May 24, 2005
To our peer review clients:
Annually we make an effort to highlight recent changes in professional standards for our peer review clients. We hope what follows is helpful to you in your accounting and auditing practice.
New Independence Rule Documentation Requirement
In September 2003 the AICPA issued a revision to Ethics Interpretation 101-3, Performance of Nonattest Services, which may be one of the more controversial amendments to professional standards in recent memory, affecting the compilation, review, audit and other attest services you perform.
According to the revised Interpretation, when you perform a nonattest service, such as income or payroll tax preparation, or preparation of depreciation schedules, for an attest client you have lost your independence unless certain conditions are met.
One of the conditions is that for services rendered after December 31, 2004, you document in writing the understanding established with the client concerning the nonattest services provided.
The documentation requirement was particularly controversial because according to the standards you would lose your independence if you did not obtain the written understanding. This, in turn, would make the engagement substandard. Such substandard engagements would likely have led to modified or adverse peer review reports.
Fortunately, in January 2005 the AICPA Ethics Committee issued additional guidance, stating that the failure to prepare the documentation would not impair independence provided the understanding between the CPA and the client did in fact exist. Failure to document will still be considered a violation of Ethics Rule 202, however.
The new guidance that the AICPA Ethics Committee issued in January 2005 also redefined some of the terminology. For example, the September 2003 revision required management to designate a “competent employee” to oversee accounting or auditing services. The January 2005 revision replaces “competent employee” with “an individual who possesses suitable skill, knowledge, and/or experience.” In addition, this individual no longer has to be an employee.
One way to document the understanding is in your engagement letter. The following suggested wording incorporates the latest guidance from the AICPA:
You are responsible for management decisions and functions, including approving all journal entries and general ledger classifications when they are submitted to you, and for designating an individual who possesses suitable skill, knowledge, and/or experience to oversee any bookkeeping services, payroll services, tax services, profit-sharing plan services, and other services we provide. You are responsible for evaluating the adequacy and results of the services performed and accepting responsibility for such services. You are responsible for establishing and maintaining internal controls related to the services we may perform.
Additional Implications of New Independence Rule
Revised Ethics Interpretation 101-3 reemphasized the importance of obtaining client approval for the adjusting journal entries that you prepare on the client’s behalf. Without this approval you are deemed to become part of management and as a result have lost your independence. There is no requirement that this approval be documented, but many firms are having clients review the journal entries together with a draft copy of the financial statements, and then asking the client to initial a copy of the journal entries or a cover sheet, and return this to the firm before the firm issues the financial statements. This policy results in a delay if the client does not respond timely. Another approach to documenting client approval might be to obtain negative assurance. Perhaps this could be accomplished by sending a transmittal letter to the client along with the journal entries. In the letter you could state that if the client does not respond within a specified timeframe that will serve as notice that the client has reviewed and approved the entries.
You may not necessarily write formal journal entries for all of your bookkeeping or income tax clients. This is particularly true with Quickbooks clients. If you are making entries directly to the client’s general ledger you should ask the client to review the general ledger report and approve your account classifications. This approval might be documented with initialing or a negative-assurance letter as described in the previous paragraph.
In recent years FASB has been issuing standards that substitute fair values for the historical cost model that has historically been the basis for GAAP. An example of this is SFAS No. 142 on goodwill. You need to take care, particularly with smaller clients, that you do not determine the fair values. The client must make this determination. This is because under Ethics Interpretation 101-3 you lose your independence if you determine fair value, the determination includes subjective elements, and the results are material to the financial statements. This presents a problem in particular with respect to FASB Interpretation No. 46: Consolidation of Variable Interest Entities. Although issued in January 2003, FASB issued a revised Interpretation 46 in December 2003. The effective date for FIN 46R is imminent, and it requires that fair value be used to determine whether an entity is a variable interest entity that should be consolidated into the operating company. There is more discussion on this below under “New Accounting Standards.”
Peer Review Standards
The new peer review standards are effective for peer reviews commencing on or after January 1, 2005. There are a number of significant revisions, among them a requirement that the firm undergoing peer review make written representations to the peer reviewer, and a requirement that the peer reviewer not provide you with a list of the engagements selected for review any earlier than two weeks prior to the commencement of a system review. In addition, on a system review at least one of the engagements selected cannot be identified until after commencement of the field work. Under the new standards, if a firm receiving a report or engagement peer review performs an engagement that would have required a system review (e.g., an audit), the reviewed firm must immediately notify the administering entity and undergo a system review within 18 months. If a reviewed firm wants to exclude an engagement from the scope of a peer review it must request a waiver from the administering entity prior to the commencement of the review.
New Compilation and Review Standards
Statement on Standards for Accounting and Review Services No. 10 issued in May 2004 requires expanded inquiries regarding fraud, requires additional representations about fraud in the management representation letter, and requires that the accountant develop and document expectations for the analytical procedures and compare the expected amounts to actual results. The expectations can be developed using a range rather than an absolute amount. SSARS No. 10 is effective for reviews of 2004 calendar year financial statements.
New Accounting Standards
In 2002 FASB signed the “Norwalk Agreement” with the International Accounting Standards Board under which both parties agree to bring about the convergence of U.S. and European accounting standards. FASB recently issued the first two statements (SFAS No. 151 and No. 153) that modify U.S. GAAP to conform more closely to European standards.
SFAS No. 151 revises how the cost of inventory is determined, requiring abnormal amounts of overhead be recognized as period costs rather than be capitalized as part of inventory cost, and that production overhead costs be allocated based on the facility’s normal capacity This standard is effective for fiscal years beginning after June 15, 2005.
SFAS No. 153 represents a rather dramatic change in the accounting for like-kind exchanges. Under current standards like-kind exchanges generally do not generate capital gains except to the extent of boot received. Under the new standard capital gains will be recognized in most cases on the exchange, and the asset received in the exchange will be recorded at fair value rather than at carry over basis. Recognition of the capital gain can be avoided if the transaction “lacks commercial substance,” which translates to mean a trade involving no material boot. This standard is effective for fiscal years beginning after June 15, 2005.
FASB Interpretation 46R may require consolidating into company financial statements assets owned by the company shareholders. Such assets may be deemed a Variable Interest Entity (VIE). A VIE tends to be a thinly capitalized entity, an entity that is not self-supporting. For existing VIE interests this standard is effective for the first annual period beginning after December 15, 2004. FIN 46R requires that fair value be used to determine whether an entity is a variable interest entity that should be consolidated into the “primary beneficiary’s” financial statements. As noted previously, determining fair values on behalf of your client will likely impair your independence.
You may not think 46R applies to your practice, but almost all of us have corporate clients where, for income tax and liability reasons, the shareholders rather than the company own the real estate and possibly the equipment and lease them back to the corporation. Under FIN 46, such real estate and equipment rental companies may be classified as variable interest entities unless there are no significant mortgages outstanding on the property and unless the lease terms are at market.
In March 2005 the FASB Staff issued FASB Staff Position (FSP) 46(R)-5 entitled “Implicit Variable Interest under FASB Interpretation No. 46.” Before the issuance of FSP 46(R)-5, an operating company that paid on a fair value lease and did not guarantee the real estate company’s debt might have avoided consolidating the real estate company (VIE). However, FSP 46(R)-5 introduces the concept of “implied guarantee.” If the shareholder’s primary personal asset is his or her investment in the operating company, and the shareholder guarantees the real estate company’s debt, the implication is that the operating company is in effect also guaranteeing the VIE’s debt, since the shareholder would have to go to the operating company to obtain the assets to satisfy the personal guarantee. Under a “tie-breaker” rule this scenario will usually lead to the VIE (real estate company) being consolidated into the operating company’s financial statements.
If the client decides not to consolidate a VIE, where standards require consolidation, you may wish to prepare the financial statements on an income tax basis or modify your report on GAAP financial statements. The modifying paragraph on the primary beneficiary’s financial statements when compiled without disclosures might read as follows:
Generally accepted accounting principles require that the Company test an entity from which the Company leases its office building, to determine whether the leasing entity is a variable interest entity that should be consolidated into the Company’s financial statements. Management has informed us that the Company has not performed a test for consolidation and has not determined whether consolidation is warranted. The effects of this departure from generally accepted accounting principals on financial position and results of operations have not been determined.
Firms with Audit Clients
The Accounting Standards Board has a number of exposure drafts outstanding that will require significant changes in how we approach our audit engagements. However, the ASB has not issued any new SAS since January 2003 and appears to be in a holding pattern, looking to the PCAOB for guidance.
An exposure draft issued January 2005 would supersede SAS 96 on audit documentation, and would require that audit documentation be sufficient to enable an “experienced auditor” having no previous connection to the engagement to understand procedures performed, audit evidence obtained and conclusions reached. This is a level of documentation comparable to that required by the GAO for governmental audits.
In December 2002 the Accounting Standards Board issued seven proposed SASs concerning the auditor’s risk assessment process that, if adopted, would result in a new framework for the audit of nonpublic companies. The new SAS will require improved documentation of the linkage between assessed risks and the nature, timing and extent of audit procedures performed in response to those risks. The concept of assessing risk “at the maximum” without support will be eliminated, encouraging although not requiring more reliance on tests of controls.
Firms with Governmental Audit Clients
In April 2005, the General Accounting Office issued updated guidance on the continuing professional education requirements (CPE) under Generally Accepted Government Auditing Standards. Among other changes, the new guidance expands the list of subjects that satisfy the 24- hour and 80-hour CPE requirements (for example, compilation and review classes will count toward the 80-hour requirement), requires prorated CPE for new hires, and exempts some audit team members from the 80-hour CPE requirement (but not from the 24-hour requirement). Specifically, auditors whose involvement is limited to performing field work will be exempt from the 80-hour requirement, as long as they charge less than 20 percent of their time to audits and attestation engagements performed under government auditing standards.
GASB Statement No. 40 on deposit and investment risk disclosures is effective for periods beginning after June 15, 2004. This means you will have to revise the wording of your footnotes on bank deposits and investments.
Our Peer Review Clients
When scheduling your peer review with the state society, the scheduling form requests information about the firm you have hired to perform the peer review. This is the information you will need if you select our firm to perform your peer review:
Name of Reviewing Firm: Read & Bose, PC
AICPA Firm Number: 10083621
Team Captain’s Name: Harry Bose
AICPA Member Number: 01153765
___________________________
This letter will be posted on our award-winning home page, along with additional guidance on peer reviews. Our web site address is:
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Please do not hesitate to contact us if you have any questions. We appreciate your business.
Very truly yours,
Read & Bose, PC