Ethics Interpretation 101-3: What It Means to Small Firms
Raymond M. Nowicki
2006 - Effective January 1, 2005, the AICPA mandates a new
documentation requirement for an old standard. Ethics Interpretation
101-3 deals with a CPA’s obligation to consider and
document how certain nonattest services may affect independence,
prior to performing compilations, reviews, audits, or other
attest services for the same client.
must establish in writing an understanding with the client
regarding the following:
The objectives of the engagement;
Nonattest services to be performed by the CPA;
The client’s acceptance of its responsibilities,
and establishing and maintaining internal controls, including
monitoring ongoing services from the CPA;
The CPA’s responsibilities; and
Any limitations on the engagement.
to the Standard
the months since a documentation requirement for Ethics
Interpretation 101-3 was implemented, many small-firm practitioners
have protested the standard. Every practicing CPA has the
obligation and right to question the profession’s
standards, and to expect that standards setters act responsibly
and practically. This seems to be the foundation of every
basic argument by small firms against Interpretation 101-3.
complaints voiced by firms include the following:
My clients don’t really understand their numbers,
so signing an internal document as required by 101-3 is
My client thinks I am doing an audit every year and even
says so to his staff when I show up. I am doing only an
annual compilation and tax return.
How can our clients be expected to maintain a system of
internal control and monitor it?
101-3 was meant for big firms, not small, family-run practices.
arguments have many variations, but the issues all seem
to boil down to the basic requirements of the standard:
The client must maintain and monitor internal control;
The client must have the capacity to oversee the CPA’s
The client must have the willingness to do so; and
The above issues must be documented.
Interpretation 101-3 Is in a Small Firm’s Best Interest
think in terms of tax services and risk to the firm. Taxpayers
often defend themselves against tax evasion by blaming the
CPA. Tax fraud is the most frequently alleged basis of malpractice.
When a client is charged with tax fraud, its first defense
is that the CPA prepared the return without explaining it
to the client, and that the CPA took positions that the
taxpayer never authorized. Usually, tax fraud cases are
followed by a malpractice suit against the CPA. It is clear
from this example that reaching a written understanding
with a client may provide the firm with additional evidence
to protect its reputation. Many firms now document the Interpretation
101-3 assertions in the engagement letter, and again in
a representation letter for reviews, audits, and other attest
engagements, providing additional evidence for the firm
to protect its reputation.
second-biggest pushback involves the client’s lack
of knowledge and capacity to maintain and monitor internal
controls, and to oversee the CPA’s work. CPA firms
throughout New York seem to think that clients do not have
that capacity, but I generally disagree. Consider the author’s
experience with Greek and Chinese family-owned restaurants.
CPA will argue about signing an engagement letter with the
client, and the client will probably say, “If I could
do all this [maintain internal controls and oversee the
CPA], why would I need you?” That response sounds
reasonable, coming from a small business owner, but this
same restaurant owner does the scheduling, works the grill
while watching the staff, and signs the checks, among other
duties. Family members run the restaurant in his absence.
He can tell you if a waitress is stealing from the cash
drawer, he knows his margins to the penny, and he knows
his labor costs better than most CPAs know theirs. CPAs
often do not give clients enough credit for what they know.
If the business is successful, then someone is minding the
internal controls and watching the numbers and will rarely
have problems passing Interpretation 101-3’s capacity
test. Conversely, for clients suffering regular losses,
maybe the CPA firm should spend more time offering nonattest
turnaround assistance, such as implementing cash-flow management
advice and simply reviewing the numbers with the client.
for a client who says to a CPA, “If I get into trouble
with the bank or the IRS, I’ll blame it on you because
you’re my right arm,” the CPA has options. With
a good client, a CPA could claim lack of independence on
the compilation. With a weak client, however, one that does
not pay fees, that acts unprofessionally or unbusinesslike,
and that poses a threat to the firm, Interpretation 101-3
provides a CPA with a basis for telling the client to seek
help elsewhere because of the CPA’s lack of independence.
Opportunity, Not a Burden
101-3 is not simply another burdensome requirement for small
practitioners. It is an opportunity to review and renew
the relationship CPAs have with many long-term clients,
and a chance to rethink which clients pose risks to the
firm and which are good, profitable clients. To the small-firm
practitioner, I say, Carpe diem, carpe Interpretation
M. Nowicki, CPA, is a partner of Nowicki
& Company CPAs LLP, Buffalo. N.Y. He is a member of the
NYSSCPA’s Peer Review Committee.