Yellow Book Independence and Preparing Financial Statements

Governmental clients must have sufficient SKE when auditors to prepare their financial statements

Yellow Book independence is critical for Yellow Book engagements.

Yellow Book Independence

Are you a CPA that prepares city or county financial statements for an audit client?

If yes, are you independent?

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.

Having Sufficient Skill, Knowledge, and Experience

When auditors prepare financial statements, the 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 (and prepare the financial statements).

Yellow Book independence

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).

Bottom Line

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.

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