Aug 28th 2009
By Cathy Allen
You call a meeting with your audit client, Baylaer Medical Devices, to discuss an advisory service they’ve asked your firm to perform. The service would help the private company identify possible financing sources to fuel much-needed growth and expansion – an important goal. You explain to the treasurer that she or another competent person would need to oversee your firm’s services, make any necessary management decisions, and so on. The treasurer listens carefully and looks pensive….
What is Interpretation 101-3?
Interpretation 101-3 (Performance of Nonattest Services) of the AICPA Code of Professional Conduct addresses whether and to what extent professionals may perform nonattest (i.e., tax and consulting) services for their attest clients. 101-3 has been in the Code since the 1970s and has received its share of attention over the years. The rule has been subject to much debate; some think it does not go far enough while others believe it is too onerous.
The 1977 version of 101-3, entitled Accounting Services, provided the ethical requirements members had to meet to help their clients with bookkeeping or data processing services and remain independent. Many of the basic principles embedded in today’s rule also appeared in the earlier version. For example, the old rule prohibited members from performing management functions and stated that “when necessary, the CPA must discuss accounting matters with the client to be sure that the client has the required degree of understanding.”
Unfortunately, 101-3 has been misunderstood. Some believe audit firms cannot perform any consulting services, such as bookkeeping, valuation or internal audit services for their attest clients. Others think all nonattest services are permitted under AICPA rules. Persons holding the latter view often know that auditors of public companies and entities subject to government auditing rules face significant restrictions on nonattest services. However, they think there are no real limitations imposed on services performed for private attest clients as long as management agrees to make all of the decisions. Neither view is correct. Whether a service may be performed depends mainly on (1) the nature of the services and (2) whether the client is willing and able to meet its responsibilities. Familiarity with the rule’s fundamentals is essential to understanding the AICPA rule.
The rule only applies when a firm has an attest relationship with a client. While members have an obligation to render all professional services objectively, 101-3 and other independence rules only apply when a member’s firm has an attest relationship with a client. Once an attest relationship exists, 101-3 applies to all nonattest services, including tax services, provided by the firm during the period of the professional engagement and the period covered by the financial statements. The period of the professional engagement starts when the attest engagement letter is signed or attest work begins, whichever is earlier. If the attest work will be ongoing (e.g., an annual audit or review), then the professional engagement period will be ongoing. The period covered by the financial statement is the period of the financial statements (or other subject matter) that will be addressed by your attest report.
A critical part of applying 101-3 occurs before you perform the engagement. Pre-engagement consideration is critical to applying 101-3. First, your client’s management must agree to the following conditions: (1) make all management decisions and perform all management functions in connection with the engagement, (2) designate a competent individual to oversee the nonattest services, (3) evaluate the adequacy and results of the services performed, and (4) accept responsibility for the results of the services. Then, you must establish and document your understanding with management regarding the objectives of the engagement, services to be performed, management's acceptance of its responsibilities, your firm’s responsibilities, and any limitations on the engagement.
Avoid management functions. A crucial element of the rule is the client’s designation of a person who is willing and able to perform all management functions; this helps to ensure that you and other members of your firm will not make decisions for management or perform their job. Throughout the engagement, you should be on guard for signs of “scope creep,” that is, expansion of your services that could taint your independence.
Beware of scope creep. Back to the earlier story: your firm accepts the engagement to help Baylaer Medical Devices identify new funding. The client’s treasurer is your primary contact. You are confident in her abilities to oversee the services and proceed. Half-way into the project, she becomes distracted with other matters, including the loss of a key employee. Expressing total confidence in your judgment, the treasurer asks you to help out by taking on more responsibility so she can attend to these pressing matters. This presents a thorny issue.
Staying on Track. Swift communication with the client to explain why you cannot perform management functions is critical. This is where your finely-tuned engagement letter or other pre-engagement documentation is invaluable. Refer to your agreement and explain the implications of impaired independence and how it would prevent your firm from performing subsequent attest services. At that point, a decision will have to be made. Attest or nonattest?
About the author
Cathy Allen, founder of Audit Conduct, LLC helps CPA firms enhance their quality controls over independence and ethics compliance. Contact her at [email protected].