New SAS No. 84 replaces SAS No. 7.

THE NEW STANDARD

ON PREDECESSOR

SUCCESSOR

COMMUNICATIONS

By Kay W. Tatum and Paul Munter

In Brief

Communicating Both Before and After Appointment.

Although SAS Nos. 7 and 84 have identical titles, the guidance found in SAS No. 84 is substantially different from that previously found in SAS No. 7. In particular, SAS No. 84--

• redefines the terms predecessor and successor and introduces the concept of conditional acceptance in light of today's competitive practice environment,

• emphasizes that inquiry of a predecessor prior to the acceptance of an engagement is a required audit procedure,

• expands the matters subject to inquiry,

• encourages broader access to a predecessor's working papers by identifying the type of working papers that the predecessor might make available to the successor,

• suggests the use of consent and acknowledgement letters and provides examples of such letters in an additional effort to encourage broader working paper access,

• discusses the role of the predecessor's working papers as audit evidence in the current year audit, and

• identifies actions the successor should take upon discovering possible misstatements in the financial statements audited by the predecessor.

In the past 20 years, the auditing profession has changed dramatically. Bidding and solicitation are now accepted as a way of life. The Securities Litigation Reform Act of 1995 stresses the auditor's responsibility for the detection of fraud. The complexity of business transactions and business structures has increased significantly. Not surprisingly, then, the Auditing Standards Board (ASB) has found it necessary in recent months to reexamine existing auditing standards in light of these revolutionary environmental changes in which audits are conducted. One of the results of these efforts by the ASB is the issuance of SAS No. 84, Communications Between Predecessor and Successor Auditors, in October 1997, that supersedes SAS No. 7 of the same name. Like its predecessor, SAS No. 84 provides guidance on predecessor-successor communications when a change of auditors is in process or has taken place. The document is effective for engagements accepted after March 31, 1998.

Predecessor Defined

Changes in auditors occur much more frequently today than in years past. Furthermore, these changes often take place through a competitive bidding process in which two or more auditors submit proposals for the engagement. In some cases, the auditor who expressed an opinion on the prior period's financial statements may be one of the firms bidding for the engagement. These conditions necessitated a new definition of the predecessor auditor.

SAS No. 84 defines a predecessor auditor as--

an auditor who (1) has reported on the most recent audited financial statements or was engaged to perform but did not complete an audit of any subsequent financial statements and (2) has resigned, declined to stand for reappointment, or has been notified that his or her services have been, or may be, terminated.

The first part of this definition raises the possibility that there may be more than one predecessor auditor. For example, assume a local CPA firm audited ABC Company's 1996 financial statements. At the request of its investment banker, ABC Company engages an international accounting firm for the 1997 audit. If the international firm resigns from the engagement prior to issuing a report, there would be two predecessor auditors. In such a situation, the successor auditor would have a responsibility to communicate with both the local firm and the international firm.

The second part of the definition recognizes that in the proposal stage of the engagement, the predecessor auditor may still be competing to provide audit services. The auditor may have only been notified that his of her services may be terminated and that the client will consider multiple proposals for the current period audit. Thus, the predecessor may submit a proposal for the current period engagement.

This new definition of the predecessor is focused on the most recent reporting period. Thus, the definition prompted two questions when SAS No. 84 was exposed for public comment:

• Does the standard apply when the prior period audit was several years ago?

• Does the standard apply when the prior period financial statements were compiled or reviewed?

Note that in each case, the most recent financial statements have not been audited.

Regarding the first question, the ASB concluded that SAS No. 84 does not apply when the most recent audited financial statements are more than two years prior to the beginning of the earliest period to be audited by the successor. To better understand this provision, assume the successor has been engaged to report on the financial statements for calendar year 1997 and the financial statements for 1996 were not audited. An auditor who audited the 1995 financial statements would be a predecessor auditor. Thus, SAS No. 84 expands the time frame in which an auditor can be considered to be a predecessor auditor. This time frame recognizes there may be an additional reason to communicate when there is a gap between the current period audit and most recent audited financial statements. However, SAS No. 84 recognizes that at some point, the prior period auditor's information becomes outdated. Thus, if the financial statements for both 1996 and 1995 were not audited, the auditor who reported on the 1994 financial statements would not be a predecessor auditor.

Regarding the second question, the ASB concluded that the standard does not apply when the prior period financial statements have been compiled or reviewed. However, SAS No. 84 does not preclude communication in this case. The auditor should use professional judgment to determine whether it would be helpful to communicate with the accountant who compiled or reviewed the financial statements in a prior period.

Successor Defined

As noted earlier, in today's competitive audit environment, two or more auditors may submit proposals for the same engagement. If so, it is unreasonable to expect the predecessor auditor to be available for questioning from multiple auditors. SAS No. 84 addresses this issue by defining a successor auditor as--

an auditor who is considering accepting an engagement to audit financial statements, but who has not communicated with the predecessor, . . . and an auditor who has accepted such an engagement.

Under this definition, an auditor who has just submitted a proposal for an audit engagement is not considered a successor auditor. Thus, no communications are required at this point. However, if the prospective client accepts the proposal and indicates an intention to engage the new firm, the auditor then becomes a successor auditor.

At this point the successor has a professional responsibility to communicate with the predecessor. SAS No. 84 specifically states that the auditor should not accept an engagement until certain communications have taken place and the responses evaluated. To comply with this requirement and, at the same time, avoid a misunderstanding with the client, SAS No. 84 suggests the auditor may wish to advise the prospective client (for example, in the proposal) that acceptance cannot be final until the communications have been evaluated. Thus, the concept of conditional acceptance of the audit is introduced.

If the auditor does, in fact, accept the engagement after evaluating the communications with the predecessor, he or she continues to be a successor auditor. Thus, there are two stages to being a successor auditor. In the first stage, an auditor is considering accepting an engagement to audit financial statements, but has not communicated with the predecessor. In the second stage, the successor auditor has accepted the engagement after making the required inquiries, but desires to obtain additional information from the predecessor that will help the successor plan the current audit. It is in this stage that the successor typically would want to review the prior period working papers.

Communications Regarding Acceptance of the Engagement

The purpose of communications made prior to accepting the engagement is to provide the successor with information that will assist him or her in determining whether to accept the engagement. As a result, the timing of these communications is critical. The communications should occur before the successor accepts the engagement. To aid these communications, SAS No. 84 establishes clear and distinct responsibilities for the predecessor and successor regarding this required communication.

The successor auditor has a responsibility to initiate the communication and to make inquiries about four matters:

• Information that might bear on management's integrity,

• Disagreements with management as to accounting principles, auditing procedures, or other similarly significant matters,

• The predecessor's understanding as to the reasons for the change in auditors,

• Communications to audit committees or others with equivalent authority and responsibility regarding fraud, illegal acts by clients, and internal control related matters.

The fourth matter regarding communications to audit committees is a new requirement that expands the successor's inquiries beyond those previously required by SAS No. 7. For example the successor should inquire whether the predecessor auditor reported to the audit committee fraudulent activities involving senior management as required by SAS No. 82, Consideration of Fraud in a Financial Statement Audit, or illegal acts as required by SAS No. 54, Illegal Acts by Client. Similarly, the successor would want to know about communications made in accordance with SAS No. 60, Communication of Internal Control Related Matters Noted in an Audit. Clearly, these communications between the predecessor and the audit committee involve significant matters that could impact a successor's decision about whether to accept an engagement. As can be seen, the audit literature is being strongly influenced by the Litigation Reform Act, changes in the SEC's rules regarding notification to the commission of fraud by a client, and the resultant response by the ASB found in SAS No. 82.

Of course, the successor should obtain the client's permission to make the communications. The successor should ask the prospective client to authorize the predecessor auditor to respond promptly and fully to the successor's inquiries. If the prospective client refuses, the successor should inquire as to the reasons and consider the implications of this restriction. SAS No. 84 does not indicate the consequences to the auditor from these restrictions; however, clearly such restrictions imposed by the client on the communication process should cause the auditor to rethink his or her decision to accept the engagement.

The predecessor's responsibility, according to SAS No. 84, is to respond promptly and fully to the successor's reasonable inquiries. While SAS No. 84 strongly encourages the predecessor to communicate with the successor, it does not compel the predecessor to respond or give a reason for not responding. SAS No. 84 states that the predecessor may decide not to respond fully to the inquiries because of unusual circumstances. In such case, the predecessor's responsibility is to state that his or her responses are limited. SAS No. 84 provides examples of unusual circumstances including impending, threatened, or potential litigation and disciplinary proceedings. Again, though, if the predecessor's response is limited, the successor may need to carefully reevaluate the decision to accept the engagement.

Although not specifically required by SAS No. 84, the predecessor would be well advised to obtain the client's authorization to respond promptly and fully in writing. This reduces the risk of a misunderstanding occurring between the client and the predecessor. Furthermore, when responding to the successor's inquiries, the predecessor should simply report information known to him or her. For example, when asked about the reason for the change, an inappropriate response would be "we left because it was a bad situation." Instead, the predecessor could state that "we discovered points one, two, and three that caused us to resign."

Communications After Acceptance

SAS No. 84 provides a list of working papers the predecessor would ordinarily make available to the successor once the successor has accepted the engagement. Again, though, it is up to the successor to request the client to authorize the predecessor to allow a review of the predecessor's working papers. Even if the client consents, the predecessor may decide not to allow a review of some or all of the working papers. In any event, the predecessor may wish to obtain a client consent and acknowledgement letter prior to allowing a review of any working papers. The SAS contains an example of such a letter.

The primary purpose of the letter is to reduce misunderstandings about the scope of communications being authorized. In the letter the client consents to two key items: (1) the predecessor can provide the successor access to the predecessor's working papers and (2) the predecessor can respond fully to the successor's inquiries. In addition, the client acknowledges that the purpose of the working papers review is to obtain an understanding of the client and the predecessor's audit to assist the successor in planning the current audit.

The predecessor auditor should determine those working papers that are to be made available for review and those that may be copied. SAS No. 84 is based on the premise that broad access to the predecessor's working papers will increase the effectiveness of the successor auditor's engagement. Accordingly, SAS No. 84 provides a list of working papers the predecessor auditor should ordinarily permit the successor to review. They include documentation regarding:

• planning,

• internal control,

• audit results, and

• matters of continuing accounting and auditing significance, such as analyses of balance sheet accounts and working papers relating to contingencies.

As can be seen, this list is more extensive than that found in SAS No. 7. It encompasses the bulk of the working papers. The inclusion of some working papers in the list is controversial. For example, it is debatable whether documentation of planning, such as an audit program, is relevant to the planning of the successor auditor's engagement. However, the ASB concluded that the planning of the predecessor auditor's engagement is relevant to the planning of the successor's engagement.

SAS No. 84 requires the predecessor to reach an understanding with the successor as to the use of the working papers. In fact, SAS No. 84 suggests the predecessor document this understanding in an acknowledgement letter from the successor.

Acknowledgment Letter

SAS No. 84 also contains an example of an acknowledgement letter from the successor auditor. The primary purpose of this letter is to reduce misunderstandings about the use of working papers. Key issues addressed in the letter are that--

• the predecessor's audit was not planned or conducted in contemplation of the successor's review,

• the predecessor may not have addressed items of possible interest to the successor,

• the predecessor's assessment of risk and materiality and the predecessor's use of professional judgment may be different than the successor's assessment and judgment,

• the purpose of the review is to obtain information about the client and the predecessor's audit to assist the successor in planning the current audit, and

• copies of the working papers will be provided and will be subjected to the normal policy for retention of working papers and protection of client confidential information.

By agreeing to the above issues, the successor may be granted broader access to the predecessor's working papers. However, experience has shown that broader access can be achieved only if the successor agrees to additional limitations on the review. These limitations, which are included in an optional fifth paragraph, are as follows:

• The successor will not comment orally or in writing to anyone as a result of the review as to whether the predecessor's audit was performed in accordance with GAAS.

• The successor auditor will not provide expert testimony, litigation support services, or comment on issues relating to the quality of the predecessor's audit.

• The successor will not use the audit procedures or the results thereof documented in the predecessor's working papers as evidential matter in rendering an opinion on the current financial statements, except as contemplated in SAS No. 84.

This last issue is extremely important. It bears on the successor's ability to express an opinion on the financial statements since opening balances will impact the current audit. As such, SAS No. 84 discusses various types of evidence the successor can use to support the opening balances.

Audit Evidence and
Opening Balances

The use of the predecessor's working papers as audit evidence regarding the opening balances has long been debated. Many auditors would agree that in theory the predecessor's working papers do not constitute audit evidence since the successor auditor has not independently obtained corroborating information. Importantly, the successor auditor has the sole responsibility for expressing an opinion on the current period financial statements. This is not a responsibility that is divided between predecessor and successor regarding the current period financial statements.

Conversely, though, most auditors would acknowledge that oftentimes the best source of information, and in some cases the only source of information, about the opening balances is the predecessor's working papers. Thus, from a practical point of view, many auditors would argue that the predecessor's working papers are audit evidence. This issue can make working paper access a sensitive issue to the predecessor.

SAS No. 84 is very clear regarding the role of the predecessor's working papers. It states that the predecessor's working papers do not constitute audit evidence for the current period financial statements. Recognizing that the task of gathering audit evidence to support opening balances can be difficult, SAS No. 84 provides guidance to the successor by identifying possible sources of evidence:

• The most recent audited financial statements,

• The predecessor auditor's report,

• Results of inquiry of the predecessor auditor,

• Results of the successor auditor's review of the predecessor auditor's working papers, and

• Audit procedures performed on the current period's transactions that may provide evidence about the opening balances or consistency.

While this does seem to say the successor can rely on the work of the predecessor to confirm opening balances, such a conclusion would be overly simplistic. The last bullet point indicates that evidence gathered by the successor in the current period is an important source of evidence. In essence, the successor is looking to determine the appropriateness of current balances and transactions and rolling back information to the beginning of the period to determine whether these procedures confirm the balances previously examined by the predecessor. To the extent the successor's procedures confirm those opening balances, the work of the predecessor together with the successor's procedures would be sufficient evidence for the successor as to the appropriateness of the beginning balances.

Importantly, however, if the successor's procedures (including rolling back amounts to the beginning of the year) do not confirm the opening balances previously opined on by the predecessor, the successor cannot simply conclude the opening balances are satisfactorily stated. In that situation, the successor would need to perform additional procedures regarding the opening balances. If the successor is unable to do so, a scope limitation may exist for the current year's examination.

The successor would need to undertake these same steps if asked to audit financial statements that have been previously audited, commonly referred to as a reaudit. Again, the inability to confirm the previous amounts based on the successor's audit work would create a possible scope limitation.

When reporting on the financial statements, SAS No. 84 emphasizes that the successor should not make reference to the report or work of the predecessor auditor as the basis, in part, for the successor's opinion. The nature, timing, and extent of the procedures performed and the conclusions reached are the sole responsibility of the successor.

Documentation

SAS No. 84 contains no specific documentation requirements although clearly the successor would need to document the communications, the timing of those communications, and the results of the communications so that the working papers show that the engagement was conducted in accordance with GAAS. The communication made prior to accepting the engagement may be oral or written. If the communication is oral, there is no specific requirement in SAS No. 84 to document the fact the communications were made, the nature of the communications, or the successor's evaluation of the communications. As such, the provisions of SAS No. 41, Working Papers, would be applicable. For example, the successor may wish to include documentation in the audit program showing the inquiries made of predecessor regarding management integrity, disagreements about accounting or auditing matters, communications with the audit committee, and reasons for termination of the engagement.

The ASB debated whether SAS No. 84 should include specific documentation requirements. The primary advantage of such a requirement is that it would encourage adherence to the standard. The primary disadvantage of a documentation requirement is that it might discourage full and candid communications. So, while SAS No. 84 does not contain specific documentation requirements, it is clear that auditors' working papers must show they have complied with the authoritative literature. Thus, some form of documentation of the communications is desirable.

Discovery of Possible Misstatements In Financial Statements Reported on By a Predecessor Auditor

The successor auditor may become aware of information that suggests that financial statements reported on by the predecessor auditor might require revision. If so, the successor auditor should request the client to inform the predecessor auditor of the situation and arrange for the three parties to discuss this information and attempt to resolve the matter. This requirement differs from SAS No. 7. SAS No. 7 required that the three parties meet to resolve the issue.

Once again, if the client refuses to cooperate by informing the predecessor auditor or if the successor auditor is not satisfied with the resolution of the matter, the successor auditor has additional responsibilities. First, the successor auditor should evaluate the possible implications of the matter on the current engagement. Second, especially when the client has refused to cooperate in attempts to resolve the matter, the successor auditor should consider the need to resign from the engagement. Because of legal implications, the successor may wish to consult with his or her legal counsel in determining an appropriate course of action.

Establish New Firm Procedures

Because SAS No. 84 responds to existing difficulties by practitioners in complying with the communication requirements of SAS No. 7, it is not surprising that SAS No. 84 is very meticulous in spelling out the responsibilities of the successor auditor both before accepting an engagement and after. Peer reviewers are likely to receive instructions to closely monitor practitioners' compliance with the requirements of SAS No 84. As such, it is vitally important that practitioners understand these new requirements and establish firm practice procedures that will minimize the likelihood that a firm might fail to comply with these new, expanded professional responsibilities for communicating with the predecessor.

Kay W. Tatum, PhD, CPA, is an associate professor, and Paul Munter, PhD, CPA, a professor and KPMG Peat Marwick Scholar, both at the University of Miami.