AICPA Ethics Interpretation 101-3: What It Means to Small Firms

By Raymond M. Nowicki

Documentation

A CPA 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.

Objections to the Standard

Over 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.

Common 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 a farce.
• 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?
• Interpretation 101-3 was meant for big firms, not small, family-run practices.

These 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 work;
• The client must have the willingness to do so; and
• The above issues must be documented.

Why Interpretation 101-3 Is in a Small Firm’s Best Interest

First, 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.

The 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. The 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.

As 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.

An Opportunity, Not a Burden

Interpretation 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 101-3.

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