Letter to our Peer Review Clients - 2009

May 30, 2009

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.

Statement on Quality Control Standards No. 7

SQCS No. 7 was effective January 1, 2009. This means that all CPA firms, including firms that do not have an audit practice, now have the following:

• A written quality control document. If the firm already has a written QC document the old one needs to be revised to reflect the concepts in SQCS No. 7.

Under the new peer review standards, peer reviewers will consider a properly completed quality control policies and procedures checklist a qualifying QC document. If your firm is going to use the checklist as your written QC document, you should complete it as soon as possible (don't wait for your peer review). You can find the checklists (one version for sole proprietors, the other version for larger firms) at:

http://www.aicpa.org/members/div/practmon/systemreview09.asp

The written QC document must establish polices for determining which engagements are subject to a special kind of independent pre-issuance review called an Engagement Quality Control Review (EQCR).

The AICPA Guide to Implementing Quality Control includes guidance on establishing your firm's EQCR policy and is available as a free download at:

http://www.aicpa.org/download/members/div/auditstd/System_of_Quality_Con...

• Written independence confirmations from all personnel at least annually.

If your firm does not have an audit practice, you can take some comfort in the following:

• Your peer reviewer will not ask to see your QC document. Peer review standards for the type of peer review you will receive, which is called an “engagement review,” explicitly prohibit the peer reviewer from asking to see your QC document.

• In its guide to implementing a quality control system, the AICPA suggests that a firm without an audit practice may establish a policy for EQCR that would, practically speaking, eliminate the need for EQCR except in rare instances. The EQCR policy for such a firm, according to the AICPA, might require an EQCR only if 1) the firm accepts an audit or 2) if the firm accepts an engagement in a specialized industry where it has no previous experience.

When SQCS No. 7 requires a sole proprietor to obtain an EQCR, the sole proprietor will have to hire an outside CPA to conduct this pre-issuance review because one of the requirements is the second reviewer be independent of the engagement.

Peer Review Standards

The new peer review standards are effective January 1, 2009. The most noteworthy change in the standards is the elimination of the letter of comments. Also, a firm whose accounting practice is limited to nondisclosure compilations may have qualified for a streamlined peer review under the old peer review standards. This type of peer review, called a “report review,” is eliminated under the new standards and such firms are now subject to “engagement reviews.”

Peer Review and Regulators

Under the AICPA Facilitated State Board Access Program, many state CPA societies, including the Oregon Society of CPAs, are posting peer review reports to a secure web site state board representatives are able to access. The peer review reports are posted on an “opt-out” basis, which means that your peer review report will be posted to the web site automatically unless you take action to prevent it. In Oregon , this program commenced January 2009. In addition, the Oregon State Board of Accountancy is considering requiring all firms submit their peer review reports with their firm registration forms. Although not previously required in Oregon , many other state boards already require submission of the peer review report.

New Compilation and Review Standards

The AICPA is revising the compilation and review standards and, as with the FASB Accounting Standards Codification project, familiar references to statement numbers, such as to “SSARS No. 8 engagements,” may be a thing of the past. Similar to the redrafting of the auditing standards (the “clarity project”), the compilation and review standards revision is intended to conform US standards to those of the International Auditing and Assurance Standards Board. Under the new standards, the accountant will be permitted, for the first time, to disclose in a compilation report the reasons for an independence impairment and, in some circumstances, may be able to issue a review report on a client even though the accountant lacks independence with respect to that client. The new standards will require the accountant obtain an engagement letter from the client (no exceptions) and establish documentation requirements for compilations and enhanced documentation requirements for reviews. This standard is in exposure draft stage but is expected to be effective for periods beginning on or after December 15, 2010.

New Accounting Standards

New Accounting Codification: On July 1 st the FASB Accounting Standards Codification will officially become the single source of nongovernmental GAAP.

International Financial Reporting Standards: The movement to replace US GAAP with international standards continues to gather force, with implementation coming possibly as early as 2014.

New Formats for Financial Statements: Working jointly with the International Accounting Standards Board, the FASB continues with its project to significantly revise the formats of the basic financial statements. We described this in more detail in our update letter last year. The most dramatically affected financial statement will be the balance sheet, which will become balkanized, composed of up to five smaller, disaggregated balance sheets. FASB issued a Discussion Paper “Preliminary Views on Financial Statement Presentation” on October 16, 2008. The comment period expired April 14, 2009. FASB is expected to publish an Exposure Draft in 2010.

Lease Accounting: FASB issued a Discussion Paper “Leases: Preliminary Views” on March 19, 2009 that recommends the distinction between capital and operating leases be eliminated and that all leases be accounted for as capital leases. A lessee will record a “right-of-use” asset and a liability for the obligation to pay rentals. Responses to the Discussion Paper are due July 17, 2009. An Exposure Draft will follow.

FIN No. 48: FASB Staff Position FIN 48-3 provides yet another one year delay for implementing this controversial standard on recognizing uncertain income tax positions. If your client elects the deferral, the election should be disclosed in the footnotes and, in addition, the client's current policy for evaluating uncertain tax positions should also be disclosed. Grant Thornton has a sample footnote for this. You can locate it by entering this expression in a Google search: Grant Thornton NDS 2009-04. Note that even after implementing FIN No. 48, the interpretation has no effect on amounts reported in the financial statements if: 1) it is more likely than not the client's tax positions will survive an audit, and 2) there is a more than 50% probability the full amount, every dollar, of the related tax benefits will be realized upon settlement.

Amendments to FIN No. 46R/SFAS No. 140: These amendments are driven by the credit crisis and the banking industry's practice of avoiding consolidation of variable interest entities through use of the “Qualified Special-Purpose Entity” exception (shades of Enron). With special purpose entities, a bank can reduce its allowance for loan losses and thereby circumvent capital reserve requirements. (See ENDNOTE for further discussion.) The amendments to FIN 46R and SFAS 140 are intended to minimize this off-balance sheet treatment. The amendments will require on going reassessments to determine whether a company must consolidate a variable interest entity. The final standards should go into effect in 2010.

FSP FAS 117-1: This FASB Staff Position is a response to the Uniform Prudent Management of Institutional Funds Act of 2006 and was effective with December 31, 2008 year ends. This standard requires significant additional disclosure for nonprofit organizations that have permanently restricted net assets.

SFAS No. 157: This standard is effective for financial assets in fiscal years beginning after November 15, 2007, and requires extensive new disclosure of fair values. Clearly, these disclosures are necessary for marketable securities, and we recommend you review recent editions of AICPA Industry Guides and Alerts to determine what other asset categories are affected.

FSP FAS 157-4: This standard concerns fair values when a market is “inactive,” which will allow banks to minimize the write downs on their portfolios of toxic assets. (See ENDNOTE for further discussion.)

SFAS No. 162: Although SFAS No. 162, issued in November 2008, established the hierarchy of generally accepted accounting principles, FASB issued an exposure draft in March 2009 that will eliminate the recently established hierarchy. The only authoritative GAAP will be what is contained in the FASB Accounting Standards Codification.

SFAS No. 165: This standard revises disclosure requirements for subsequent events, including a requirement to disclose the date through which an entity has evaluated subsequent events. Part of the effort to converge US GAAP with international standards, SFAS No. 165 is effective for periods ending after June 15, 2009.

Firms with Audit Clients

The standards for reporting control deficiencies to management are changing next year, when SAS No. 115 replaces SAS No. 112. If you early implement this standard, take care to revise your report language to reflect the new definitions contained in SAS No. 115. You should not early implement SAS No. 115 on A-133 audits.

The AICPA recently issued an exposure draft for a proposed SAS that will reemphasize the requirement that audit procedures be performed on opening balances during an initial audit engagement.

The AICPA has issued an interpretation that affects CPAs who prepare financial statements for use by other CPAs who are performing the audit. The interpretation says that such compilation engagements come under SSARS No. 8 and therefore are issued without a compilation report.

The Risk Assessment SAS were effective with calendar year 2007 audits. We have covered them in previous peer review update letters. This year we would like to highlight a few areas where firms seem to be having difficulty as follows:

  • Most firms are using the PPC practice aid to implement the new auditing standards. Firms sometimes conclude the form PPC provides for documenting the five COSO components (CX-4.1), is sufficient documentation of the control activities as required under SAS No. 109, which is not true. The Risk Assessment SAS require more, not less, documentation of internal control. We recommend that you use the form that PPC has designed to document the financial reporting system, which is CX-4.2.1.
  • All of the procedures required under SAS No. 99 for fraud risk considerations and responses still apply. However, the PPC planning materials blend fraud risk with other audit risk considerations, which can be confusing, and sometimes results in poor documentation of fraud risk considerations. To add to the confusion, PPC has revised its planning forms this year. Fraud and other audit risks were formerly documented on CX-6.1 but are now identified on CX-3.1, while CX-6.1 has become a listing of potential risk factors (a memory jogger) and CX-6.2 is a listing of possible fraud risk factors.
  • Firms sometimes have difficulty relating the risk assessments on PPC Form CX-7.1 with the audit plan. Firms using the PPC SMART e-practice aid tend to have more success than firms performing the process manually. The new audit standards require linkage between the risk of material misstatement and the audit procedures developed. The days of the canned audit program are history. The audit program steps should be consistent with your risk of material misstatement for each of the assertions. If many of the steps on your audit programs have “N/A” or “NCN” entries next to them, you may want to rethink your approach to planning.
  • Walkthroughs are generally required, not only in the first year the risk assessment standards are implemented, but in subsequent years too.

Firms with Governmental Audits

The footnote disclosure for cash in bank will be different this year, since the amount of FDIC coverage fluctuated during the year. Another difference affects Oregon governmental units: Oregon changed the collateralization requirements for bank deposits effective July 1 st of last year. Collateral pool certificates are a thing of the past. Footnote disclosure this year might include expanded FDIC discussion, including discussion of the Temporary Liquidity Guarantee Program, which provides unlimited coverage for noninterest bearing accounts starting on October 14, 2008. With respect to the coverage provided by the new Oregon collateral pool, there might be a reference to “collateral held in a multiple financial institution collateral pool administered by the Oregon State Treasurer.”

The new edition of the ACIPA Guide to Single Audits will have a chapter on sampling in an A-133 audit that will provide much needed guidance in this area. The new edition will be available in September 2009. GASB Statement No. 54 significantly revises how fund balances in the governmental funds are reported and is effective for periods beginning after June 16, 2010. GASB No. 55 establishes a hierarchy of GAAP for state and local governments. GASB No. 56 codifies the accounting guidance contained in the AICPA auditing standards. OPEB presentations and disclosures apply to smaller clients this year. The 2007 edition of the Yellow Book is effective with this audit season and requires you to make your peer review report available to the public, which might be accomplished by joining either the PCPS or the GAQC.

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:

www.peer-review.com

Our email address if your wish to contact us about peer review is:

harryb@readandbose.com

Please do not hesitate to contact us if you have any questions. We appreciate your business.

Very truly yours,

Read & Bose, PC

ENDNOTE:

A special purpose entity (SPE) is a type of variable interest entity. A SPE tends to be organized as a foreign corporation in order to avoid or defer payment of US federal income tax on global income. These are the shell companies set up in the Cayman Islands that you hear about in the media. Banks used the SPE structure to inflate their capital reserves in the following two ways:

  1. To create Collateralized Debt Obligations (CDOs): The bank establishes the SPE to issue bonds. The bonds issued are also known as CDOs and they are marketed to investors. The SPE uses the proceeds from the sale of the CDOs to acquire a portfolio of “underlying assets,” such as corporate loans or subprime mortgages, from a bank or banks. By packaging and selling its loan portfolio to the SPE, the bank passes credit risk to the investors, lowering its allowance for loan losses and increasing its capital reserves, which allows the bank to engage in riskier lending practices. (This is the best way to understand the process, although there is an intermediate step: the bank provides short term financing to the SPE to acquire the underlying assets that will back the CDO issue. The SPE repays this “warehousing” loan with the funds received from the investors who purchase the CDO bonds.)
  2. To create synthetic CDOs: After setting up the SPE, the bank creates a credit default swap (CDS) between the SPE and the bank itself. A CDS is like an insurance contract, where the SPE is the insurer and the bank is the insured. The SPE agrees to reimburse the bank if borrowers named in the CDS document default on their loans. In exchange for this agreement the bank pays the SPE an insurance premium. The bank's salespeople then sell ownership interests in the SPE to investors. They market this product as a CDO with investment grade returns. The investors might be pension funds, nonprofit organizations or your local school district. The SPE invests the proceeds provided by the CDO offering in liquid assets so that funds are available if a payout to the bank (the swap counterparty) is required. The return to the investors in the SPE is higher than on more traditional investments because return on investment includes the insurance premium the SPE is receiving from the bank. While the bank has transferred its credit risk off the books, lowering its allowance for loan losses and pumping up its apparent capital reserves, a school district investor looking for a slightly higher, but safe, return on its investment now finds itself a counterparty potentially obligated to cover a credit loss that is many times the book value of its investment. The school district has the same role as the “Lloyds Names” who back the London reinsurance company. There is the potential for a mass transfer of wealth from unsuspecting investors such as the local school district to the banking industry if the CDS is triggered. If any of your audit clients have invested in synthetic CDOs, you will have to carefully consider the presentation and disclosure involved.

Less than a decade ago, our professional standards were revised with the issuance of FIN 46 in response to the abuse of variable interest entities perpetuated by Enron and yet, apparently not learning any lessons from this experience, FASB granted an exemption from FIN 46 to the banking industry allowing the banks to engage in the behaviors that led to the credit crisis. It is true that FASB was a minor player in the credit crisis. After the banks convinced the banking regulators that credit derivatives removed credit risk from the balance sheet, FASB simply followed along, but at times like these FASB appears to be asleep at the wheel, or so swayed by political pressure as to be utterly ineffective. While CPAs in local firms struggled to interpret FIN 46, obsessing over such matters as whether or not the office building the small corporate client leased from its sole shareholder should be consolidated, the financial services industry was free and unimpeded as it went about destroying the larger economy.

We again see FASB bowing to political pressure with FSP FAS 157-4. As it did with variable interest entities, Enron pioneered the abuse of mark to market accounting. We now see the financial services industry abusing mark to market, and yet our standard setters refuse to acknowledge the risk in their rush to fair value accounting. FASB 157 established an approach to determining the fair value of an asset using “unobservable inputs” when market prices are not readily available. This is also known as the “mark to make believe” asset category. With FSP FAS 157-4, FASB has blessed the banking industry's practice of hiding impaired assets in the “mark to make believe” category. What the credit crisis has made clear is that fair market value is whatever the most powerful interest group says it is.