The CPA Journal

New GAO Independence Standard

By Craig Foltin

In Brief

Independence Controversy Hits the Yellow Book

The controversial new GAO independence standard calls for strict restrictions on the scope of services provided by auditors that are far broader than the restrictions found in the recent SEC and AICPA independence rules. A review of the comments to the original exposure draft reveals a marked difference in opinion between the public practice community and the government audit community of the standard’s provisions. Critics claim that the standard is too complex and will significantly drive up the cost of audits. The new standard likely represents the beginning of a new, post-Enron phase in the independence debate, one that may be marked by an increasingly limited scope of services and diminished self-regulatory powers.

On January 25, 2002, The U.S. General Accounting Office issued the greatly anticipated final amendment to Government Auditing Standards (Yellow Book) titled Independence. These standards, often referred to as Generally Accepted Government Auditing Standards (GAGAS), are required under the Inspectors General Act of 1978, the Office of Management and Budget (OMB) Circulars A-73 and A-133, the Chief Finance Officers Act of 1990, and the Single Audit Act of 1984.

The proposed changes affect both CPA firms and government auditors, including all auditors of federal, state, and local governments and not-for-profit and for-profit recipients of federal and state grant and loan funds. Examples include auditors of cities, counties, school districts, colleges, hospitals, and charitable organizations.

The Advisory Council on Government Auditing Standards, appointed by the Comptroller General, is responsible for reviewing standards and recommending changes. They issued a preliminary views document in April 2000 which raised a stir, but the exposure draft issued May 4, 2001, and the final standard have been even more controversial. The standard concentrates on nonaudit services, personal impairments, differences between external and internal reporting, and organizational impairments. The seemingly unending independence debate continues with this standard.

A Checkered Past

Auditors exist to provide an honest, objective, and independent review of financial statements. The new general Yellow Book standard reads:
In all matters relating to the audit work, the audit organization and the individual auditors, whether government or public, should be free both in fact and appearance from personal, external, and organizational impairments to independence and should maintain an independent attitude and appearance.

Auditors, however, possess inherent characteristics that impair independence. Unlike a judge, who is not dependent on clients for income or continuance of employment, a CPA is dependent on clients for employment, and their work is not subject to scrutiny of a higher court. In addition, there are the issues of auditors’ financial dependence on a client, the provision of consulting and management services, and the emergence of large firms with conflicting financial interests.
To ensure user confidence, there has been considerable discussion and new regulations to deal with these perceived threats to independence.
Exhibit 1 is a timeline of notable independence actions.

Proposed Revisions

The new standard addresses three principal concerns. In the first, which is the most expansive, the GAO supplements the definition of personal impairments to include broad restrictions on the scope of services provided by auditors. The advisory council noted ambiguity in definitions of personal impairments and added criteria to expand what is presently considered an independence conflict. The GAO provides two broad general principles to use for guidance:

Audit organizations may still provide some nonaudit services that do not violate the above principles and restrictions, but they must follow extensive procedures relating to documentation, quality control systems, communication with the audit organization, monitoring, and management responsibilities.

Many services commonly provided by Yellow Book auditors will no longer be allowed. The revised GAO standard now prevents the audit client from continuing to obtain these services from the auditor. The standard severely limits or expressly prohibits bookkeeping and record-keeping services; payroll processing; and the design, development, or installation of accounting systems. Specifically, auditors may not post transactions of any type (coded or not coded) to an entity’s financial records, or provide any payroll services if payroll is material to the audit—activities currently allowed under existing rules and AICPA guidance. Thousands of entities and auditors will be affected by these changes.

In a counterintuitive position taken by the GAO, audit organizations are still allowed to prepare adjusting, correcting, and closing entries for the audited entity as well as draft financial statements, and draft notes as long as they are approved by management. Other allowed services include preparing routine tax filings, assisting management on human resource functions, preparing indirect cost proposals, and advising on internal controls.

A second, less controversial area addressed in the new standard is the difference between external and internal reporting, specifically when reporting to management. The GAO suggests that internal auditors must now document conditions, include internal policies and procedures for reporting and resolving external impairments, and be subject to an external quality assurance review in order to demonstrate organizational independence.

Third, the new standard proposes expanding the criteria that define how organizations can be free from impairments to independence. Examples include organizational heads being directly elected by voters, subject to removal by a legislative body, or accountable to a statutorily elected body.

Departures from SEC and AICPA Guidance

The SEC and AICPA have also recently released new authoritative guidance on independence. The SEC’s final rules on auditor independence, issued in November 2000, contained additional requirements for nonaudit services, internal audits, audit fees, and employees and family members that hold investments in audit clients.

In August of 2001, the AICPA modernized its independence rule as part of an update to the Code of Professional Ethics. The overriding goals of this modernization were to update and simplify the rule while harmonizing it with the SEC. Most of the same topics covered by the GAO’s standard were also addressed by the AICPA and SEC. Exhibit 2 details key differences between the standards. Although there are some moderate differences between the SEC and AICPA rules, the GAO’s proposal is significantly broader and more restrictive than both.

Comments from the Profession

To say the new standard is controversial would be an understatement. The first two amendments to the Yellow Book each received less than 50 comment letters. The independence standard’s exposure draft received by far the most comment letters of any GAO issue, with 635 responses, 88% of which were from the professional audit community and clients. Exhibit 3 summarizes the responses. A clear division can seen between the professional practice community, which includes the AICPA, state societies, the Big Five, and clients, and the government audit community, which includes federal, state, and local government, and internal auditors. The professional practice community strongly opposed the standard; the government audit community generally supported the GAO’s changes.

The professional practice community thought that the GAO did not adequately consider the full effect of the rule changes and that there is insufficient evidence to support stricter rules on the profession. Major criticisms of the standard include the following:

The AICPA commented: “The costs associated with the implementation of the standards as proposed far outweigh the intended benefits to the government and the taxpayer public it serves.” The Government Finance Officers Association (GFOA) commented: “We must go on record opposing the proposed guidance that we believe ultimately would prove detrimental to audit quality and place an undue burden on many of the nation’s smaller governments.”

Many objections focused on non-audit services. Opponents have said that the proposal will unduly reduce or eliminate auditor involvement in essential services such as bookkeeping, payroll, GAAP conversions, and human resources. Impeding an auditor from performing these services may not be geographically or economically feasible. In fact, it may even reduce audit quality because there would be fewer qualified firms, and independent auditors might not share knowledge in fear of compromising independence. It has been argued that the potential decline in actual audit quality is far greater than any perceived gains in independence.

On the other hand, the government audit community offers some strong points in support. From their perspective, the standard is theoretically sound and follows the original intent of lawmakers. After all, how can auditors objectively audit a schedule they themselves prepared or be impartial with a finance officer hired by their firm? Such now restricted activities definitely appear to promote perceptual bias and leave much room for actual independence impairment. But the question remains whether they impair actual independence.

The AICPA’s Position

Most of the profession appeared to think that the existing SEC and AICPA guidance is sufficient. Adding another conflicting source of guidance only adds to the complexity and confusion of the issue. The AICPA argued that the GAO should simply refer to the non-audit service restrictions in Interpretation 101-3 of the Code of Professional Conduct. The GFOA believes that this document “already provides relevant guidance that, in our view, is both practical and theoretically sound.” Many in the professional community think that the AICPA deliberated the topic fully and has done a good job of self-regulation thus far.

The AICPA’s words seemed to fall upon deaf ears. There were substantial changes to the final standard from the original exposure draft, but many of the revisions were even more restrictive. In the wake of the Enron debacle, the AICPA’s arguments may be losing their weight with the GAO. The AICPA’s position has softened somewhat, and they are collaborating with the GAO to develop clear guidance.

Now What?

With such strong opposition to the new standard, the GAO took a tough stance. The GAO Advisory Council’s position is based upon sound concepts and strong theory. The audit profession does have an interest in opposing such changes, as they will more than likely lose engagements and revenue. This standard may be the beginning of the end of the accounting profession’s unfettered self-regulation. The GAO appeared overly cautious when they first issued the exposure draft. After the Enron debacle, the GAO appears to be ahead of the pack. Look for many more stricter changes to occur now that the issue has become politicized. Further elimination of any nonaudit services and the prohibition of audit firms soliciting audit engagements may be next. Even the federalization of accounting standards might not be out of the question.

The amendment to the standard becomes effective for all audits with periods beginning on or after October 1, 2002. It is critical that all auditors become familiar with the new standard immediately in order to prevent unknowingly performing newly prohibited services. To review the standard, comments from the AICPA, or other information, see the web sites in Exhibit 4.

Craig Foltin, DBA, CPA, is the mayor of Lorain, Ohio, and a part-time lecturer at Cleveland State University.