Independence and Preparation of Financial Statements

For many years, preparation of financial statements was considered a part of an attest engagement (audits, reviews compilations). No longer.

The Professional Executive Ethics Committee (PEEC) recently added guidance to the “Nonattest Services” interpretation as follows:

activities such as preparation of financial statements…are considered outside the scope of the attest engagement, and, therefore, are considered a nonattest service

Consequently, if an accountant prepares financial statements (a nonattest service) and performs an attest service (e.g., audit, review, compilation), then consideration should be given as to whether: 

  • the client makes all management decisions,
  • the client properly oversees the service,
  • the client evaluates the adequacy and results of the service, and
  • the client accepts responsibility for the service

We have, for some time now, included the aforementioned language in engagement letters when we have performed both attest services and nonattest services. But the language referring to nonattest services usually addressed tax preparation, depreciation schedule preparation, bookkeeping and the like. Now preparation of financial statements should be listed as another nonattest service and the requisite language concerning client responsibilities (in the previous paragraph) applies to the preparation-of-financial-statements engagement.

The requirement to treat financial statement preparation as a nonattest service is effective for engagements covering periods beginning on or after December 15, 2014. If you, for example, perform a compilation engagement for January 2015 (i.e., a monthly financial statement), the new guidance is applicable. Of course, with regard to compilations, you can lack independence if it is noted in the compilation report. Not true for reviews and audits. CPAs are precluded from performing reviews and audits if their independence is impaired.

Here is the sample relevant paragraph from Illustration 1 of the compilation engagement letters in Section 80 of SSARS 21:

You are also responsible for all management decisions and responsibilities and for designating an individual with suitable skills, knowledge, and experience to oversee our preparation of your financial statements. You are responsible for evaluating the adequacy and results of the services performed and accepting responsibility for such services.

If other nonattest services are to be provided (e.g., tax return), they are to be listed alongside preparation of financial statements.

The client must accept responsibility for financial statements prepared as a part of an audit or a review for periods beginning after December 15, 2014. So, for example, if a client desires for you to perform a review engagement for the first quarter of 2015, the client must be able to oversee your preparation and accept responsibility for the financial statements. If the client is unable to accept that responsibility, then the accountant is not independent and would be precluded from performing the review engagement.

Simply including the standard language in the engagement letter (that management assumes responsibility) is not the same as management actually accepting responsibility.

Obviously, the determination of whether the client can (or has the ability to) accept responsibility is a subjective one. I anticipate additional guidance to be forthcoming from the AICPA to assist CPAs in making this decision.

New AICPA Code of Professional Conduct Effective December 15, 2014

The AICPA’s new Code of Professional Conduct is now effective.

On January 28, 2014, the AICPA Professional Ethics Executive Committee (PEEC) approved the new Code of Ethics Codification. The prior code of ethics evolved over many years without a great deal of structure, making it difficult to find answers to CPA’s ethical and independence questions. The purpose of the new codification is to enhance the clarity and organization of the Code.

You will find the new codification delivers as promised: easy-to-follow and well designed. The AICPA did a fine job with this project.

AICPA Code of Professional Conduct Table of Contents

AICPA Code of Professional Conduct Table of Contents

Table of Contents

The Code is organized into three parts:

  1. Public practice
  2. Members in Business
  3. All other members (including those who are in between jobs or retired)

Effective Dates

The revised Code is effective as of December 15, 2014. The new conceptual frameworks, however, are not effective until December 15, 2015. 

The Code includes a threats and safeguards framework (not effective until December 15, 2015–this delay is provided to give CPAs time to consider and understand the new framework). CPAs will identify threats and then consider safeguards to mitigate those threats. The CPA will be able to proceed with the engagement if threats–after considering safeguards–are at an acceptable level. The conceptual frameworks (there are two–one for members in practice and one for members in business) are to be used only in situations for which the revised code does not contain a specific rule or requirement.

Access to New Code of Conduct

Access to the revised code is free (you may be thinking, finally something free), and users will be able to save searches and bookmark content.

Access the electronic version of the code here.

Download a free PDF version of the code here.

Independence Standards

For CPAs in public practice, the independence standards are located at 1.200.

Merging of AICPA and Yellow Book Independence Rules

If the threats and safeguards framework sounds familiar, it should. You will recall the GAO issued the revised 2011 version of the Yellow Book which includes similar independence language and approaches.

For many years the AICPA and the GAO went in different directions. The result was independence standards that were quite different. Now, thankfully, they are similar.

Comparison of Compilations and Financial Statement Preparation

Here's a summary of how a compilation engagement differs from a preparation service

This post provides a comparison of compilations and financial statement preparation services.

Recently, the Accounting and Review Services Committee of the AICPA issued SSARS 21.

Under SSARS 21, a CPA can use Section 70 — Preparation of Financial Statements or Section 80 — Compilation Engagements. The Preparation option offers some economies of effort, one being that no compilation report is required. But some CPAs have wondered, “What are the difference in the two types of services?”

Here’s a summary.

QuestionPreparing Financial StatementsCompilations
Can notes to the financial statements be omitted?
YesYes
Can the financial statements go to users other management?
YesYes
Considered an assurance service?
NoNo
Considered an attest service?
NoYes
Does the engagement require a report?
No - required wording stating “no assurance is provided” or a disclaimer
Yes - compilation report
Effective for periods ending on or after December 15, 2015 (early implementation permitted)?
YesYes
If the accountant is not independent, is that fact required to be disclosed?
NoYes
Is a signed engagement letter required?
YesYes
Is the accountant required to determine if he or she is independent of the client?
NoYes
Management is responsible for financial statements?YesYes
Minimum documentation
1. Engagement letter
2. Copy of financial statements
1. Engagement letter
2. Copy of financial statements
3. Copy of report
Procedures1. Prepare the financial statements based on the information provided
2. If the accountant becomes aware that supplied information is incorrect or incomplete, request corrected or additional information
1. Read the financial statements
2. Consider whether the financial statements appear appropriate
3. If the accountant becomes aware that supplied information is incorrect or incomplete, request corrected or additional information
4. If the accountant becomes aware that revisions to the financial statements are necessary, request that corrections be made
Is the accountant required to make inquiries or perform other procedures to verify, corroborate, or review information supplied?NoNo
Subject to Peer ReviewNot known at this timeYes
When does the standard apply?
Accountant engaged to prepare financial statements
Accountant engaged to compile financial statements

For additional information about Preparation of Financial Statement engagements, click here.

The New Preparation of Financial Statements Standard

The art of life is a constant readjustment to our surroundings. –Kakuzo Okakaura

Significant change has occurred in the compilation world.

  • The Accounting and Review Services Committee recently added a new twist to the standards that govern the preparation of financial statements. Now CPAs can issue financial statements without a compilation report. To do so, you need to follow the guidance in Section 70 (Preparation of Financial Statements) of SSARS 21. So let’s unwrap this package and see what’s inside.

First, when is the Preparation standard applicable?

Section 70 states it is not applicable when the accountant prepares financial statements:

  • and is engaged to perform an audit, review, or compilation of financial statements
  • solely for submission to taxing authorities
  • for inclusion in written personal financial plans
  • in conjunction with litigation services that involve pending or potential legal or regulatory proceedings, or
  • in conjunction with business valuation services

In other words, the standard applies when you create financial statements that are not for any of the above purposes.

If you create financial statements that will, for example, be used for litigation purposes, then Section 70 does not apply. If you create a balance sheet that is a part of a tax return, Section 70 is not applicable. If you are engaged to create financial statements as a part of a compilation, then, again, Section 70 doesn’t apply. (You will only issue a compilation report when you are engaged to do so. Under Section 70, no compilation report is issued. See my prior SSARS 21 post for more information.)

Difference in Preparation and Merely Assisting

The Preparation standard also makes a distinction between preparing financial statements and merely assisting in the preparation of financial statements.

Preparing refers to the creation of financial statements.

Merely assisting refers to bookkeeping services. Here are examples of accounting services that are not covered by Section 70:

  • Preparing or proposing certain adjustments, such as those applicable to deferred income taxes, depreciation, or leases
  • Drafting financial statement notes
  • Entering general ledger transactions or processing payments in accounting software

Independence Not Required

Bear in mind that the preparation of financial statements and related bookkeeping services (e.g., entering transactions into a general ledger) are both considered nonattest services. So you can do either without considering whether you are independent.

What does this mean? Well, I can process payments for a client (even sign checks or have custody of a client’s assets) and prepare financial statements. Am I independent? No. Does it matter? No, not if I am just preparing financial statements under the guidance of Section 70 (and not issuing a compilation report). Do I need to disclose my lack of independence? No. (If you do issue a compilation report, you need to disclose your lack of independence–as you have in the past.)

Must the accountant verify the accuracy or completeness of the information? No. Remember, however, that AICPA ethics rules prohibit a CPA from issuing financial statements that are intentionally misleading.

Required Wording or Disclaimer?

Each page of the financial statements should include, at a minimum, the words “no assurance is provided” or issue a disclaimer that makes clear that no assurance is provided.

The example disclaimer provided in .A12 of Section 70 reads as follows:

The accompanying financial statements of XYZ Company as of and for the year ended December 31, 20XX, were not subjected to an audit, review, or compilation engagement by me (us) and, accordingly, I (we) do not express an opinion, a conclusion, nor provide any assurance on them.

[Signature of accounting firm or accountant, as appropriate]

[Accountant’s city and state]

[Date]

Can the financial statements omit disclosures?

Yes.

The disclosure of the omission of substantially all disclosures may be made on the face of the financial statements or in a selected note to the financial statements. (Selected disclosure is permissible under Section 70.)

If disclosures are omitted and a special purpose framework is used, then the accountant should include a description of the financial reporting framework on the face of the financial statements.

Engagement Letter Required

An engagement letter is required by Section 70. Both the accountant and the client must sign the letter.

Documentation Requirements

The accountant should retain:

  • A copy of the financial statements
  • The signed engagement letter

That’s it: Nothing else is required.

The documentation may also include any significant consultations or professional judgments.

Subject to Peer Review?

My February 2015 AICPA Peer Review Update (newsletter) states the following:

On November 18, 2014, the Peer Review Board (PRB) issued an exposure draft, which proposed that firms that only perform preparation engagements under AR-C Section 70 – Preparation of Financial Statements (issued as part of Statement on Standards for Accounting and Review Services (SSARS) No. 21, Statement on Standards for Accounting and Review Services: Clarification and Recodification) would not be required to enroll in the AICPA peer review program (Program). However, it also proposed that a firm’s preparation engagements would be included in the scope of a peer review when the firm either elects to enroll in the program (e.g. to comply with licensing or other requirements) or is already enrolled due to other engagements it performs. This proposal was issued in order to address the effect of these engagements on the scope of the Program.

The PRB considered comments raised by the peer review community about the proposal and elected to adopt the proposed guidance changes. The changes are effective for peer reviews commencing on or after February 1, 2015.

The key points of this communication are:

  • Firms that only perform the Preparation of Financial Statement service under section 70 of SSARS 21 are not required to enroll in the AICPA peer review program.
  • Firms that are enrolled in the peer review program will have the Preparation of Financial Statements service included in the scope of their peer reviews.

Note that these are the AICPA rules. Peer review requirements may be more stringent in your state, possibly requiring a peer review–even if you only perform Preparation of Financial Statement engagements. Check with your state board of accountancy.

When can I apply Section 70 of SSARS 21?

Now, if early implemented.

When am I required to apply SSARS 21?

For periods ending on or after December 15, 2015.

Coming SSARS 21 Book

My SSARS 21 book will be available on Amazon in late April. It will be available in Kindle and paperback formats. The book will provide concise overviews of the Preparation and Compilation sections of the standard.

Yellow Book Independence and Preparing Financial Statements – Sufficient SKE

Does your client have sufficient skill, knowledge and experience?

Are you a CPA that prepares city or county financial statements for an audit client? If yes, are you independent under the Yellow Book independence standards?

Yellow Book Independence

Picture from AdobeStock.com

Yellow Book Independence

The 2011 Yellow Book (effective for periods ending after December 15, 2012; http://www.gao.gov/yellowbook) requires that the external auditor document the CPA firm’s independence when the firm also provides nonaudit services (such as preparation of financial statements).  Many small governments have their external auditors prepare their financial statements.

This independence determination will largely hinge on one factor: whether the city or county has a person with sufficient skill, knowledge or experience (SKE) to qualify as a reviewer.

If the government has no one with sufficient SKE, then the external auditor is not independent and can’t ethically perform the audit.

Examples of SKE

Consider the following potential reviewer scenarios:

1. A 15 year mayor who is a businessman, no accounting education, no formal training in reading governmental financial statements, he understands the fund level statements but can’t grasp the reconciliation between the government-wide financial statements and the fund level financial statements.

2. Second year finance director with no prior accounting experience, graduated from a two year college with a degree in general business.

3. Finance director with 25 years experience and is a CPA, member of GFOA, trains others in governmental accounting.

4. Finance director with a high school education but has extensive governmental accounting training from the Carl Vinson Institute, could if he liked, create the financial statements from scratch.

As you can see, the independence assessment will sometimes be black and white, but sometimes there will be shades of gray.

An Alternative

If the auditor can’t get comfortable with the SKE of the government’s financial statement reviewer, there is one alternative: the local government can hire someone outside the government with sufficient SKE to be the reviewer (for example a CPA not affiliated with the external audit firm).

At the end of the day, the local government must have a designated person (either internally or externally) with sufficient SKE for the audit firm to be independent.

Yellow Book: Preparation of Financial Statements – Threat to Independence?

An auditor's creation of a client's financial statements can impair independence

An auditor’s preparation of financial statements can create an independence impairment. The self-review threat has to be overcome.

It was over two years ago that I posted the following information. I’m doing so again, just as a reminder and to provide some clarification.

There has been a great deal of discussion about maintaining independence when an external audit firm prepares the financial statements subject to the Yellow Book.

gao-yellow-book-199x300

Does the preparation of financial statements – considered a nonattest service – impair the external auditor’s independence?

In some cases, the answer is “yes”.

Let’s see how you can avoid this potential problem.

AICPA Practice Aid 

If you identify a significant threat to independence, then safeguards should be implemented to mitigate the threat; both the threat and the safeguards must be documented. (See examples below.)

The AICPA offers an editable 2011 Yellow Book Independence Documentation Practice Aid for $28 (for AICPA members);  the aid, which I recommend, can be purchased at: www.cpa2biz.com.

Yellow-Book-Practice-Aidt-300x198

The following examples were taken from that practice aid (I have bolded certain words):

Preparation of Financial Statement – Threats to Independence

Example 1 (Client has sufficient skill, knowledge or experience (SKE), no significant threat)

The auditor has been requested to prepare the financial statements for an audited entity for which the requirements for performing nonaudit services have been met under paragraphs 3.37 and 3.39 (client assumes responsibility) of the 2011 Yellow Book.  The auditor considered the following in evaluating whether a significant threat to independence existed:

The audited entity’s books and records are substantially complete and accurate.  Few, if any, correcting entries are expected to be proposed.

The individual designated by the audited entity who oversees the preparation of the financial statements possesses SKE sufficient to reperform the service, not just oversee the service.  The designated individual, in order to make better use of his or her time, has asked the auditor to prepare the financial statements. The designated individual will also review the draft financial statements using a comprehensive disclosure checklist.

This is the only nonaudit service that the auditor has been requested to perform.

Conclusion:  Based on the foregoing; the auditor reached the conclusion that preparation of the financial statements would not result in a significant threat to independence; therefore, it is not necessary to apply safeguards.

Example 2 (Client has sufficient SKE, but cannot reperform the preparation of the financial statements, significant threat)

The auditor has been requested to prepare the financial statements for an audited entity for which the requirements for performing nonaudit services have been met under paragraphs 3.37 and 3.39 (client assumes responsibility)  of the 2011 Yellow Book.  The auditor considered the following in evaluating whether a significant threat to independence existed:

The audited entity’s books and records are substantially complete and accurate.  Few, if any, correcting entries are expected to be proposed.

The individual designated by the audited entity who oversees the preparation of the financial statements possesses SKE sufficient to oversee the service but is not capable of reperformance.

This is the only nonaudit service that the auditor has been requested to perform.

Conclusion:  Based on the foregoing; the auditor reached the conclusion that preparation of the financial statements would result in a significant threat to independence; therefore, it would be necessary to apply safeguards.

aid-example

 Safeguards

When there is a significant threat, the audit firm must apply safeguards; here are some examples of such safeguards:

  1. Have someone not involved in planning or supervising the audit engagement review the financial statements before releasing the statements.
  2. Educate management on the nonaudit services performed by reviewing and explaining the basis for preparing the financial statements, so that management is in a position to determine or approve all assumptions and judgments and take responsibility for the financial statements.
  3. Request that the audited entity complete a disclosure checklist as part of the overall review of the financial statements.
  4. Include the audit engagement as a required Engagement Quality Control Review under the audit firm’s system of quality control.

Not all of these safeguards need be applied, just the ones necessary to reduce the risk to an acceptable level.

Required Minimums

The audited entity must always accept responsibility for the financial statements and must approve them or else the general requirements under Interpretation No. 101-3 and paragraph 3.37 of the 2011 Yellow Book will not be met.

In all cases, management (or its designee) must possess sufficient skill, knowledge or experience; the designee may be a second CPA firm or professional but cannot be the audit firm.

Note as of November 19, 2017: The GAO is working on a revision of the Yellow Book. So, once the new Yellow Book is issued, you’ll need to follow that guidance. 

Preparation of Financial Statements and Independence

Your firm’s preparation of financial statements for an attest client may impair your independence. And, of course, you can’t perform audits or reviews if you are not independent.

When might your firm’s independence be impaired?

When a client does not have a person with suitable skill, knowledge, and/or experience (SKE) to review the financial statements (prepared by the auditor) and assume responsibility.

If the client can’t assume responsibility, the auditor is deemed to be attesting to his own work (the self-review threat).

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PEEC Adopts New Code of Conduct

As I recently posted, the AICPA Professional Ethics Executive Committee (PEEC) adopted a revised Code of Conduct that will be effective for engagements covering periods beginning on or after December 15, 2014. The new Code provides enhancements to independence standards, highlighting that preparation of financial statements is a nonattest service.

AICPA and GAO Independence Standards Converging

If you followed the changes to Yellow Book independence standards, this all sounds familiar. And it should. The AICPA and the GAO are intentionally moving in the same direction, which is a good thing–no need for competing standards.

A problem arises however.

Say your small business client does not have a person with sufficient education or experience to assume the responsibility for the financial statements, then what? You would no longer be independent and could not provide audit or review services.

Recently I received my Reviewer Focus newsletter from the AICPA (information provided to peer reviewers), and this letter plainly states that auditors must be “satisfied that management has agreed and can assume all management responsibilities.” This includes overseeing the preparation of financial statements. An engagement would be considered “nonconforming” if the auditor lacks independence (due to the client’s lack of requisite SKE). Clearly, the AICPA is placing more emphasis on clients being able to assume responsibility for their financial statements.

I believe this dynamic creates significant problems for small businesses when CPAs review or audit their financial statements. If the independence issue arises, it may be necessary to involve a second person or firm (another CPA or CPA firm). This second party would review the statements on behalf of the client, thus enabling the client to assume responsibility. (Yes, I know this increases the client’s cost–just saying.)

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To remain independent, you need to determine that the client has requisite skill, knowledge, and/or experience.

Documentation of Independence

Documentation of your independence is another issue, but a CPA’s lack of documentation does not–in and of itself–lead to an impairment of independence.

You’re familiar with the standard language that goes into most engagement letters with regard to performing nonattest services such as maintaining depreciation schedules or providing tax services. Well now you will add one more: preparation of financial statements. But remember this issue is more than just adding a few words to the engagement letter.

It’s about determining that the client has sufficient SKE.