Can Proposed Audit Adjustments Challenge Auditor Independence?

By Peter M. Drexler

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AUGUST 2005 - The Sarbanes-Oxley Act of 2002 (SOA) has added importance to proposed adjusting entries to financial statements. The Public Company Accounting Oversight Board (PCAOB), authorized by the SOA to set auditing standards for registered companies, requires auditors to issue opinions on registered company internal controls as well as on their financial statements. The PCAOB briefing paper dated July 10, 2003, states that “a material weakness in internal control was defined as a reportable condition in which the design or operation of a component(s) of internal control does not reduce to a relatively low level the risk that a material misstatement may be contained in the issuer’s financial statements.” In other words, had the auditor not discovered the misstatement, the company might have issued financial statements that would have been materially misleading. In the public company audits of internal controls mandated by the PCAOB, the material weakness would “preclude an unqualified opinion that internal control is effective.”

This raises independence issues for audits of both publicly owned and private entities. When the auditor discovers material misstatements during the course of an audit, one of the following may occur:

  • The auditor notifies the client of the error, and the client’s accounting staff investigates the circumstances, then makes the appropriate adjustments; or
  • The auditor prepares the appropriate accounting entry and furnishes a copy to the client’s accountant, who would understand the entry, verify the correctness of the entry, and accept responsibility for it in the representation letter; or
  • The client’s accountant is not familiar with the entry’s necessity and validity but accepts responsibility for the entry without understanding or necessarily agreeing with it.

In the last case, could the auditor’s independence be adversely affected? Can a conflict arise when an auditor prepares material proposed audit adjustments for such a client?

Interpretation 101-3 and Independence

On June 24, 2003, the AICPA Professional Ethics Executive Committee (PEEC) issued Code of Professional Conduct Interpretation 101-3, “Performance of Nonattest Services.” This interpretive guidance clarifies, and in some cases places additional restrictions on, already existing guidance related to whether independence is considered to be impaired when performing nonattest services for an attest client. Interpretation 101-3 applies to audit, review, or compilation services. In circumstances where independence has been impaired, an audit or review cannot continue. Compilations may be conducted, but the resulting reports must be modified to clearly stipulate the lack of independence.

According to Bisk Education’s Monthly Accounting & Auditing Report, the substantive provisions of Interpretation 101-3 became effective December 31, 2003. PEEC, however, delayed until December 31, 2004, the requirement to document, in writing, the understanding of the nonattest services with the client. Certain general requirements must be considered and complied with in order to maintain independence when performing nonattest services for an attest client. The Interpretation 101-3 requirements are as follows:

  • The CPA should not perform management functions or make management decisions for the attest client. The CPA may provide advice, research materials, and recommendations to assist the client’s management in performing its functions and making decisions.
  • The client must—
    • agree to perform a number of functions in connection with the engagement to perform nonattest services;
    • make all management decisions and perform all management functions;
    • designate an individual with suitable skills and knowledge to oversee the services;
    • evaluate the adequacy and results of the services performed;
    • accept responsibility for the results of the services; and
    • establish and maintain internal controls, including the monitoring of ongoing activities.

According to Interpretation 101-3, “The CPA should be satisfied that the client will be able to meet all of these criteria and make an informed judgment on the results of the CPA’s nonattest services. In assessing the competency of the client’s designated employee, the CPA should be satisfied that the designated person understands the services to be performed sufficiently to oversee them. In cases where the client is unable or unwilling to assume these responsibilities (e.g., the client does not have an individual with the necessary competence to oversee the nonattest services provided, or is unwilling to perform these functions due to lack of time or desire), CPAs providing nonattest services would have their independence impaired.”

In the first two scenarios, the client’s related accounting issues would probably be addressed in subsequent periods, and the proposed audit adjustments would probably not be repeated in the future. If proposed audit adjustments should be subjected to the same standards as nonattest services, then the third situation described above requires the auditor to consider whether independence is impaired and to address the issue every year when preparing material audit adjusting entries that are submitted to the client.


Consider the case of a contractor that recognizes revenues on the percentage-of-completion basis. The auditor routinely calculates the amounts of realized and deferred revenues, prepares the appropriate adjusting entries each year, incorporates them into the financial statements, and submits the proposed entries. During the current audit, the auditor realizes that a major project that was 40% complete in the prior year was reported as 80% complete. The auditor’s erroneous calculation in the prior period caused the financial statements to be materially misleading.

The auditor should promptly notify the contractor of the misstatement, recall all copies of the prior audit report, and reissue the audit report with appropriately adjusted accompanying financial statements and disclosures (if a single year is currently being audited) or issue an audit report with attached financial statements with corrected prior-year amounts in the statements (if comparative financial statements are to be presented). In either case, appropriate disclosures in the audit report and financial statements should describe the prior-year misstatement and its effect on the financial statements.

In this situation, an auditor risks adversely affecting, and possibly losing, its relationship with the client. Furthermore, reissuing the prior audit report may damage the auditor’s reputation or result in lawsuits from disgruntled investors and lenders, as well as professional ethics investigations.

The auditor might be tempted to let the problem correct itself in the subsequent period. Any overreporting of revenues in the prior period would be canceled by underreporting revenues in the current period. Financial statements for both years would be materially misstated, even though retained earnings would be correct at the end of the second year. An auditor might be tempted to take this easy way out.

An independence conflict might arise when a company lacks the sophistication to address the accounting issues, or the time or inclination to investigate and solve the problems. In such a situation the auditor may be asked to “fill the gap” in the client’s accounting system, and in effect take responsibility for an element of the financial statements.

Two Accountants

This potential independence issue must be resolved for the countless audits and reviews in which a client requires an auditor to prepare major adjustments. Ideally, one outside accounting firm would be engaged to compile the financial statements and related disclosures after analyzing the general ledger and making the appropriate adjustments. The second firm would actually conduct the audit or review. The accountant providing nonattest services should agree by contract to not undertake to audit the client unless strict protocols have been met.

Companies with unsophisticated accounting staffs would benefit by gaining the ability to issue unaudited financial statements that satisfy GAAP. Audits and reviews would be less costly because the financial statements will have already been prepared with the help of an outside accountant. The savings on the audit or the review would partially offset the costs of hiring a second accountant.

As a result, some firms would come to specialize in audits and others in nonattest accounting functions. This arrangement would raise the competency of all involved and, more important, eliminate a potential conflict of interest.

Peter M. Drexler, CPA, is retired. During his 37-year career he worked as an auditor, controller, and internal auditor at several companies, including an SEC registrant.




















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