ISBS NO. 1: THE FIRST STEP TOWARD EFFECTIVE COMMUNICATIONS WITH AUDIT COMMITTEES ON INDEPENDENCE
By Douglas R. Carmichael, PhD, CFE, CPA
The Independence Standards Board (ISB) has issued Independence Standard No. 1, Independence Discussions with Audit Committees. It is effective for audits of financial statements of public companies with fiscal years ending after July 15, 1999, but earlier application is encouraged. It applies to any auditor intending to be considered an independent accountant within the meaning of the securities acts administered by the SEC, so it would apply to engagements for both reviews of quarterly financial information and audits of annual financial statements.
ISBS No. 1 requires the auditor to provide the audit committee (or the full board if there is no audit committee) a written description of all relationships between the auditor (and its related entities) and the company (and its related entities) that in the auditor's professional judgment may reasonably be thought to bear on independence. The written description also has to confirm that the auditor believes the auditor is independent within the meaning of the securities acts. The auditor must also discuss the auditor's independence with the audit committee. Both written and oral communications are required at least annually. The ISB observes that ideally the communication would occur before any substantive audit procedures had begun, but ISBS No. 1 does not require that timing.
Implementation of this new requirement will require a CPA firm to review quality assurance policies and procedures related to monitoring independence to ensure the firm's current approach is adequate. The communication mandated by the ISB has to encompass the relationships of all related entities and not just the CPA firm. "Related entities" is not defined, but presumably would include a strategic alliance with another entity in which the CPA firm has no equity interest. The spirit of ISBS No. 1 tends toward inclusiveness. CPA firms will have to establish a mechanism for ensuring that the auditor with final responsibility for the audit engagement is informed of all relationships with the company and its related entities that may reasonably be thought to bear on independence.
Beyond the specific requirements of the first standard, this initial pronouncement is interesting for its implications concerning the ISB's attitude and approach in the following areas:
* Ethics enforcement
* Quality communication
* Corporate governance and GAAS.
Ethics Enforcement. Isolated and inadvertent violation of ISBS No. 1 would not constitute per se an impairment of the auditor's independence, provided that the auditor is in compliance with all other independence rules. The auditor must, however, promptly remedy the violation upon discovery. This ability to remedy a violation is important because when independence is considered to be impaired, an audit in accordance with GAAS is not possible. The auditor would not be able to provide any assurance on the company's financial statements. The ISB's position seems to be that as long as a CPA firm has made a good faith attempt to comply with the requirements and responds appropriately to any isolated instances of noncompliance, there would be no impairment of audit independence. Ethics enforcement actions have been known to follow this same approach, with the evaluation of whether the violation was isolated and inadvertent being made by individual panel members in the circumstances of the particular case.
This is the first time the professional requirements have themselves contained an explicit recognition of the "isolated and inadvertent" defense. It will be interesting to observe whether this approach will become the norm for ISB pronouncements.
Quality Communication. The ISB has opted for quality communication with the audit committee on independence issues rather than a simple affirmation of conformity with professional standards. The SEC Practice Section of the AICPA had proposed that CPA firms be required to confirm their independence annually to the audit committee. This written affirmation was to include an invitation to meet with the audit committee to discuss independence matters, but the discussion was voluntary.
The ISB rejected that approach in favor of mandatory written and oral communications that are meant to
provide a more fulsome discussion of independence matters. The ISB describes the dual benefits of its approach as follows:
* Corporate governance is improved by affording audit committees a "mandated opportunity" to deepen their understanding of independence issues.
* CPA firms will bring more focus to the independence issue within
The ISB acknowledges that its authority to establish corporate governance requirements is controversial but has found an effective means of disposing of that issue.
Corporate Governance and GAAS. One of the most interesting features of ISBS No. 1, and the feature with the greatest long-term implications, is the solution adopted to the problem of potential lack of authority in the corporate governance arena.
The ISB did not concede that it lacked authority to impose requirements on audit committees, but sidestepped the issue by imposing the requirement on the auditor. The
ISB observes that the auditor of a public company has to comply with
ISBS No. 1 and would be expected to
withhold issuance of the audit report until the mandated discussion with the audit committee takes place.
The Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees has recommended that the listing rules for both the NYSE and NASD require that the audit committee charter for every listed company specify that the audit committee is responsible for ensuring receipt of the communications required by ISBS No. 1. This would be helpful and lend support to the ISB, but why not push the NYSE and NASD to mandate compliance with all ISBSs that involve audit committee communications with the auditor? This broader commitment would bring the investment community into the picture as a full-fledged supporter of the process.
On a related matter, the Blue Ribbon Committee also recommends that GAAS require a company's independent auditor to discuss with the audit committee the auditor's judgments about the quality, not just the acceptability, of the company's accounting principles. This would jump-start the languishing proposal on this same point made in September 1994 by the Kirk panel on auditor independence in a report to
The next logical step in getting audit committees on board to improve the quality of audits and financial reporting would be for the AICPA's Auditing Standards Board to amend SAS No. 61 to mandate the communications to audit committees required by the ISB and proposed by the Kirk panel.
A Procedural Note
In accounting and auditing authoritative literature, the term "auditor" traditionally means the person on the engagement team with final responsibility. The ISB goes back and forth between the auditor being "it" (the CPA firm) or "he or she" (the person with final responsibility). Following a single convention would add clarity. *
FIVE IMPORTANT PROPERTIES OF ACCOUNTING NUMBERS
By Thomas R. Craig
Auditors work with numbers practically every day. There are five interesting properties of accounting numbers that are directly relevant to the day-to-day work of most auditors.
Large Numbers Are Important, Small Numbers Are Not. Everyone who works with numbers ends up being distracted, at least occasionally, by insignificant items that have captured their time and attention. To be sure, experience helps in judging whether an item is significant or not. However, unless an auditor makes a concerted effort to stay focused on what is important, she inevitably becomes distracted by minutiae and the myriad exceptions produced by an imperfect world. As a result, the auditor wastes not only her own time and energy, but also the time and energy of client officials and audit staff personnel that interact with her.
Here are a few pointers for developing insight into relative magnitudes when working with numerical data. First, be mindful that Pareto's "20/80 rule" (i.e., 20% of the items account for 80% of the total) fits most heterogeneous economic populations reasonably well. Second, the "largest order of magnitude rule" is an informal technique to avoid insignificant details. Under this rule, the focus is only on items greater than one-tenth the size of the largest item in the population. Third, data residing on computer-accessible files frequently can be graphed or sorted to provide useful insights into relative magnitudes. In the final analysis, however, there is no substitute for keeping perspective, priorities, and purpose firmly fixed in mind when working with numerical data. Perfectionism and the tendency to be distracted by insignificant detail extract a huge cost in auditing.
Noise Tends to Cancel out, Bias Does Not. Noise is a statistical term referring to effects of random errors, which have a cumulative expected value of zero. Bias does not have an expected value of zero, but rather a positive or negative value, depending upon intent. When accounting data have been developed in an unbiased manner, income effects of individual misstatements tend to offset one another, especially in large, multidivisional companies. However, when income has been biased via a series of individual actions and judgments, detected misstatements will tend in the same
At the conclusion of an audit, an auditor may not know which detected misstatements reflect random noise and which, if any, reflect systematic bias. Nonetheless, if she suspects that detected misstatements reflect bias, she may be more inclined to propose adjustments than if she believed otherwise. Client officials normally do not attempt to conceal noise (which has an expected effect on income of zero), but would be expected to attempt to conceal bias (which typically has an effect on income). Hence, if the aggregated effect of detected misstatements is anywhere close to materiality thresholds, an auditor would be prudently concerned about the possibility that further undetected bias would cause the financial statements to be materially misstated.
Editor's Note: Under Lee Seidler's proposal in this month's CPA Journal, all but inconsequential adjustments would have to be recorded. That would not, however, eliminate the need to consider whether undetected bias exists.
An Estimate Is No License to Be Sloppy. Accounting information based upon objective facts is usually developed with reasonable care. However, there is a tendency for a noticeable degree of imprecision and lack of analytical rigor to creep into calculations involving accounting estimates. While it is true that estimates are inherently less precise than facts, this lack of precision is not a license for sloppiness.
Significant accounting estimates should be based upon explicit assumptions and objective calculations that function within the context of existing facts. Otherwise, estimates tend to become subjective opinions for which objective standards of evaluation do not exist. In some instances, management's inability to articulate assumptions and furnish objective calculations to support an estimate may cause an auditor to conclude that a reasonable estimate cannot be made in the first place.
Different Samples Give Different Results. Auditors base conclusions on samples all the time. For example, if the audited value of a sample is 103% of book value, an auditor might project a three percent dollar misstatement to the population. While there probably is nothing incorrect with this error-projection method, it is quite incorrect for the auditor to assume the projected misstatement actually equals the true misstatement. If the auditor drew a different sample, he would almost certainly project a different misstatement, and the difference between the two projections can be quite large.
The fact that different samples yield different estimates should give pause to all people that work with samples, auditors included. Unfortunately, it usually doesn't. Distributions of sample outcomes are much more diverse than people realize.
Income Misstatements Originate in One Period and Reverse in Another. People intuitively understand how misstatements in closing balance sheet accounts misstate current-period income. However, many inexperienced accountants and auditors fail to internalize the notion that errors in the opening balance sheet also can misstate current-period income. For example, if a year-end accrued liability is omitted, the omission causes income to be misstated in both the period the liability is omitted and the period the liability is settled.
In most continuing engagements, an auditor will have waived various adjustments in the prior period due to immateriality and will have also detected potential adjustments to current-period statements during the current-year audit. In evaluating audit findings, it is natural to focus primarily on how end-of-period misstatements affect current-period income. However, paragraph 30 of
SAS No. 47 states:
If the auditor believes that there is an unacceptable high risk that the current period's financial statements may be materially misstated when those prior-period likely errors that affect the current period's financial statements are considered along with likely errors arising in the current period, he should include in aggregate likely error the effect on the current period's financial statements of those prior-period likely errors.
This paragraph alerts auditors to apply good judgment when making the overall evaluation of the financial statements, especially those that may be applying the "iron curtain" approach. That approach says that once a set of financials has been given a clean opinion it is, for all practical purposes, accepted as being "correct." The cumulative effect of unadjusted items cannot be ignored. *
Thomas R. Craig, PhD, CPA, is a professor of accounting at Illinois State University.
Douglas R. Carmichael, PhD, CFE, CPA
Stan Ross Department of Accountancy,
Zicklin School of Business,
John F. Burke, CPA
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