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Independence Questions Recurring Theme at PCAOB's Small Business Auditing Forum

How much advice can a small company get from its auditor?

August 2, 2007
from BNA Tax and Accounting

(Excerpted from Accounting Policy & Practice Report, July 13, 2007)

SAN FRANCISCO — A recurring question at the Public Company Accounting Oversight Board's (PCAOB) June 27-28 Forum on Auditing in the Small Business Environment was, how much advice and assistance auditors can give to their small public company clients without crossing the line that separates an independent auditor from a non-independent one.

PCAOB member Daniel Goelzer told BNA that the PCAOB has found in inspections that auditor participation in the creation of financial statements is a very common problem in the small business environment.

Specifically, one of the most commonly cited problems in PCAOB inspections is a violation on the prohibition against independent auditors providing bookkeeping and other services related to financial statements. This includes preparing source data underlying the audit client's financial statements and provision of appraisal or valuation services, fairness opinions or contribution-in-kind reports, according to Mark West, Denver-based regional associate director of inspections and the small firm national coordination for the PCAOB.

Goelzer told participants that when the PCAOB finds violations, it refers the issue to the Securities and Exchange Commission (SEC).

The bottom line according to officials from the PCAOB and the SEC is that auditors cannot satisfy independence rules if they audit their own work. Much discussion at the meeting on June 27th with auditors, and June 28th with financial officials and audit committee members of small businesses, went to what this means in practice.

When Does Advice Compromise Independence?

PCAOB and SEC officials said external auditors and company management can have early, robust and extensive discussions about areas that management should consider and controls that ought to be in place.

“They can have a conversation saying ‘here’s what you need to look at,’’’ said Sharon Virag, associate chief auditor with the PCAOB. “What auditors should not do is say, ‘Here’s the control you want to put in place, and here’s what it should look like,’” Virag said.

Auditors may provide general technical training for management, and may provide general tools, such as risk assessment models or blank checklists, according to both Virag and Josh Jones, professional accounting fellow with the SEC's Office of the Chief Accountant.

However, when asked if an audit firm could interview the client, and offer a checklist of what that client should do based on those interviews, Virag said that may be going too far in directing the client to a specific result.

“You can provide them with a lot of information on what they should be thinking of,” Virag said. “You can't make their decisions.”

If company management does not have the technical competence to deal with complicated accounting issues such as accounting for income taxes, fair value or stock options, company management must find that expertise elsewhere, rather than obtain it from their external auditor, the PCAOB officials emphasized.

Two small company representatives who spoke June 28th said that hiring the talent in-house will pay off in the long run, even though it is always difficult for small companies to devote the resources.

David Goldsmith, a member of the audit committee for Endocare, said: “The absolute last thing you want to do is hire experts [in accounting]. But, in the long run, it’s the best thing for the business, as revolting as that sounds.”

Goldsmith said that his company spends a lot of time worrying about independence issues, and a lot of money with law firms to police it.

Marty Baumann, director of the PCAOB’s Office of Research & Analysis, pointed out that violations of independence rules are not just a problem for the auditor. If a company’s external auditor is found not to be independent, it impacts the validity of a company’s financial statements, Baumann said.

Tullus Miller, a partner with small audit firm Moss Adams, said the accounting standards for income taxes and uncertain tax positions raise significant concerns about independence. He said that external auditors may not help companies with the measurement aspect of complying with the Financial Accounting Standards Board's Financial Interpretation 48 on uncertain tax positions. “At some point we may be giving too much advice” to qualify as independent, Miller said.

Common Independence Problems Encountered

West observed that many small audit firms have difficulty following all of the SEC and PCAOB rules on independence, noting that independence rules from the American Institute of Certified Public Accountants, which have been around much longer, are more relaxed.

An independence problem area encountered frequently by PCAOB inspectors is use of indemnification clauses in engagement letters, West said. These indemnity agreements seek to limit auditor liability for situations in which there is a knowing misrepresentation by company management. West pointed out that the SEC strictly forbids these types of indemnity clauses, but AICPA standards do not prohibit them.
Many auditors that do most of their work for nonpublic companies routinely include these clauses in their engagement letters, and neglect to remove them from engagement letters with public clients, West said. These clauses also appear in engagement letters with foreign audit firms, West said, noting that there is a very different attitude toward auditor independence in other countries.

Auditors also must provide annual written disclosure to audit committees of all relationships between the auditor and its related entities and the company and its related entities, known as an ISB No. 1 letter. West said that in practice the PCAOB has found that these disclosures often are sent late.

The presentation material from the PCAOB meeting is available on the PCAOB Web site (PDF). For more information about the Accounting Policy & Practice Series, please visit http://www.bna.com/promotions/appsp3/.

Copyright © 2007 by The Bureau of National Affairs, Inc., Washington D.C.