes, I read as you did that the entities don’t need to be able to create the financials (see section 3.34 above)– but someone at the entity does need to be able judge whether the auditor did it right.


And I have already heard auditors figure out the way around this dilema.   Auditors want to keep doing what they have been doing for years.  These auditors reason that they are really the best ones to create the financial statements.  So they decide that – going forward - they won’t report their client’s incompetence in their audit report.  They also decide that the client should sign a letter saying they are responsible for the subject matter.  Both of these are cheesy-cover-your-asset moves.  


I can have my seven-old-daughter sign a piece of paper saying that she is responsible for my family’s asset portfolio – it doesn’t mean much, does it?  Imagine me actually abdicating responsibility to her!  Whoa.  Why would the government want to fund organizations with 7 year-olds at the helm?  


And not reporting their financial incompetence is contrary to two the core tenants of governmental auditing – transparency and accountability.  But there I go again… bla bla bla… harp harp harp.


I recommend you read the entirety of sections 3.02-3.59 of the 2011 Internet Version of the Yellow Book ( for yourself and make your own call regarding this issue.  Also, make sure to read the extra guidance in the appendix at A3.02-A3.09. 


As disappointed as I am, I am at least glad that this debate is at rest for the time being.   Or is it?


Courses:  Essential Audit Skills and the Art of the Finding qualifying for Yellow Book hours in Austin this fall.  See  

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Governmental auditors unite! Leita Hart-Fanta, CPA, CGFM, and CGAP is the author of “The Yellow Book Interpreted” and owner of a website devoted to training for governmental auditors. Whether you are an internal auditor or monitor for a government entity or a CPA doing grant audits, you will enjoy Leita’s humorous take on the complexity of auditing in the government environment.

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